This Fiesta Ain't No Party

Professor Daniel Kleinberger brought the case of Movitz v. Fiesta Investments, LLC to the attention of the LNET-LLC listserve. This case arises from the bankruptcy of a member of a family limited liability company. It should serve as a warning to those who believe that LLCs are bulletproof asset protection vehicles.

The debtor was a member of Fiesta, a family LLC that had two assets, interests in a leasing company and in another LLC. The leasing company was sold shortly after the debtor filed bankruptcy. Fiesta received cash distributions in the amount of $837,000 from the sale of the leasing company and regular quarterly cash distributions from the LLC.

Rather than distribute the cash to its members, "substantial amounts of cash . . . flowed out of Fiesta to or for the benefit of . . . members [other than the debtor or the bankruptcy trustee], including $374,500 in loans to members or to corporations owned or controlled by members, a $42,500 payment to one member, and $124,000 paid to another member to redeem his interest." In response to the bankruptcy trustee's demand for information and distribution, the managing member of Fiesta, the debtor's father, stonewalled. He stated that he "created 'Fiesta a few years ago to remove assets from our estate for estate tax purposes, and to accumulate investments for the benefit of our children after our deaths . . .[W]e see no reason to accede to the wishes of any member or assignee of any member which runs contrary to our original goals.'" The court rather dryly noted that "the outflow of over half a million dollars does not seem to be consistent with the original goal 'to accumulate investments for the benefit of our children after our deaths.'"

Fiesta argued that under Arizona law and under the terms of Fiesta's operating agreement, an assignee of an LLC interest remains a mere assignee and does not become a member of the LLC. Thus, it contended that the assignee would "only [be] entitled to receive to the extent assigned the share of distributions . . . to which such Member would otherwise be entitled with respect to the assigned interest." The court totally rejected that argument, concluding that:

All of the limitations in the Operating Agreement, and all of the provisions of Arizona law on which Fiesta relies, constitute conditions and restrictions upon the member’s transfer of his interest. Code § 541(c)(1) renders those restrictions inapplicable. This necessarily implies the Trustee has all of the rights and powers with respect to Fiesta that the Debtor held as of the commencement of the case.

The court was able to reach this conclusion because Fiesta, more specifically, its operating agreement, did not constitute an executory contract. As the court noted:

not only do there not appear to be any obligations imposed upon members by the Fiesta Operating Agreement, but there are certainly none with respect to either receipt of a distribution or proper management of the company by its managers. Members do not have to do anything to be entitled to proper management of the company by the managers. The Trustee’s complaint does not involve the Debtor’s lone arguable obligation not to voluntarily withdraw.

In responding to Kleinberger's posting, Jay Adkisson noted that the:

court's reasoning as to the executory/nonexecutory issue is probably correct.

But doesn't this have the potential to effectively gut charging order protection for a non-managing membership interest, at least to the extent that a creditor can maneuver a debtor-member into bankruptcy?

While Adkisson's analysis may be correct, the case could have been decided on much narrower grounds. Specifically, even if the trustee were merely an assignee of the debtor's rights to distributions, the actions of the other family members were nothing short of an attempt to fraudulently divert assets (i.e., the distributions) that rightfully should have been paid over to the trustee. The court's action in making the trustee a member is problematical since there are arguably some remaining obligations imposed upon the members.

While it is true that the members had no real management responsibility, they certainly had the right to participate in making certain types of decisions with respect to Fiesta's business. By way of example, it is reasonable to expect that at some point in time the members might have to consider refinancing or selling Fiesta's remaining asset. To the extent that each of the members entered into the LLC predicated on their faith in each of the other members' business acumen and judgment, their legitimate expectancies are being frustrated when the trustee becomes a member. At that point, they will have a partner that they did not bargain for.

Typically, I will draft operating agreements that allow members to assign most of their economic rights to family members, but require that voting rights be retained by the true "partners" in the deal. The reason is simple--the members agreed to join with each other in large measure due to their faith in the judgment of those specific individuals who are entering into the deal, not their spouses, their children, or trustees of family trusts. To the extent that any residuum of management decision making remains, the LLC remains an executory contract and the trustee should not be admitted as a substitute member.

Contingent Attorneys' Fees Not Really Deductible

In November, I commented on the cases cases of Commissioner v. Banks and Commissioner v. Banaitis. I also commented on Rev. Rul. 2004-109 and Rev. Rul. 2004-110. In concluding, I pointed out that:

If the Service prevails in Banks and Banaistis, as a practical matter, pro athletes will not be able to deduct the consideration paid to their agents since virtually all of these athletes are subject to the alternative minimum tax. Of course, this dramatically increases the transactional costs that they incur in the course of the negotiation.

Today, by an 8 to 0 vote, the Supreme Court upheld the Service's position in Banks and Banaistis.

The opinion is relatively straight-forward, rejecting the taxpayers' claims that by entering into contingent fee contracts they had assigned something other than income or, alternatively, that they had entered into partnerships or quasi-partnerships with their attorneys. The Court also rejected the taxpayers' variations on these themes, where they contended that some state attorney lien statutes effectively divested them of a portion of their rights to recovery before those rights had ripened into income.

One part of the opinion is curious and, I think, clearly wrong. The Court took note of the passage of the American Jobs Creation Act of 2004 which amended the Internal Revenue Code by adding §62(a)(19). (A copy of the Conference Committee Report for the Act can be found here.) That portion of the Act allows a taxpayer, in computing adjusted gross income, to deduct "attorney fees and court costs paid by, or on behalf of, the taxpayer in connection with any action involving a claim of unlawful discrimination." It defines "unlawful discrimination" to include a number of specific federal statutes, §§62(e)(1) to (16), any federal whistle-blower statute, §62(e)(17), and any federal, state, or local law "providing for the enforcement of civil rights" or "regulating any aspect of the employment relationship . . . or prohibiting the discharge of an employee, the discrimination against an employee, or any other form of retaliation or reprisal against an employee for asserting rights or taking other actions permitted by law." These deductions are permissible even when the alternative minimum tax applies.

