Petitioners Brief — Randall v. Loftsgaarden

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Supreme Cou.t, U... |

= FILED

No. 85-519 JAN 6 1986

NIOL, JR.

In The CLERK

Supreme Court of the United States

October Term, 1985

DR. WILLIAM C. RANDALL,

DR. ROGER E. AUSTIN,

DR. TOM W. ANDERSON and

DR. MYREL A. NEUMANN,

Petitioners,

BEST AVAILABLE aa

B. J. LOFTSGAARDEN; ALOTEL INCORPORATED,

a Minnesota corporation; PROPERTY DEVELOPMENT

AND RESEARCH COMPANY, a Minnesota corporation;

and 2361 BUILDING CORPORATION, a Minnesota cor-

poration,

Respondents.

ra’

ON WRIT OF CERTIORARI

TO THE UNITED STATES COURT OF APPEALS

FOR THE EIGHTH CIRCUIT

BRIEF FOR THE PETITIONERS

ray

* Robert Arthur Brunig Terence M. Fruth

O'CONNOR & HANNAN FRUTH & ANTHONY, P.A.

3800 IDS Tower 1350 Internationa! Centre

80 South Eighth Street 900 Second Aven se South

Minneapolis, Minnesota Minneapolis, Minnesota

55402 55402

Telephone: (612) 343-1200 Telephone: (612) 349-6969

Ted S. Meikle Wilbur F. Dorn, Jr.

FREDRIKSON & BYRON, P.A. DORN LAW FIRM, LTD.

1100 International Centre 300 East Main Street

900 Second Avenue South Anoka, Minnesota 55303

Minneapolis, Minnesota Telephone: (612) 427-5903

55402

Telephone: (612) 347-7000 Counsel for Petitioners

* Counsel of Record

OCKLE LAW BRIEF PRINTING CO., (800) 835-7427 Ext. 333

QUESTIONS PRESENTED

1. Whether favorable tax consequences to defrauded

investors in a limited partnership, together with imputed

interest thereon, constitute ‘‘income received’’ which sec-

tion 12(2) of the Securities Act of 1933 requires be de-

ducted from the consideration paid when the investors’

purchase of the securities is rescinded.

2. Whether favorable tax consequences to defrauded

investors in a limited partnership, together with imputed

interest thereon, are to offset rescissionary damages

awarded pursuant to section 10(b) of the Securities Ex-

change Act of 1934 and Securities and Exchange Commis-

sion Rule 10b-5 to insure that the investors do not recover

more than ‘‘actual damages.”’

TABLE OF CONTENTS

Page

QUESTIONS PRESENTED i

TABLE OF CONTENTS ..... ii

TABLE OF AUTHORITIES iv

OPINIONS BELOW 1

JURISDICTIONAL STATEMENT 1

STATUTES AND REGULATION .. 1

STATEMENT OF THE CASE 3

SUMMARY OF THE ARGUMENT 9

ARGUMENT —

Il. The Interpretation Of Section 12(2) And The

Caleulation Of Damages Under Section 10(b)

And Rule 10b-5 Must Be Consistent With The

Language Of The Statues And The Rule.

wee eereee

A. There Is No Statutory Basis For Differenti-

ating Between ‘‘Tax Shelters’? And Other

Securities

The Language Of Section 12(2) Does Not

Allow Deduction Of ‘‘Tax Benefits’? From A

Defrauded Purchaser’s Recovery

1. **Tax Benefits’’ Are Not ‘‘Income,’?’ ...........

2. ‘‘Interest’’ Should Not Be Added To

‘*‘Tax Benefits’’ Even If ‘‘Tax Benefits’’

Were To Be Considered ‘‘Income Re-

ceived.’’ a er

Nothing In Section 28(a) Justifies Reducing

Damages Under Section 10(b) And Rule 10b-5

By ‘*Tax Benefits.’’

