UNITED STATES TAX COURT

T.C. Memo. 1996-442

UNITED STATES TAX COURT

DAVID ROTHNER AND NANCY J. ROTHNER, Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 26134-93.

Filed September 26, 1996.

Francis J. Emmons, for petitioners.

Joseph Ferrick, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

WELLS, Judge:

Respondent determined deficiencies in, and

penalties on, petitioner David Rothner's (petitioner) Federal

income taxes as follows:

Year

Deficiency

Penalty

Sec. 6662(a)

1989

1990

$246,497

88,759

$49,299

17,752

- 2 Respondent also determined a deficiency of $97,892 in, and a

penalty of $19,578 pursuant to section 6662(a) on, petitioners'

1991 Federal income tax.

Unless otherwise noted, all section

references are to the Internal Revenue Code in effect for the

years in issue, and all Rule references are to the Tax Court

Rules of Practice and Procedure.

After concessions, the sole issue to be decided is whether

petitioner may deduct, as an ordinary and necessary business

expense, a $75,000 fine paid during 1989 to the Chicago

Mercantile Exchange (CME) in settlement of a disciplinary

proceeding brought against him by the CME.

FINDINGS OF FACT

Some of the facts have been stipulated for trial pursuant to

Rule 91.

The parties' stipulations of fact are incorporated

herein by reference and are found as facts in the instant case.

At the time they filed the petition in the instant case,

petitioners resided in Wilmette, Illinois.

During relevant

periods, petitioner used the cash method of accounting.

Since 1984 and at all times relevant to the instant case,

petitioner was a member of the CME.

Petitioner conducted two

separate trades or businesses as a member of the CME, acting as a

floor broker executing trades in Eurodollar futures contracts (an

interest-rate sensitive futures contract) for the accounts of

other persons and trading certain types of futures contracts for

his own account.

Petitioner conducted his business as a floor

- 3 broker as a member of a brokerage association consisting of

petitioner, Richard Lowrance, and Patrick Maloney.

Petitioner

initially was employed as an assistant to Mr. Lowrance during

1982 and, beginning during 1984 and continuing at least through

the end of 1989, worked as an order filler for Mr. Lowrance.

Petitioner paid Mr. Lowrance a portion of the commissions

petitioner earned.

Petitioner executed orders as a floor broker in a trading

pit at the CME.

Customers would signal an order to a clerk, who

would bring it to petitioner, and petitioner would attempt to

execute it as quickly as possible while obtaining the best price.

Petitioner was responsible for the restitution of any money lost

by reason of errors made in filling a customer's order, which

errors could involve sums from $25,000 to over $100,000.

During

busy times, petitioner could have 50 to 100 orders of various

types to be executed.

Petitioner might make 200 trades in 1 day.

Competition for customers' orders was keen; a broker could lose

customers for repeated failures to fill orders on the terms they

specified and could attract customers by claiming the ability to

provide the best service available.

As many as 300 or 400 others

also worked in the pit, and petitioner traded with persons all

over the pit, but it was easier to trade with persons near him.

Petitioner and the other members of his brokerage association

stood together in the pit, and it was therefore easy for them to

trade with one another.

Each of petitioner's trades usually

- 4 involved 50 futures contracts, and the trades of his brokerage

association also involved a larger number of futures contracts

than were customary for others in the pit.

Petitioner's

association accounted for approximately one-third of the trading

volume in Eurodollar futures contracts on the CME.

The CME maintains a written set of rules and regulations

specifying the rights and obligations of membership in the CME

and governing trading through its facilities.

As a condition of

membership in the CME, a member must agree to abide by its rules.

Except as otherwise provided by Federal law, the rights and

obligations of CME members arise pursuant to contract law, rather

than statute, government regulation, or tort.

During May 1987,

the CME adopted new rules and amended existing ones that imposed,

inter alia, a limitation on the percentage of trades that one

member of a brokerage association could execute with members of

the same association and specified sanctions for violations of

those rules.