Taking note of the Jobs Creation Act, the Court stated that "[h]ad the Act been in force for the transactions now under review, these cases likely would not have arisen." While that might be true with respect to Banks' claims which were squarely articulated as civil rights claims, it does not seem to be correct with respect to Banaitis. As described by the Court, Banaitis contended "that Mitsubishi Bank willfully interfered with [his] employment contract, and that the Bank of California attempted to induce [him] to breach his fiduciary duties to customers and discharged him when he refused." I simply do not understand these claims to arise out of "a claim of unlawful discrimination."

The Court's action today underlines the concerns that I voiced in November concerning the "warping of the negotiation process . . . putting the employee at a severe disadvantage when negotiating the end of an employment relationship gone sour."

All the News That's Fit to Link, Part II

I've now uploaded additional documents in the ongoing litigation between the Sun and Governor Ehrlich. An index which describes and links to the documents can be found here.

The story has now gotten national attention, including a mention in The New Republic. (While some articles in TNR are available for free online, the weekly Notebook feature in which the comment appears is available to subscribers only.)

In a nutshell, Ehrlich is contending that all that he is doing is blocking reporter Nitkin and commentator Olesker from so-called "particularized" access to governmental officials. That is, direct, private interviews, off-the-record briefings, etc. The Governor is simply lying.

The initial memo (which can be found on page 8 of the Sunpaper's Complaint) is not limited in any way. It states categorically that no one in the Executive Department or any agency is to "return calls or comply with any requests" from Nitkin and Olesker. More recently, Nitkin was locked out of a public press conference on the pretext that it was by invitation only. See here. Thus, it is manifest that the Governor is attempting nothing less than to embargo governmental information from flowing to these two journalists.

There are actually three disturbing aspects to this case.

The first is, of course, that an elected official feels that he has the power to lock out specific reporters from access to information whenever they displease him. Ehrlich's arrogance in this regard is best illustrated by his reference to "his government" and his quite explicit intent to create a "chilling effect" upon the journalists.

The second is more subtle. The Sun has made overtures to the Governor that would resolve this matter in an amicable way. Obviously, I am not privy to the discussions between the Governor's office and the Sun, but it strikes me that the Sun's attempt to make nice is wholly inappropriate. What Ehrlich has done is unacceptable and the Sun should offer him nothing but the back of its hand and the rough of its tongue.

Finally, this is a matter that should not be reported merely in snippets. The Sun should do what I have undertaken to do--publish on the web the source documents from both sides.

Malpractice Corrective

Judge Richard A. Posner offered several comments concerning recent efforts at tort reform, in general, and medical malpractice, in particular. They appear on the weblog that he publishes with Professor Gary S. Becker.

First, he points out that the total cost of malpractice premiums are only about one percent of U.S. health costs.

Second, he notes that while so-called "defensive medicine" may be viewed as an additional cost derived from medical malpractice claims "there may be offsetting benefits, to the extent that defensive medicine actually improves outcomes for patients; and surely it does for at least some."

Third, he points out that "[n]o doubt capping judgments, which is the principal reform that is advocated, has some tendency to reduce premiums, but perhaps not much, because there is evidence that premiums are strongly influenced by the performance of the insurance companies' investment portfolios."

Judge Posner concludes that "it is simplistic to assume that the total annual malpractice premiums paid is a good index of the net social cost of malpractice liability, or that measures to reduce those premiums by capping malpractice liability would result in a net improvement in welfare." He thus warns that "[w]e should be cautious about tort reform. It would be unfortunate if interest-group politics, and anecdotes concerning outlandish lawsuits (such as the suit against McDonald's by the customer who spilled hot coffee in her lap), were allowed to obscure the difficult policy issues."

I have significantly abbrieviated Judge Posner's comments. One should read them in their entirety as well as Professor Becker's response. (Becker points out, inter alia, that the American tort system has a "tendency to underestimate compensatory damages." Of course, the principal suggested correctives to the alleged malpractice crisis generally involve reducing the availability of compensatory damages.)

Reading Posner's and Becker's comments make more obvious the conclusion that the current "debate" in Maryland over the malpractice issue is more of a shouting match than a debate, since the arguments on both sides, particularly those advanced by the Governor, are virtually devoid of any empirical support. By way of example, the proponents of capping compensatory damage awards have not offered any evidence as to the amount malpractice premiums might be reduced as a result of the caps.

Genug Ist Genug!

One of the most hilarious websites is VidLit. Perhaps the funniest bit on Vidlit is Yiddish with Dick and Jane. While of immense artistic value in its own right (the concept of pediatric gynecology, standing alone, is simply brilliant), the web piece is really an extended advertisement for the "bestselling parody," Yiddish with Dick and Jane.

Today, the NY Times reports that "Pearson Education, the publishing company that owns the copyright to the Dick and Jane reading primers, has filed a lawsuit against [the publisher]in Federal District Court in Los Angeles claiming that the book . . . violates Pearson's copyrights and trademarks for the familiar characters."

Other weblogs have offered detailed, and even scholarly, economic and legal criticism of our copyright laws and their extension under the unholy alliance of Hollywood lobbying and Republican corporatism. But, really, the schmendricks at Pearson Education go too far. Can't these guys take a joke? I'm certain that the attorneys for the defendants will craft an appropriate formal legal response to the law suit, but shouldn't it be sufficient for them to merely say "Kush meer in toches?"

Acting Responsibly

In Lubetzky v. U.S., the First Circuit addressed the question of whether a individual who was designated as a corporate officer was a "responsible person" for purposes of liability for the 100% penalty for unpaid withholding taxes under IRC §6672.