Il. Permitting Defrauded Purchasers To Recover

Their ‘‘Consideration Paid . .. With Interest’’

Without A Reduction For ‘‘Tax Benefits’’ Is

Consistent With Precedent

ili

TABLE OF CONTENTS—continued

Page

A. The Eighth Cireuit’s Decision Fails To Defer

To This Court’s Precedent 25

B. The Eighth Cireuit’s Decision Fails To Defer

To Othe. ?recedent 27

C. Deducting ‘‘Tax Benefits’? From Recoveries

For Securities Fraud Disregards The Collat-

eral Source Rule .............................. 29

Ill. Public Policy Considerations Require That ‘‘Tax

Benefits” ot Be Subtracted From Securities

IRR ST Ee ne I tc ST ON al a 32

A. Subtracting ‘‘Tax Benefits’’ From Securities

Fraud Recoveries Undermines The Disclosure

Requirements Of The Federal Securities Laws 32

B. Subtracting ‘‘Tax Benefits’? From Securities

Fraud Recoveries Effectively Transfers

Monies From The Public Treasury To The

Defrauder 36

C. Subtracting ‘‘Tax Benefits’’ From Securities

Fraud Recoveries Creates Anomalous Damage

Awards 37

D. Subtracting ‘‘Tax Benefits’? From Securities

Fraud Recoveries Does Not Fully viet saa

Defrauded Investors 200. 38

EK. A Securities Fraud Action Is Not An Appro-

priate Proceeding In Which To Litigate The

Tax ape Of An Investment Induced

By Fraud . PLDs a ee 41

FI casctetttcietecctvierstans sieielsatiidhdcinemesttiasal 43

TABLE OF AUTHORITIES

CasEs:

Page

Affiliated Ute Citizens v. United States, 406

oF By ans rk 25

Alfred Bell & Co. v. Catalda Fine Arts, Inc., 191

je ae DB: Bs ek 24

Austin v. Loftsgaarden, 768 F.2d 949 (8th Cir.

1985), petition for cert. granted, 54 U.S.L.W.

3328 (U.S. Nov. 12, 1985) (No. 85-519) passim

Austin v. Loftsgaarden, 675 F.2d 168 (8th Cir.

| Re aee eae ee alien 1, 7, 8, 9, 14, 17, 28, 39, 48

Bayoud v. Ballard, 404 F.Supp. 417 (N.D. Tex.

1975) 28

Berg v. Xerxes-Southdale Office Bldg. Co., 290

PAF GB Eile Soka eh salen 28

Birdsall v. Coolidge, 93 U.S. 64 (1876) 23

Blue Chip Stamps v. Manor Drug Stores, 421

ee fs ee 9, 13, 32

Borovoy v. Bursar Realty Cory., 86 Mich. App.

732, 273 N.W.2d 545 (1979) a 28

Bridgen v. Scott, 456 F.Supp. 1048 ire Tex.

RGD. iii senceieteainaeadecail. 28

Brown v. Producers Livestock Loan Co., 469 F,

SS OE 2 eee oer ee 40

Burgess v. Premier siti 727 F.2d 826 “— Cir.

1984) ag Pe a ieee AC ne Oo nt ORR 29, 36

Carter Prod., Inc. v. Colgate-Palmolive Co., 214

F. Supp. 383 1S Rh nena cht ae ek Se 24

Cereal Byproducts Co. v. Hall, 16 Il. App.2d 79,

147 N.E.2d 383, aff'd, 15 Ill. 2d 313, 155

pe § 8 Bs pe ce ee 31

TABLE OF AUTHORITIES—continued

Page

Chris-Craft Indus., Inc. v. Py r Aircraft Corp.,

480 F.2d 341 (2d Cir.), ce. . denied, 414 U.S.

Se I sechistchicincenc techeeesntlicticetatieasncahia tiphbaaniloriedlalidatabetas 27

Consumer Prod. Safety Comm’n v. GTE Syl-

vamta, Toec., 447 U.S. 102 (1980) nena ne ccc ceececneceesnneeeeneee 13

Cooper v. Hallgarten & Co., 34 F.R.D. 482

ee a en 27

Danzig v. Jack Grynberg & Assoc., 161 Cal. App.

3d 1128, 208 Cal. Rptr. 336 (1984), cert. de-

nied, 106 S. Ct. 67 (1985) .. eee a. ae

Dupuy v. Dupuy, 551 F.2d 1005 (5th Cir.), cert.

denied, 434 U.S. 911 (1977) ease. re 28

Eichel v. New York Cent. R.R., 375 U.S. 253

(1963) . A ET TEL a RT 31

wiheds | v. Gagnon, 766 F.2d 770 (3d Cir. 1985) 29

Eisner v. Macomber, 252 U.S. 189 (1920) 0 17

Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976) . 9,13

Freschi v. Grand Coal Venture, 767 F.2d 1041

(2d Cir. 1985), petition for cert. filed, 54 U.S.