Those rules provide that petitioner could execute

no more than 25 percent of his trades with other members of his

brokerage association.

There had been no limit on the amount of

trading petitioner could conduct with the other members of his

association prior to the adoption of those rules.

The limit

imposed by the CME rule made it harder for petitioner to fill

customer orders.

In an attempt to avoid exceeding the limitation

on trading with the other members of his association, petitioner

would execute trades with them through Brian Elliott, a CME

- 5 member trading for his own account.

Petitioner would, for

instance, sell futures contracts to Mr. Elliott, and another

member of petitioner's brokerage association would buy the same

contracts from Mr. Elliott.

The trades were executed at market

prices, and Mr. Elliott was not paid for accommodating

petitioner's brokerage association.

Trading through Mr. Elliott

was "helpful" to petitioner's business.

The CME's rules allow it to conduct disciplinary proceedings

against its members for violations of its rules and to impose

sanctions on its members if violations are found to have

occurred.

Enforcement of the CME's rules is generally conducted

through investigators employed by it and a committee with

authority to bring charges of violations, to conduct hearings,

and to impose punishment.

Disciplinary violations may result in

sanctions which may include monetary fines, suspension of trading

privileges, or expulsion.

When the CME conducts disciplinary

proceedings involving any of its members or takes disciplinary

action against any of them, it does not act as an agency or agent

of any government.

During September 1987 through March 1988, CME employees

monitored the floor brokerage activity of petitioner's

association, including the portion of its members' trades

involving Mr. Elliott.

As a result, during 1989, the CME

conducted disciplinary proceedings against petitioner, Mr.

Lowrance, Mr. Maloney, and Mr. Elliott.

The transactions on

- 6 which the proceedings against petitioner were based arose out of

petitioner's business as a floor broker.

Petitioner had

previously paid a $1,000 fine to the CME for violating its rule

limiting the amount of trading among members of the same

brokerage association.

Sanctions imposed by the CME during 1987

and 1988 for violations of its rules governing brokerage

associations tended to consist of warning letters and fines

ranging from $1,000 to $10,000.

Petitioner, Mr. Lowrance, Mr. Maloney, and Mr. Elliott made

offers to settle the charges against each of them without

admitting or denying violations of the CME's rules.

Based on the

offers, the CME's Business Conduct Committee concluded that

petitioner, Mr. Lowrance, and Mr. Maloney each pre-arranged

Eurodollar futures trades with Mr. Elliott for the purpose of

evading the CME's limits on execution of customer orders with

other members of the same brokerage association.

In so doing,

the committee concluded that each of those individuals had

committed an act that was substantially detrimental to the

interest or welfare of the CME, a major offense pursuant to the

CME's rules, and had engaged in prohibited pre-arranged trading,

a minor offense pursuant to those rules.

The committee

accordingly imposed the following fines and suspensions of

exchange membership privileges:

- 7 Individual

Amount of Fine

Suspension Period

(business days)

Petitioner

Mr. Lowrance

Mr. Maloney

Mr. Elliott

$75,000

200,000

25,000

100,000

10

30

5

30

The fines and suspensions noted above were the only

sanctions imposed for the conduct that formed the basis for the

CME charges against petitioner and the others.

During 1989, petitioner paid $75,000 to the CME (sometimes

hereinafter referred to as the CME fine) in satisfaction of the

monetary sanction imposed on him.

Petitioner's payment of the

fine did not provide him with any future right or economic

benefit other than the right to continue to exercise his rights

as a member of the CME and the right to retain and hold his

membership interest.

Had petitioner failed or refused to pay the fine within the

time allowed by the CME rules, he would have been denied the

right to trade on the floor of the CME.

Moreover, if a member

fails to pay a fine within the prescribed time, the CME may,

inter alia, sell the member's seat and apply the proceeds against

the unpaid fine.