The Court began its analysis by acknowledging that:

[T]here is a surprising gap at the center of [§6672]: it nowhere says who is so required or whether "required" refers to some statutory concept, common law doctrine, company by-laws or actual practice, or some mixture of all these.

According to the facts, there were a number of quarters at issue where the testimony was essentially uncontradicted that the taxpayer could only pay those bills that were approved by his superiors. The taxpayer testified that he would have regarded himself as "stealing" if he had acted contrary to his superiors'directions.

The Court acknowledged that if the taxpayer were a mere bookkeeper who only wrote checks, he would not be liable under §6672. However, the Court concluded that, because of the position held by the taxpayer (he was nominally the chief financial officer and had held himself out as an executive vice president of the company), the taxpayer had to confront what the Court termed a "harsh dilemma"--either confront top management and possibly resign from his position or face liability under §6672.

The Lubetzky opinion seems to me to say too much. If Lubetzky was truly a cypher, only executing the orders of others, he doesn't fall within the ambit of a statute that imposes some fairly harsh penalties. However, I am not certain that his actions fail the "responsible person" prong of the statute. Conceptually, it seems to make more sense to take the position that the willfullness prong is not satisfied, since he had no abililty to willfully make any payment other than as directed. The Court basically skipped any analysis of the willfullness requirement, stating that everybody agreed that the requirement was satisfied because Lubetsky knew that the taxes were due, but made other disbursements anyway.

The case is worth reading as well for the distinction the Court drew between the facts presented and those presentd in Vinnick v. Commissioner, 205 F.3d 1 (2000). In that case, the taxpayer, unlike Lubetzky,was "neither paid by the company nor engaged in day-to-day business affairs, had no office at the company, and did not sign checks in the relevant time frame."

Who's On First?

More often than not, private letter rulings and Chief Counsel Advice memoranda deal with fairly esoteric questions of tax law, but present facts that are clear and unambiguous. It is a somewhat refreshing change to read a Chief Counsel Advice memorandum that deals with the sort of factual pattern that real life lawyers deal with all the time. That is, nobody could say with any certainty what the facts were. In CCA 200501001, a simple transaction became so overwhelmingly screwed up that the Service couldn't determine whether an LLC had only one member, making it a disregarded entity, or two members, calling for classification as a partnership for income tax purposes.

Sonny Boy and another individual organized the LLC in Year 1. The LLC filed for a tax identification number. As part of that process, it indicated that it was a partnership for tax purposes. It had no articles of organization or operating agreement.

Subsequently, the LLC ran into employment withholding tax difficulties. It did not cooperate with the Service with respect to the Service's investigation of the employment tax issue, but Sonny Boy "represented that [Daddy] became a member of LLC atapproximately the time the TIN was requested and that x percent of LLC was owned by [Sonny Boy]and y percent by [Daddy]." Ultimately, a notice of tax lien was filed against the LLC.

The LLC's authorized representative contacted the Service and stated that LLC should be treated as a single member LLC and not as a multi-member LLC. The representative explained that Daddy was a mere investor, was not a member of the LLC. The representative further explained that Sonny Boy reported all of the income from LLC on his Schedule C for each year of LLC's existence. Daddy concurred in this analysis, contending that he was merely an "investor" in the LLC, without any knowledge of being a member.

The Service essentially declined to offer any certainty to the taxpayers. It said that "There is insufficient evidence to determine the number of owners of [the] LLC. There are apparently no ownership documents or articles of organization. Moreover, inconsistent information has been provided." In other words, you might be a partnership, but then again, you might not be.

There seems to be little question in my mind that Daddy was perfectly happy to be a "member" of the LLC until he faced the possibility of being tagged with liability for unpaid employment taxes or penalties for failure to file partnership returns. (In fact, absent additional facts, Daddy would seem to have no liability exposure for unpaid employment taxes. However, it would not surprise me if his advisors had informed his that this was a possibility, since the CCA indicates that their professional performance was less than stellar.) The Service made the right call in throwing this fish back into the taxpayer's (or, should I say, taxpayers') lap(s).

The Write Stuff

Terry Cuff, a prolific writer and speaker on tax law subjects, was asked by a colleague, who was not a lawyer, to quickly summarize some general principles of writing for publication. Terry passed them on to some of his colleagues who are lawyers and I pass them on here because I think that they should be of interest to a wider audience.

• Write for a reader who is bored, disinterested, and has little patience. That often will not be far off the mark.


• Write for a reader who will only skim the text -- and perhaps pick what is interesting.


• Write for the reader -- not for yourself. Try to know your reader--or potential reader -- and divine what he or she is interested in.


• Be practical. Stress applications over rules. Use examples where appropriate.


• Say something useful. If you can, say something original, but definitely say something useful.


• Provide an introduction to capture the reader's attention. Assume that the reader has 100 manuscripts to read and that he will select only one of them based on the introduction. You are fighting for the reader's attention.


• Write in an inverted pyramid, with most important material at the front and least important material at the end.


• Have a strong summary close to the beginning. State all material conclusions in that summary.


• Use strong subtitles that summarize.


• Write introductory paragraphs of each section as if that is all the reader will read. Stress the conclusion of the section in the introductory paragraph.


• Generally, write paragraphs as if reader will read only the first sentence of the paragraph. This often will be the case. Readers often merely skim material.


• Write in a simple, direct style.


• Avoid long sentences.


• Minimize passive voice.


• Avoid or minimize introductory clauses.


• Stress subject-object-verb format.


• Write unambiguously. Check all pronouns for ambiguity.


• Readers tend to skip boxes, long quotations, etc. Summarize them in the text.
  