L.W. 3154 (U.S. Sept. 6, 1985) (No. 85-377) 0. 29

Funston v. United States, 513 F.Supp. 1000

+ te. Yh GRWRSROAR LURE ne sie 2.aiboror Sienna 31

G & R Corp. v. American Sec. & Trust Co.,

Be bs Bi they Ae.) ) ene 28

Gerstle v. Gamble-Skogmo, Inc., 478 F.2d 1281

i a aignebaine 20

Goodyear Tire & Rubber Co. v. Overman Cush-

ton Tire Co., 95 F.2d 978 (6th Cir. 1937)... 24

Hanover Shoe, Inc. v. United Shoe Mach. Corp.,

TR 11, 26, 27, 42

TABLE OF AUTHORITIES—continued

Page

Harris v. Metropolitan Mall, 112 Wis. 2d 487, 334

N.W.2d 519 (1983) 29

Hayden v. McDonald, 742 F.2d 423 (8th Cir. 1984) . 37

Herman & MacLean v. Huddleston, 459 U.S. 375

(1983)

Hickman v. Groesbeck, 389 F.Supp. 769 (D.

Utah 1974) .

Hokama v. E. F. Hutton ¢& Co., 566 F.Supp.

636 (C.D. Cal. 1983) 29

Houlihan v. Anderson-Stokes, Inc., 78 F.R.D.

232 (D.D.C. 1978) ................ 28

Iowa-Des Moines Nat’l Bank v. Schwerman

Trucking Co., 288 N.W.2d 198 (Iowa 1980) _.. 31

Janigan v. Taylor, 344 F.2d 781 (1st Cir.), cert.

Aemted, BB2 U.S. STD (19GB) naan eaceeecnnneenncerneeevneneevnernnee 20, 25

Johns Hopkins Unw. v. Hutton, 297 F. Supp.

1165 (D. Md. 1968), rev’d on other grounds,

422 F.2d 1124 (4th Cir. 1970), cert. denied,

416 U.S. 916 (1974) ... “a 10, 19, 20, 22, 27

Jones & Laughlin Steel iat v. si ani. 462 U.S.

Ss NE ee le a ae

Kauffman v. Sidereal Corp., 695 F.2d 343 (9th

Cir. 1982) 31

Koehler v. Pulvers, [Current] Frp. Sec. L. Rep.

(CCH) ¥ 92,232 (S.D. Cal. 1985) 29

Landreth Timber Co. v. Landreth, 105 S, Ct. 2297

(1985) 9, 13,17

L. P. Larson, Jr., Co. v. William Wrigley, Jr.,

ka ee Ue ND cette 23

Vii

TABLE OF AUTHORITIES—continued

Page

Lumber Terminals, Inc. v. Nowakowski, 36 Md.

App. 82, 373 A.2d 282 (1977) 31

Mills v. Electric Auto-Lite Co., 396 U.S. 375

(1970) 40

Mills Music, Inc. v. Snyder, 105 S. Ct. 638

(1985) 13, 16

Murphy v. Cady, 30 F. Supp. 466 (D. Me. 1939),

aff’d, 113 F.2d 988 (1st Cir.), cert. denied, 311

U.S. 705 (1940) 21

Myzel v. Fields, 386 F.2d 718 (8th Cir. 1967),

cert. denied, 390 U.S. 951 (1968) 20, 25

NLRB v. Gullett Gin Co., 340 U.S. 361 (1951). 31

Norfolk & W. Ry. v. Liepelt, 444 U.S. 490

(1980) 11, 26, 27

Osofsky v. Zipf, 645 F.2d 107 (2d Cir. 1981) 0. 11, 23

Red Bank Oil Co., 20 S.E.C. 863 (1945) 00. 33

Regional Properties, Inc. v. Financial & Real

Estate Consulting Co., 678 F.2d 552 (5th Cir.

1982) 40

Rhode v. Hershberger Explorations, Inc., 349 F.

Supp. 993 (D. Minn. 1972) ....... 27, 40

S & E Contractors, Inc. v. United States, 406

U.S. 1 (1972) 13

SEC v. Capital Gains Research Bureau, Inc.,

375 U.S. 180 (1963) 12

Salcer v. Envicon Equities Corp., 744 F.2d 935

(2d Cir. 1984), petition for cert. filed, 53

U.S.L.W. 3688 (U.S. Mar. 13, 1985) (No.