By settling the charges against him, petitioner

avoided protracted litigation concerning his conduct and was able

to resume his business activities without further disruption.

During relevant times, it was a common occurrence for the

CME to fine members for violations of its rules, and a list of

- 8 persons fined was issued weekly.

The following table summarizes

the number of disciplinary actions taken pursuant to the rules of

the CME during the years indicated in which monetary sanctions

were imposed:

Year

Actions

Actions Involving

Pre-Arranged Trading

1987

1988

1989

76

141

139

17

15

21

The parties stipulated that the fine paid by petitioner was

not a capital expenditure within the meaning of section 263.

OPINION

In the instant case, we must decide whether the fine paid by

petitioner to the CME is deductible as an ordinary and necessary

business expense pursuant to section 162(a).

To qualify as an

allowable deduction pursuant to section 162(a), an item must be:

(1) Paid or incurred during the taxable year; (2) for carrying on

any trade or business; (3) an expense; (4) ordinary; and (5)

necessary.

Commissioner v. Lincoln Sav. & Loan Association, 403

U.S. 345, 352 (1971).

Respondent concedes that petitioner's

payment of the CME fine satisfies the first three requirements

set forth in Lincoln Savings.

Considering respondent's

concession and the record in the instant case, we view the

disciplinary proceedings against petitioner as having arisen out

of petitioner's trade or business of acting as a floor broker and

- 9 the payment of the fine to be an expense of that business.

See

Commissioner v. Tellier, 383 U.S. 687, 689 (1966); Ostrom v.

Commissioner, 77 T.C. 608, 613 (1981).

Respondent also concedes that section 162(f), which

disallows the deduction of "any fine or similar penalty paid to a

government for the violation of any law", does not apply to

petitioner's payment of the CME fine.

Accordingly, no question

as to the allowability of the deduction on public policy grounds

is involved.

Sec. 1.162-1(a), Income Tax Regs. ("A deduction for

an expense * * * which would otherwise be allowable under section

162 shall not be denied on the grounds that allowance of such

deduction would frustrate a sharply defined public policy");1 see

also S. Rept. 92-437, at 72 (1971), 1972-1 C.B. 559, 599; S.

Rept. 91-552, at 247 (1969), 1969-3 C.B. 423, 597.

Consequently,

the only matter remaining in dispute is whether the payment of

the CME fine was "ordinary" and "necessary", which is a question

of fact.

Commissioner v. Heininger, 320 U.S. 467, 475 (1943).

The general guidelines for deciding whether an expense is

"ordinary and necessary" are well established.

Two significant

aspects of the term "ordinary" have been identified by the cases

construing section 162(a) and its predecessors.

In Commissioner

v. Tellier, supra at 689-690, the Supreme Court noted that the

1

The Commissioner has also taken this position in rulings.

See, e.g., Rev. Rul. 80-211, 1980-2 C.B. 57.

- 10 "principal function of the term 'ordinary' * * * is to clarify

the distinction, often difficult, between those expenses that are

currently deductible and those that are * * * capital

expenditures".

Additionally, the term "ordinary" has been

Deputy v. DuPont, 308

defined as "normal, usual, or customary".

U.S. 488, 495 (1940).

A payment of an expense is "normal" if it

arises from an action that is ordinarily to be expected of one in

the taxpayer's position.

471.

Commissioner v. Heininger, supra at

Although an expense may be incurred only once in a

taxpayer's lifetime, it is ordinary if the transaction that gives

rise to it is "of common or frequent occurrence in the type of

business" in which the taxpayer is engaged.

Deputy v. DuPont,

supra at 495; Welch v. Helvering, 290 U.S. 111, 114 (1933); see

also Lilly v. Commissioner, 343 U.S. 90, 93 (1952).

To be "necessary", an expense need only meet the minimal

requirement that it be appropriate and helpful for the

development of the taxpayer's business.

supra at 689.

Commissioner v. Tellier,

An expense is not to be considered unnecessary

simply because the taxpayer could have avoided it by pursuing a

different course of conduct.