• Drop citations and unimportant material that break up the text to footnotes. Citations in text slow a reader down and disrupt the flow. (I understand that some periodicals require citations in text. This is an unfortunate, outdated practice, but one I cannot reform.)


• Edit ... edit ... edit ... edit. The best editing is multiple pass editing. On each pass, edit for a different purpose: content ... organization (does the text adhere to the best outline?) ... streamlining text for readability ... clarity and ambiguity ... subtitles ... section introductory paragraphs ... paragraph introductory sentences ... paragraph length ...sentence organization, simplicity, length and structure ... passive voice and personal writing quirks ... pronouns ... adverb placement ... punctuation ... spelling ... citations ... format and overall manuscript appearance ... finalread through. This represents many independent passes. Approach the material like a woodcarver who gradually shapes and forms his carved wood. Allow more time for editing the manuscript than for writing it in the first place. The key to excellent writing is excellent editing.
  

Terry states that, "I sometimes have not adhered to these principles quite so well as I should have. My writing would have been better if I had."

I have often said that there is no such thing as good legal writing. There is only good writing. While Terry's guidelines were designed to set out principles for drafting for publication, they are applicable as well to all written communication that is expositive (e.g., briefs, memoranda, letters to counsel and to clients, etc.)

Gee, It Really Was Educational

When I was much younger, I would often read science fiction. This met with a good deal of hostility from my parents who contended that the stuff was trash. My riposte was that it was really quite educational. I'm not at all certain that, at the time, I actually believed my argument, but the Court of Appeals just bought it in the case of Baltimore Science Fiction Society, Inc., v. Dept. of Assessments & Taxation.

BSFS owns a two-story building in Baltimore City. In 2001, it applied for an exemption from real property taxes on the basis that the property was "necessary for and actually used exclusively for a charitable or educational purpose to promote the general welfare of the people of the State" and was owned by "a nonprofit charitable, fraternal, educational, or literary organization." All of the parties conceded that BSFS qualifies as a literary organization. The question before the Court was whether the property was "necessary for and actually used [primarily] for . . . an educational purpose."

The Tax Court found, as a matter of fact, that:

1. BSFS, among other things, participates in a regional Baltimore Science Fiction Fantasy Conference, organizes writing contests, provides writing workshops and seminars, raises funds, and maintains a lending library.


2. The property is used for all of the BSFS activities. None of it is used for any other activity. About 20-25% of the building space is used for the storage of supplies and other items necessary for BSFS activities. The lending library takes up another 20-25% of the space. More than 30% is used for group functions, such as workshops and meetings. The building is open only on Saturday, Sunday, and Wednesday evenings, but during those times the public can visit the library or participate in other BSFS activities.


3. The organization is run entirely by volunteers, who donate time and money. Members of BSFS pay annual dues. Non-members are allowed to use the library and attend all BSFS activities, but they do not usually visit the library or attend meetings.

The SDAT contended that:

[T]he property did not qualify for the tax exemption because it was used primarily as a social or hobby club – that the building is open only on Saturday, Sunday, and Wednesday evening, that some of the organization’s major activities are held off-site or occur only infrequently, that the library is mostly for the members, that the "function" space is for business and social meetings, and that the existence of BSFS and its activities are not well-known to the public. Its witness contended that, because the property was not being used for "systematic instruction," it was not being used for an educational purpose.

The Tax Court agreed with BSFS, rejecting SDAT's suggested definition as being too narrow and limiting and, basically, "unworkable." The Tax Court concluded that requirement that property be principally used for educational purposes did not require that the property be frequently used for educational purposes since "the property, when open, is exclusively used to promote BSFS's educational purpose." The Circuit Court, however, adopted my parents' view that "promoting science fiction is [not] what is deemed to be the operations of an educational institution."

Before the Court of Appeals, SDAT argued that "property is not used for an 'educational purpose' unless it is used for 'systematic instruction' in a 'branch of learning.'" The Court of Appeals rejected this argument and said:

[T]he adjective "educational" cannot be limited in the way posited by SDAT and decreed by the Circuit Court. Formal instruction may be the heart of education, but it is not the entire body. Webster's defines the verb "educate" as "to give knowledge or training to; train or develop the knowledge, skill, mind, or character of, especially by formal schooling or study; teach; instruct." Webster's New Universal Unabridged Dictionary 576 (2nd ed. 1983). That allows for other methods of imparting knowledge and training. Courts have found that a museum may constitute an educational purpose. See Georgia O'Keeffe Museum v. County of Santa Fe, 62 P.3d 754 (N.M. 2002); In re Everson's Will, 52 N.Y.S.2d 395 (N.Y. App. Div. 1944). See also State Tax Comm. v. Whitehall, 214 Md. 316, 323, 135 A.2d 298, 301 (1957) (use of property by Foundation to conduct experiments in breeding of dairy cattle was for charitable and educational purpose; experiments "are comparable to research carried on under grants at universities and add to the dissemination and general store of scientific knowledge"); Oregon Writer's Colony v. Dep't of Revenue, 1996 WL 706994 (Or. Tax), 14 Or. Tax 69 (1996).

See Mom and Dad, whaddid I tell ya'.

Is That Reasonable, Part II

I previously commented on a reasonable compensation/disguised dividend case out of the First Circuit. I have also commented previously (here and here) on the issue of the underpayment of or attempts to recharacterize compensation in order to reduce FICA taxes. A new Fifth Circuit case, Brewer Quality Homes, Inc. v. Commissioner, shows that neither taxpayers nor the Service have determined which side their bread should be buttered on. The Fifth Ciruit's unpublished opinion throws little light on the tension inherent in the positions variously taken by taxpayers and the IRS with respect to these two issues.