84-1447) ...... 22, 29, 30

Sharp v. Coopers & Lybrand, 83 F.R.D. 343

(E.D. Pa. 1979), rev’d on other grounds, 649

Vili

TABLE OF AUTHORITIES—continued

Page

F.2d 169 (3d Cir. 1981), cert. denied, 455 U.S.

938 (1982) 28

Sheldon v. Wetro-Goldwyn Pictures Corp., 106

F.2d 45 (2d Cir. 1939), aff’d, 309 U.S. 390

(1940) 24

Smith v. Bader, 83 F.R.D. 437 (S.D.N.Y. 1979) 0. §=28

Spatz v. Borenstetm, 513 F. Supp. 571 (N.D. Tl.

1981) 28

Teamsters v. Daniels, 439 U.S. 551 (1979) 0 9,18

United Housing Foundation, Inc. v. Forman,

421 U.S. 837 (1975) 10, 17, 18, 19

United States v. Gilliland, 312 U.S. 86 (1941) 0000. =«12

United States v. Naftalin, 441 U.S. 768 (1979)..11, 33, 36

United States v. Standard Brewery, Inc., 251

U.S. 210 (1920)

Western Fed. Corp, v. Erickson, 739 F.2d 1439

(9th Cir. 1984)

Wiesenberger v. W. E. Hutton & Co., 35 F.R.D.

556 (S.D.N.Y. 1964)

29, 40

Wigand v. Flo-Tek, Inc., 609 F.2d 1028 (2d Cir.

1979)

Wolf v. National Lead Co., 272 F.2d 867 (9th

Cir. 1969)

STATUTES:

Section 1 of the Minnesota Uniform Securities

Act, Minn. Stat. § 804.01 . ae

Section 23 of the Minnesota Uniform Securities

Se, NG CG SII seictotce a crcnapenieneneeocsntinenie

5, 6,7

TABLE OF AUTHORITIES—continued

Page

Section 2 of the Securities Act of 1933, 15

U.S.C. §$77b ... : 18, 19

Sections 3-4 of the Securities Act of 1933, 15

U.S.C, §§ 77¢-77d 34

Section 12 of the Securities Act of 1933, 15

U.S.C. § 771 passim

Section 17 of the Securities Act of 1933, 15

U.S.C. § 77q 5

Section 10 of the Securities Exchange Act of

1934, 15 U.S.C. § 78) _...... * ..passim

Section 25 of the Copyright Act, 17 U.S.C. § 25

(1928) . 23

Section 28 of the Securities Exchange Act of

ane passim

Section 29 of the Securities Exchange Act of

Se eee ae 40

Sections 16-19 of the Trademark Act, 15 U.S.C.

§§ 96-99 (1928) 0... CBleh Cie ae OSs a . B

Section 1 of the Internal Revenue Code, 26

ES ys I ne 10

Section 11 of the Internal Revenue Code, 26

U.S.C. $11 - e 10

Section 61 of the Internal Revenue Code, 26

ae Oe ee PS OR oe Ae eee 10, 17, 18, 19

Section 165 of the Internal Revenue Code, 26

8 RS Aa Ee ae ee 15

Section 219 of the Internal Revenue Code, 26

hs Se lc iciaietantineins eae

Section 305 of the Internal Revenue Code, 26

8 NE ST eA Ay ns On 15

Section 401 of the Internal Revenue Code, 26

Ra RE SR aE ee coy

Section 403 of the Internal Revenue Code, 26

aes I hcaliataletiaseseeibtiisnetesirciisieesntttnlinibabiaiiectnietate

TABLE OF AUTHORITIES—continued

Page

Section 6111 of the Internal Revenue Code, 26 °

U.S.C. § 6111 | : ae 14

Section 6501 of the Internal Revenue Code, 26

U.S.C. § 6501 ete ao - 39

Sections 1311-14 of the Internal Revenue Code,

26 U.S.C. §§ 1311-14 va . .....09, 40, 41

Sections 346-47 of the Judicial Code of 1911, 28

U.S.C. § 1254 m nS ee 5 ae a

Section 59 of the Patent Law, 35 U.S.C. § 67

(1928) . 23

REGULATION :