Mason & Dixon Lines, Inc. v. United

States, 708 F.2d 1043, 1044-1045 (6th Cir. 1983).

As respondent concedes that petitioner's payment of the CME

fine was not a capital expenditure within the meaning of section

263, we need not further consider that aspect of the term

- 11 "ordinary".

Accordingly, we are left to consider only the other

aspect of that term; i.e., whether the payment of the fine was

"normal, usual, or customary" in petitioner's business.

It is

clear that petitioner's payment of the CME fine settled the

disciplinary proceedings and allowed petitioner to resume his

business activities without further disruption.

In that context,

we view petitioner's payment of the CME fine as a response that

could ordinarily be expected from one in petitioner's situation.

In that sense, petitioner's payment of the CME fine was "normal".

Respondent argues that engaging in transactions in violation

of the CME's rules was not an ordinary part of petitioner's

business.

Nonetheless, within the context and meaning of the

statute allowing deductions for ordinary and necessary expenses,

a private wrongdoing in the course of conducting a business is

not extraordinary.

Helvering v. Hampton, 79 F.2d 358, 360-361

(9th Cir. 1935), affg. a Memorandum Opinion of the Board of Tax

Appeals dated Aug. 12, 1932; Vanderbilt v. Commissioner, T.C.

Memo. 1957-235.

Moreover, even if improper conduct were

extraordinary in business, the payment of a settlement or

judgment attributable to the conduct is generally expected to be

made by the person in the course of whose business the conduct

occurred.

Helvering v. Hampton, supra at 361.

During relevant periods, other disciplinary proceedings

charging violations of the CME's rules, and the payment of

- 12 monetary sanctions in connection with those charges, occurred

frequently.

From 1987 through 1989, the CME undertook 356

disciplinary proceedings pursuant to which monetary sanctions

were imposed, and 53 of those actions involved pre-arranged

trading, an offense in connection with which petitioner paid his

fine.

Moreover, the parties have stipulated that, during

relevant periods, other securities and commodities exchanges

imposed monetary sanctions on their members for alleged

violations of their rules several hundred times per year.

Such

facts indicate that payments of fines pursuant to disciplinary

proceedings by securities and commodities exchanges were a common

and frequent occurrence in the type of business in which

petitioner was engaged.2

Accordingly, we conclude that

petitioner's payment of the CME fine was an ordinary expense of

petitioner's business.

We further conclude that payment of the CME fine was

"necessary" within the meaning of the statute.

By settling the

disciplinary proceedings against him, petitioner avoided any

further expense and risk associated with continuation of the

2

Respondent contends that a large number of the disciplinary

actions of the CME involved violations of "housekeeping rules",

such as prohibitions on improper dress, spitting, or fighting.

We, however, have rejected the suggestion that a certain

percentage of an industry must pay or incur an expense in order

for it to be ordinary, and the question depends on the facts and

circumstances of each case. Brizell v. Commissioner, 93 T.C.

151, 158-159 (1989). We also reject respondent's attempt to

narrow the type of conduct in the business community of which

petitioner was a part that is to be considered in deciding

whether payment of the fine in question was ordinary.

- 13 proceedings.

Moreover, had petitioner failed to pay the fine, he

would have been denied access to the floor of the CME and thus

rendered unable to carry on his floor brokerage business.

Additionally, his seat on the exchange could have been sold.

By

paying the fine, petitioner was able to resume his business

activities without further disruption.

Based on the foregoing,

we hold that petitioner's payment of the CME fine was an ordinary

and necessary expense and is therefore properly deductible

pursuant to section 162(a).

Because we have decided that the payment of the fine is an

allowable deduction pursuant to section 162(a), we need not

consider petitioner's alternative contention that the fine is

deductible as a business loss pursuant to section 165(a) and (c).

To reflect the foregoing and concessions,

Decision will be entered

under Rule 155.