Brewer Homes was a retail seller of mobile homes. It was a C corporation owned by a married couple, Jack and Mary Brewer. From the early '70's to the mid-90's, the company provided its owners with a comfortable living. However, in the mid-90's its business really took off. It had upwards of 22 employees and was able to pay Jack Brewer $762,186 in salary and bonuses 1995 and $863,559 in 1996. After an audit (and apparently some negotiation), the IRS determined that reasonable compensation for Mr. Brewer was $604,117 for 1995 and $485,966 for 1996. The remainder of the compensation in those years was deemed to not be a deductible expense, but, instead, a dividend to the Brewers.

The Court applied analysed the case using the following nine factors:

1. The shareholder/taxpayer's qualifications;
2. The nature, extent, and scope of the shareholder/taxpayer's work;
3. The size and complexity of the corporation;
4. The comparison of the shareholder/taxpayer's salary with the gross and net income of the corporation;
5. Prevailing economic conditions;
6. A comparison of the purported salary paid with other distributions to shareholders;
7. Compensation for comparable positions in comparable concerns;
8. The salary policy of the corporation with respect to other employees; and
9. The amount paid to the shareholder/taxpayer in previous years.

To some degree, this case will give succor to those attempting to minimize compensation in order to maximize FICA avoidance. After all, tax advisors of an ah, certain age, are comfortable with the various tests applied in reasonable compensation cases. However, a review of the cases recasting dividends as wage income for FICA purposes share certain other characteristics that one should pay attention to:

1. Is the shareholder the principal provider of compensable labor? Thus, if we are dealing with a professional practice where the income of the business is virtually exclusively driven by the professional services rendered by shareholder/owner, there is likely to be a finding that virtually all of the income is subject to FICA. That might not be the case, for example, if the service business is pyramidal, such as in an accounting firm with a large number of junior accountants who generate profit.


2. Is there a significant capital component to the business? For instance, a veterinary surgeon may have far less capital invested in equipment than, say, a radiologist. It might be relatively simple to carve out some income of the business as being a return on capital and thus free from recharacterization as compensation subject to FICA. It is worthy of some note that in the First Circuit reasonable compensation case that I commented on previously, that Court rejected the use of a "return on capital" analysis.
   

Sooner or later, some court or the Service should attempt to harmonize the treatment of what is, to a greater or lesser extent, two sides of the same coin.

All the News That's Fit to Link

I received an email from a friend who asked whether I could find a copy of the lawsuit that The Baltimore Sun filed in federal court against Governor Robert Ehrlich. The lawsuit has attracted national attention (since Ehrlich's action is a local example of the national trend of Republican Party elected officials using the power of their offices to attempt to cow the press), but for some reason the complaint itself was not freely available on the web.

I downloaded a copy of The Sun's complaint via PACER (a service of the federal courts that charges a relatively small fee) and you can see the complaint, together with Exhibit 1 (Governor Ehrlich's memo that set off the dispute) here. I will, as the case progresses, post and link to other documents that seem to me to be of general interest.

One question: Why didn't The Sun post the complaint? Certainly, the story is newsworthy. And, the Sun could hardly be accused of bias if, as I intend to do, it posted and linked to all important filings in the case. Going one step further, why don't all media outlets that publish on the web provide links to all available source documents pertinent to stories that they're covering?

Performance Enhancing Drug Update I

Via ContractsProf Blog we learn that the Yankees are assembling "an elite team of outside lawyers" to attempt to free the team from the contract with Jason Giambi due to his apparent admitted use of performance enhancing drugs. The posting links to a story in the New York Daily News picked up at philly.com here. The best quote:

"It's ridiculous," said one senior major league scout visiting the Dominican winter league. "Nobody looked at (Giambi) and didn't know he was on something?"

Now where have I heard that before?

Not Snarky

I had intended to write a snarky posting about the baseball steroid scandal. Tenatively called "Baseball's Claude Raines Moment" it would have shown early career and current pictures of Barry Bonds and Jason Giambi. The point, of course, would have been that no sentient human being could be surprised that they were using steroids and other performance enhancing drugs.

However, before I posted I came across Phillip Carter's piece in Intel Dump. Carter takes the high road and, after reading it, I just couldn't summon the energy to smirk online.

No Infinite Arm

Due to the press of other business, this will be a short post.

Today, Judge Andre M. Davis of the U.S. District Court for the District of Maryland issued a careful and well-reasoned opinion in a case that raised issues concerning whether long-arm jurisdiction could be exercised over a defendant simply because it maintained a web site that sold goods to Maryland residents. The case, Shamsuddin v. Vitamin Research Products, dealt with a claim for patent infringement.

The plaintiff who holds the patent is a professor at the University of Maryland School of Medical. The principal defendant is a Nevada corporation that manufactured and sold the allegedly infringing product. The defendant has no assets in Maryland and sells its products via the Internet and through a toll-free telephone number.

The court discussed the so-called "sliding scale" approach first articulated in the case of Zippo Manufacturing Company v. Zippo Dot Com, Inc., 952 F. Supp. 1119 (W.D. Pa. 1997). In a nutshell, the touchstone of that test is that "the likelihood that personal jurisdiction can be Constitutionally exercised is directly proportionate to the nature and quality of commercial activity that an entity conducts over the Internet."

Judge Davis went beyond the sort of facile application of Zippo that other courts have used. Instead, he focused on whether the defendant had purposely directed its activities toward Maryland and its residents. Because there was no evidence of any focus on sales to Maryland residents (the only sales to Maryland residents were to the plaintiff and his agents), the Court concluded that a Maryland court could not exercise personal jurisdiction over the defendant. The case is important because it stands for the proposition that so long as a commercial website does not target residents of a particular state, sales to those residents will not, of themselves, subject the seller to process in that state.