Rule 10b-5 of the Securities and Exchange Com-

mission, 17 C.F.R. § 240.10b-5 passim

Oruer AUTHORITIES:

S. Banoff, To What Extent Will Benefits from

Tax Shelters be Permitted to Offset Rescis-

sion Damages, 57 J. Taxation 154 (1982) 38

A Blankenheimer, Tax Consequences of Rescis-

sion: The Interplay Between Private & Pub-

lic Law, 42 U. Cun. L. Rev. 562 (1975) 22241, 42

Bureau of Nat’!] Affairs, Ine., Daily Report for

Executwes (Feb. 21, 1984) . 34

77 Cong. Rec. 937 (1933) ........................ 32,37

77 Cong. Ree. 2913 (1933) .......... | 21

F. Easterbrook & D. Fischel, Optimal Damages

in Securities Cases, 52 U. Cur. L. Rev. 611

(1985) 12, 34

[1976] 5 Fep. Sec. L. Rep. (CCH) ? . 34

TABLE OF AUTHORITIES—Continued

Page

[1985] 6 Fep. Sec. L. Rep. (CCH) ...... Bee Sateen . 34

H. R. Rep. No. 85, 73d Cong., Ist Sess. (1933),

reprinted in 9 J. Ellenberger & E. Mahar,

LEGISLATIVE History OF THE SEcurRItTIES ACT OF

a 3 3 & THE SecurITIES ExcHaNnGeE Act oF 1934

R. Haft & P. Fass, Tax SHeuterep INVESTMENTS

(3a ed. 1960) se EP a ee (a Oey

T. Hazen, Administrative Enforcement: An

Evaluation of the SEC’s Use of Injunctions

& Other Enforcement Methods, 31 Hastines

we: £0) — RET Me eae AOD ER 33

T. Hazen, Tue Law or Securities ReauLaTIon

a ec araaheaiioan 32,33

O. Holmes, The Theory of Legal Interpretation,

12 Harv. L. Rev. 417 (1898) Se,

A. Jacobs, Litigation & Practice Unper Rue

10b-5 (2d ed. 1985) .... 19, 40

M. Kaminsky, An Analysis of Securities Litiga-

tion Under Section 12(2), 13 Hovs. L. Rev.

231 (1976) 19, 43

D. Korn, A Taxing Quandry: Should Investors

Deprived of Shelter Sue, Barron’s, Jun.

a inlin 43

L. Loss, Securities Reauxiation (2d ed. 1961) ....... 33

J. Mertens, Law or Feperat Income TAXATION

Sr aa 41

Note, Austin v. Loftsgaarden: Securities Fraud

in Real Estate Limited Partnership Invest-

ments, 16 Cretonton L. Rev. 1140 (1982) .........17, 28, 35

xii

TABLE OF AUTHORITIES—-Continued

Note, Insiders Liability under Rule 10b-5 for

the Purchase of Actively Traded Securities,

be 6p OS OS ee eee ea 23

Note, Real Estate Limited Partnerships & Al-

locational Efficiency: The Incentive to Sue

for Securities Fraud, 63 Va. L. Rev. 669

(3977) ...... in nani esldgiiels lca Ldleeidilicabieideoaiadedianines 12, 34, 35

RESTATEMENT (SECOND) OF TORTS (1979) oecceccocceccccosose 29, 31

S. Rep. No. 47, 73d Cong., Ist Sess. (1933),

reprinted in 2 J. Ellenberger & E. Mahar,

LEGISLATIVE History OF THE Securities ACT OF

1933 & THe Securitres Excuance Act or 1934

0 ERE ENES 5) SIT 11, 21, 33

sf & 2 -eee a OEP Tor AP Avo 32

R. Thompson, The Measure of Recovery under

Rule 10b-5, 37 Vann. L. Rev. 349 (1984) ................ 31, 36

Tre, Nov. 26, 198¢4 ............... Pd SA ee ee 34

~ Washimagtonm Post, Sram. 4, 1984 nnnceecceccecececnesoesnseeneenneenneenens 34

OPINIONS BELOW

The en banc opinion ot the Eighth Circuit and the

accompanying panel opinion (hereinafter ‘‘ Austin II1’’)

are reported at 768 F.2d 949 and are set forth in Petition

Appendix A. The unreported Amended Judgment and

the unreported Order of the district court on a remand by

the Kighth Cireuit on a prior occasion are set forth in

Petition Appendices B and C. The earlier opinion of an-

other panel of the Kighth Cireuit (hereinafter “ Austin

I’’) is reported at 675 F.2d 168 and is set forth in Peti-

tion Appendix D. The unreported Findings of Fact, Con-

clusions of Law and Order for Judgment and the Memo-

randum Order of the district court at the conclusion of

the first trial are set forth in Petition Appendices FE and F.