No Conflict In Their Interest

The case of Stup v. UNUM Life Insurance Co. illustrates that (i) insurance companies are as susceptible to the lures of conflict of interest as anyone else, (ii) insurers apparently have no problem buying "expert" opinions that are tailored to fit the conclusions they desire, and (iii) insurers will often go to great length to deny benefits, putting costly roadblocks in the path of insureds who are entitled to coverage.

Wanda Stup suffers from lupus, fibromyalgia, Graves disease, or hyperthyroidism, degenerative disc disease, and eye problems. Without going into detail here, her various maladies are serious, painful, chronic, and have been well-documented for a substantial period of time. The Board Certified rheumatologist who had been her treating physician for several years wrote a detailed opinion letter that concluded that she could not perform even sedentary work.

Stup had a long-term disability insurance policy through her employer. Under the terms of the policy, her benefits were limited to two years if she could not "perform each of the material duties of any gainful occupation for which [s]he is reasonably fitted by training, education or experience." After two years, UNUM, the insurer, denied Stup further benefits declaring that "[s]ince the definition of disability now applies to ‘any occupation’ we feel you could return to work in a sedentary occupation."

Stup challenged the denial of benefits. As part of the appeal process she was required to undergo a "Functional Capacity Evaluation" or FCE. Again without going into details, the description of her efforts during the FCE make for painful reading. They must have been equally painful to watch, since the physical therapist conducting the FCE halted the exam after only 2 1/2 hours due to Stup's physical exhaustion. The physical therapist concluded that "it would not be prudent to make recommendations regarding specific job duties that [Stup] can or cannot perform due to a lack of consistent and true information [from the FCE]."

Based on the FCE, UNUM continued to deny Stup benefits. She filed suit in the U.S. District Court for the District of Maryland. UNUM opposed her claim, contending that its denial of benefits was based upon "substantial evidence." Neither the District Court nor the Fourth Circuit had any great difficulty concluding that not only was there no substantial evidence for the claim, but that its denial of the claim was not "the product of a principled reasoning process." The Fourth Circuit (a notoriously pro-business court) essentially smashed UNUM's defenses into pieces.

This case demonstrates a theme that I've already touched on in different ways in previous posts and which I intend to come back to regularly. The relationship between employor and employee (actually, in this case, insurer and insured) is asymetrical, with the employer holding a good deal of leverage in any dispute or negotiation. In this case, for instance, Stup was out of work due to her disability, a disability so severe that she could not even due all of her own housework. For four years, she was without income. She faced an insurance company with a strong incentive to deny benefits (every claim denied discourages other potential claimants from making claims in the first instance) and which had created an institutional machine designed to achieve that goal. The opinion doesn't reveal whether UNUM had ever made an offer to settle the claim, but such an offer, even a niggardly one, if it were made, would have been tempting to Stup given the financial straits she was in. And, of course, UNUM had a small platoon of medical professionals willing to issue an opinion favorable to UNUM despite a mountain of facts to the contrary. (If you don't believe me, read the Court's comments in footnote 7 on page 14 of the slip opinion.)

The lesson of this case should, but probably won't, be instructive to the public in the current dispute over so-called tort reform. Insurance companies win when they don't pay claims. While some modifications of the tort system may be justified (so that, for instance, in cases such as presented by Stup, her attorneys' fees are paid and she receives recompense for the time value of the benefits that were denied her), but that's not what proponents of tort reform want. They simply want to rig the game in their favor, systemically limiting or prohibiting claims. If you don't believe me, re-read the Stup opinion.

Let the Mishegaas Begin

The TaxProf Blog reports here on the pending Tax Court case of Michael and Marla Sklar, who are trying to deduct their children's private school tuition based on the IRS's closing agreement entered into with the Church of Scientology. In essence, the Sklars are arguing that the tuition they pay is deductible because (i) the religious instruction their children receive is the same as that received by Scientologists, and (ii) that there is an administrative inconsistency in the Service's treatment of Scientologists and its position vis a vis the Sklars.

My sense is that the Service has the far better argument here. Indeed, I have always wondered why the Service entered into a consent agreement with the Church of Scientology in the first instance. However, the purpose of this post is not to discuss tax law. Rather, it is to highlight the great opportunity for humor that the Sklar case presents.

The TaxProf's recent post was triggered by an article in the National Law Journal entitled Scientology Settlement Puts IRS in a Kosher Pickle. In his concurring opinion in the Sklar case when it was before the Ninth Circuit, Judge Silverman mused "Why is Scientology training different from all other religious training?" He went on to state that "The sole issue before us is whether the Sklars' claimed deduction is valid, not whether members of the Church of Scientology have become the IRS's chosen people."

Clearly, this is a case that is ripe for non-sexual double-entendre. In this regard, the case of Paul V. Hornung, 47 T.C. 428 (1967) comes to mind where the Tax Court stated in part:

In making this argument, petitioner shifts into a shotgun formation, contending that his accomplishments in the championship football game constitute educational, artistic, scientific, and civic achievements within the meaning of section 74(b). We believe that petitioner should be caught behind the line of scrimmage on this particular offensive maneuver.

(By the way, am I showing my age? Do I have to point out to the young that Mr. Hornung was one of the greatest running backs in pro football history?)

In any event, I hereby announce a contest for the most clever double-entendre commentary concerning the Sklar case. Commentary can be as short as one line.

The deadline is the date the Sklar case becomes final and non-appealable. I am the sole judge of the quality of the entries and my decision as to the winner is final and non-appealable. The prize: The pure satisfaction of having your witticism broadcast far and wide over the blogisphere.

Calling Arliss Michaels

On November 1, the Supreme Court heard oral arguments in the cases of Commissioner v. Banks and Commissioner v. Banaitis. (The Circuit Court opinions in the two cases can be found here and here.) Two revenue rulings issued by the Service this week highlight the importance of these two cases.

Both Banks and Banaistis address the question of whether that portion of a settlement or award paid to the claimant's lawyer in the form of a contingent fee is part of the claimant's gross income. The position of the Service is that the contingent fee portion of the settlement is gross income and is merely deductible by the claimant. If the Service's position is sustained, any legal fee paid in the course of a lawsuit concerning, for instance, the breach of an employment contract, will generally get added back into income when computing the claimant's liability for alternative minimum tax. Since such fees are not deductible for alternative minimum tax purposes, they are, in essence, not deductible at all.

The issue before the Court is vividly summarized by Alexis Garamfalvi of the Medill News Service of Northwestern University as follows:

Plaintiffs sitting across wide conference room tables from a flotilla of lawyers probably don't always consider how large a bite Uncle Sam will take out of the amount they are being offered to settle a lawsuit. Even fewer of them consider that they may be taxed on a large chunk of the settlement they never see - the perhaps 33 percent going to their lawyer. Of course, their lawyer is paying taxes on that amount too. So, trial lawyers aren't the only beneficiaries of our increasingly litigious society. Uncle Sam is smiling too.

Garamfalvi illustrates the problem by pointing out that if the Service prevails, Banaitis, who settled an employment claim against the Bank of America for $8.73 million, would be left with only $1.98 million, or 22.7 percent of the settlement amount.

In Rev. Rul. 2004-109 the Service addressed the question of whether upfront bonuses for signing or ratifying an employment contract are wages for purposes of FICA and FUTA. Two specific situations were considered. In one, a baseball prospect was given a "signing" bonus. To earn the bonus, the player needed only to show up for spring training. In the second example, various union members who were employees at the time a collective bargaining agreement was ratified became entitled to a "ratification" bonus. In both cases, the bonuses were not contingent upon whether the bonus recipients subsequently rendered services.

Rev. Rul. 2004-109 concluded that both sorts of payments constitute remuneration for employment and were thus subject to FICA and FUTA. The Service explicitly revoked Rev. Rul. 58-145, 1958-1 C.B. 360, which had held that a signing bonus did not constitute remuneraton for services and thus did not constitute wages for withholding tax purposes.

In Rev. Rul. 2004-110 the Service addressed the backend of the employment relationship. There, an employment contract for a period of several years had a provision that it could be terminated with the mutual agreement of the parties. The parties agreed that the employee would accept a payment from the employer in consideration of his agreement to cancel the contract before the expiration of the stated term. The ruling holds that the payment was part of the remuneration paid for the employee's employment because "[t]he employee [did] not provide clear, separate, and adequate consideration for the employer’s payment that is not dependent upon the employer-employee relationship and its component terms and conditions." Thus the payment was ordinary income, not capital gain income, and was subject to withholding, FICA, and FUTA.

While the precise questions addressed in the two revenue rulings are different from the question before the Court in Banks and Banaistis, they will frequently pop up in similar situations.

For instance, pro athletes typically have professional agents negotiate their contracts for them. Under Rev. Rul. 2004-109, all of the remuneration under those contracts are wages subject to withholding, FICA, and FUTA. If the Service prevails in Banks and Banaistis, as a practical matter, pro athletes will not be able to deduct the consideration paid to their agents since virtually all of these athletes are subject to the alternative minimum tax. Of course, this dramatically increases the transactional costs that they incur in the course of the negotiation.

In the case of "termination" payments, a similar warping of the negotiation process takes place, putting the employee at a severe disadvantage when negotiating the end of an employment relationship gone sour.

Knee Jerk Under-Reaction

One of the problems with blogging is the pressure to react swiftly to new developments. Often, this leads to comments which may a little too heated than would be the case if some time had passed to allow measured reflection.

However, after further consideration of the Court of Appeals' opinion in the Conte case, I think that the opposite might have occured. Upon reflection, I think that my comments were not critical enough of the Court's action.

The Court's opinion squarely presents what might be called a "theoretical defect." That is, the majority opinion undercuts the principle of the objective interpretation of contracts. Instead of determining what the parties meant by certain terms in a contract (i.e., what constitutes cause), factfinders in employment contract disputes are limited to:

determin[ing] the objective reasonableness of the employer’s decision to discharge, which means that the employer act[ed] in objective good faith and base[d] its decision on a reasoned conclusion and facts reasonably believed to be true by the employer.

However, the Court's reasoning is also faulty with respect to the perceived need of businesses to be able to act with certainty when discharging employees.

First, except for top actors and professional athletes, employers almost always have the upper hand when negotiating an employment agreement. Even a little knowledge of game theory will tell you that if the employee holds out for better terms, he or she is risking 100% of a limited and irreplacable resource, his or her time. The employer, on the other hand, more often than not has the luxury of walking away from the negotiating table and simply seeking another employment candidate. Thus, the employer is in a position to demand a contract with more and larger escape hatches. Where, as in Conte, the employer agrees to a contract with a limited set of escape hatches (i.e., the employer could only terminate the employee for cause), the courts should presume that the employer knew what it was doing and enforce the contract according to its objective terms.

Second, and perhaps more importantly, is what I will term the "HR Problem." It is simply this: Most employers with even a modest number of employees have, at the least, a "human relations" staffer if not a "human relations" staff or department. As a consequence, there is an institutional dossier regularly kept on the employee's job performance. Every failure to perform can be reflected in this dossier--every instance of tardiness, every instance where the employee lost his or her temper, every act of performance with any job task that someone acting for management thought was less than par. Of course, this dossier will have a management spin on it, with each story told from the perspective of the employer. Few employees keep a analogous record of their successes.

In the event that the employer decides to terminate the employee, the employer is well armed for any lawsuit alleging that it breached the employment contact. Each failure of the employee recorded in his or her personnel file (and even the best employee will have some failures) will be the subject of close scrutiny and thus magnified. After the fact, given a detailed, but employer-biased, employment history, duly recorded in the ordinary course of business, most factfinders will likely conclude that the employer acted reasonably.