ra’

JURISDICTIONAL STATEMENT

The judgment of the Court of Appeals for the Kighth

Cireuit was entered on July 16, 1985. The Petition for a

Writ of Certiorari was filed on September 24, 1985, and

was granted on November 12, 1985. (J.A.3). This Court’s

jurisdiction is invoked pursuant to 28 U.S.C. § 1254(1).

STATUTES AND REGULATION

Section 12(2) of the Securities Act of 1933, 15 U.S.C.

§ 771(2):

Any person who—

(2) offers or sells a security ... by the use

of any means or instruments of transportation

or communication in interstate commerce or of

the mails, by means of a prospectus or oral com-

munication, which includes an untrue statement

of a material fact or omits to state a material

fact necessary in order to make the statements,

in the light of the circumstances under which they

were made, not misleading (the purchaser not

knowing of such untruth or omission), and who

shall not sustain the burden of proof that he did

not know, and in the exercise of reasonable care

could not have known, of such untruth or omis-

sion,

shall be liable to the person purchasing such security

from him who may sue either at law or in equity in

any court of competent jurisdiction, to recover the

consideration paid for such security with interest

thereon, less the amount of any income received there-

on, upon the tender of such security, or for damages

if he no longer owns the security.

Section 10(b) of the Securities Exchange Act of 1934, 15

U.S.C. § 78)(b) :

It shall be unlawful for any person, directly or

indirectly, by the use of any means or instrumentality

of interstate commerce or of the mails, or of any fa-

cility of any national security exchange—

* m7 *

(b) To use or employ, in connection with

the purchase or sale of any security . . . any ma-

nipulative or deceptive device or contrivance in

contravention of such rules and regulations as

the [Securities and Exchange] Commission may

prescribe as necessary or appropriate in the pub-

lic interest or for the protection of investors.

Rule 10b-5 of the Securities and Exchange Commission, 17

C.F.R. § 240.10b-5:

It shall be unlawful! for any person, directly or

indirectly, by the use of any means or instrumentality

of interstate commerce, or of the mails or of any

facility of any national security exchange,

(a) To employ any device, scheme, or arti-

fice to defraud,

(b) To make any untrue statement of a ma-

terial fact or to omit to state a material fact nec-

essary in order to make the statements made, in

the light of the circumstances under which they

were made, not misleading, or

of business which operates or would operate as

a fraud or deceit upon any person, in connection

with the purchase or sale of any security.

Section 28(a) of the Securities Exchange Act of 1934, 15

U.S.C. § 78bb(a) :

The rights and remedies provided by [the Se-

eurities Exchange Act of 1934] shall be in addition

to any and all other rights and remedies that may

exist at law or in equity; but no person permitted

to maintain a suit for damages under the provisions

of [the Securities Exchange Act of 1934] shall re-

cover, through satisfaction of judgment in one or more

actions, a total amount in excess of the actual dam-

ages on account of the act complained of.

ra’

—

STATEMENT OF THE CASE

Petitioners are four investors who purchased one or

more units! in Alotel Associates, a limited partnership

formed to operate a Ramada Inn in Rochester, Minne-

sota. (Pet.App.D1). Respondents are the individual and

corporate general partners of Alotel Associates and their

affiliates. (Pet.App.D3-D4).

Respondents distributed an Offering Memorandum

to potential investors, including Petitioners. (Pet.App.

D7). The Offering Memorandum purported to describe

the limited partnership, the Ramada Inn project, the terms

available for financing the partnership’s activities and the

timetable for constructing the Ramada Inn. (Pet.App.D7;

! The price of each unit was $35,000. (Pet.App.D7).

PLEx.2: Tr.42). The Offering Memorandum contained

a pro forma projection of cash flow, of resale price and

anticipated profit at the time of resale and of the tax

consequences of a limited partner’s investment. (PLEx.2

at 27; Tr.42).