I am not moved by the argument that a rule allowing the factfinder to examine whether there truly was cause for termination would cause the courts to act "as a super personnel officer, or of second-guessing a company’s decisions." Most cases, after all, result in a compromise settlement. I suspect that this is as true of employment contract disputes as it is with other sorts of litigation. The Court's opinion seriously weakens the employee's ability to negotiate a honorable termination of the contract. After all, in most cases, it will be the employer who has shuffled and then cut the cards. And, given the disparity in negotiating power, it will be the employer who gets to deal the cards as well. At the least, the employee should be entitled to have an impartial arbiter determine whether the shuffle was clean.

Subjective Objective

As a general matter of principle, I do not post comments on cases that I am either involved in or have been involved in. Since this is my first substantive posting in over a year, I will make an exception to that rule. In further defense, I would note that the matters at issue during the period of my involvement are no longer at issue. The various disputes between my client, Michael Conte, Ph.D., and Towson University continued to fester after my representation of Dr. Conte ended. Litigation ensued and the Court of Appeals of Maryland issued an opinion in that case today.

Dr. Conte was the director of the Regional Economic Studies Institute at Towson University. He held that position pursuant to the terms of a written employment agreement.

The employment agreement provided that he could only be discharged for "cause." Cause was defined to "include" eight specific grounds set forth in the written document. The University terminated Dr. Conte's contract alleging "incompetence" and "wilful neglect of duty"—two of the grounds that constituted "cause" enumerated in the written agreement. Dr. Conte filed suit for breach of contract in the Circuit Court for Baltimore County.

At trial held before a jury, Dr. Conte prevailed and obtained a judgment for over $900,000 for breach of contract. The jury had been instructed that the "University [had] the burden to prove by a preponderance of the evidence that one or more of the [causes in Dr. Conte's] contract existed for [his] termination." (Emphasis added by the Court of Appeals.) The Circuit Court rejected a request by the University to instruct the jury that the University was nevertheless permitted to terminate Dr. Conte for "common law cause" or cause that goes to the "essence of the contract."

The Court of Appeals considered a spectrum of three different provisions concerning the right of employers to terminate an employee.

At one end of the spectrum is the at-will contract of employment. Here, the employee is subject to termination "for any reason, even a reason that is arbitrary, capricious, or fundamentally unfair." Manifestly, the written contract between Dr. Conte and the University did not allow such an unbridled right of termination.

Somewhere in the middle of the spectrum is the so-called "satisfaction contract" in which:

[T]he employer has the right to terminate the contract and discharge the employee, whenever he, the employer, acting in good faith is actually dissatisfied with the employee's work. This applies, even though the parties to the employment contract have stipulated that the contract shall be operative during a definite term, if it provides that the services are to be performed to the satisfaction of the employer. It is not necessary that there exist grounds deemed adequate by the trier of facts for the employer's dissatisfaction. He is the judge as to whether the services are satisfactory. However, this dissatisfaction, to justify the discharge of the employee, must be real and not pretended, capricious, mercenary, or the result of a dishonest design. If the employer feigns dissatisfaction and dismisses the employee, the discharge is wrongful. The employer in exercising the right of dismissal because of dissatisfaction must do so honestly and in good faith.

(Emphasis by the Court of Appeals.)

However, the contract between Dr. Conte and the University was a "just cause" contract. That is, it could be terminated only for cause as set forth in the written document itself. The Court held that in reviewing a breach of contract claim for wrongful termination under a "just cause" contract:

[T]he proper role of the jury is to review the objective motivation [of the employer], i.e., whether the employer acted in objective good faith and in accordance with a reasonable employer under similar circumstances when he decided there was just cause to terminate the employee. The jury's inquiry should center on whether an employer's termination was based upon any arbitrary, capricious, or illegal reason, or based on facts not reasonably believed to be true by the employer. But the fact-finding prerogative will remain with the employer, absent some express intention otherwise.

In other words, the jury need not determine whether there was actually "cause" for termination as set forth in the contract. Instead, the inquiry is only whether the employer, in good faith, thought there was cause for termination at the time it terminated the employee. As noted by Chief Judge Bell in his dissent, underlying the majority opinion is the "the strong judicial policy against interfering with the business judgment of private business entities." (Judge Eldridge also dissented, but on other grounds.)

However, the majority opinion was also based in large measure on the question of whether the "fact-finding perogative" to determine if cause for termination exists rests with the employer. Presumably, a contract could be drafted that states that whether or not cause for termination exists is a matter of objective fact and that, in the event of a dispute, either a judicial tribunal or an arbitrator can make a determination as to whether appropriate grounds for termination existed.

I think that Chief Judge Bell has the better part of the argument here. Succinctly put, the majority opinion offers "little, if any, distinction between the test [it enunciates] for the review of 'just cause' contracts and that applicable to satisfaction contracts." Quoting Toussaint v. Blue Cross & Blue Shield of Michigan, 292 N. W. 2d 880, 896 (Mich. 1980), he notes that:

Where the employee has secured a promise not to be discharged except for cause, he has contracted for more than the employer’s promise to act in good faith or not to be unreasonable. An instruction which permits the jury to review only for reasonableness inadequately enforces that promise.

For some years, courts have been under fire by conservatives and pro-business groups for allegedly "legislating" and dictating what the law is based upon their normative views of what the law should be. In the Conte opinion, the Court ruled in favor of an employer being allowed to exercise its "business judgment," thus preventing a independent third-party from making an objective factual analysis that might lead to a contrary conclusion. I'm not going to hold my breath waiting for conservative, pro-business criticism of the decision.

I'm Coming Back

I am currently in the process of refreshing and redesigning this weblog. I expect to be fully back on line in a week.