The Offering Memorandum misrepresented the rate

and amount of interest to be paid for construction finane-

ing, the length of a ground lease, the completion date and

the terms of financing available for furnishings and equip-

ment. (Pet.App.D7-D8). The Offering Memorandum de-

seribed a non-existent commitment for long-term financ-

ing. (Pet.App.D8). The Offering Memorandum omitted in-

formation about the control which Respondent B. J. Lofts-

eaarden (hereinafter “Loftsgaarden”) exercised over Re-

spondents Alotel Incorporated, Property Development and

Research Company (hereinafter “PDRC”) and 2361 Build-

ing Corporation (hereinafter ‘‘2361’’), about PDRC’s an-

ticipated profits on a sale of land, about a commitment

fee to be paid to PDRC, about Loftsgaarden’s interest in

are-TECH. ine. a firm which was to design the Ramada

Inn and to supervise its construction and about Lofts-

caarden, PDRC, 2361 and are-TECH, ine.’s anticipated

profits. (Pet.App.D9, E11).

PDRC_ received $23,100 as a commitment fee and

$57,390 for undisclosed purposes. (Pet.App.E11; PLEX

50: Def.Ex.41A; Tr.371,662). PDRC also earned a profit

of between $37,388 and $54,078 on land transactions. (Pet.

App.D9,E7; P1.Ex.51,55,56 ; Tr.372,398,403-07). 2361 re-

ceived $35,000 as ‘‘contractor’s overhead,’’ $23,524 for ‘‘re-

imbursement,’’ $449 for ‘‘general contracting services,”’

3.972 for “eontracting work” and $2,349, $63,724 and

$38,041 for undisclosed purposes.” (Def. Fx.41B,41C,41E,

41F,41G6,41H,41J,41K ; Tr.662). Are-TECH, inc., received

$90,000 for its services. (Pet.App.E7,E11).

The limited partners’ investments and the available

loans proved insufficient to construct and furnish the

Ramada Inn. (Pet.App.D10). Alotel Associates had no

initial operating capital. Alotel Associates was forced to

obtain additional investors. (Pet.App.D10; P1.Ex.79; Tr.

672-73,693-94). The additional investments proved insuf-

ficient, and the business continued to flounder. The in-

vestors then made several loans to Alotel Associates.’

(Pet.App.F12). Alotel Associates ultimately defaulted

on its loans and its rental payments, and its creditors

foreclosed. (Pet.App.D10; P1.Ex.46; Tr.348,350,577).

On February 24, 1976, Petitioners and others com-

menced this action to recover their investments. (J.A.1;

D.R.1-10). Their amended complaints alleged that Re-

spondents had violated sections 12(2) and 17(a)* of the

Securities Act of 1933, 15 U.S.C. §4§771(2) and 77q(a);

section 10(b) of the Securities Exchange Act of 1934, 15

U.S.C. § 78j(b); Rule 10b-5 of the Securities and Exchange

Commission, 17 C.F.R. § 240.10b-5; and section 1 of the

Minnesota Uniform Securities Act, Minn, Siat. § 80A.01

(1978), had committed a fraud under the common law of

Minnesota, had been negligent and had breached fiduciary

duties to Petitioners.’ (D.R.219-46,266-74). Petitioners

alleged misrepresentations and omissions of material in-

2 Respondents had anticipated that 2361 would receive

$316,572 as “overhead” and “contingency and profit.” (Pet.

App.£5; PI.Ex.27 at 2; Tr.305).

3 The total loans “assessed” against each unit was $8,500.

(PI.Ex.34-45; Tr.337,345,497).

The district court dismissed Petitioners’ section 17(a) claim.

Petitioners discontinued their negligence and breach of

fiduciary duty claims at trial. (Tr.730).

formation. (DR.219-46,266-74). They sought rescission®

or damages. (D.R.245-46,273-74).

Respondents denied liability. (D.R.196-218). Respon-

dents argued that reductions in Petitioners’ federal and

state income tax liabilities which resulted from deductions

Petitioners took as a result of operating losses sustained

by and depreciation and investment credits attributable

to Alotel Associates constituted “income received” and that

section 12(2) mandated that “income received” be deducted

from any recovery. (Pet.App.F5-F9). They also argued

that the tax consequences reduced the “actual damages”

to which Petitioners might be entitled under section 10(b)

and Rule 10b-5. (Pet.App.F5-F9).

The district court refused Respondents’ request to

instruct the jury that it might reduce damages by “income

tax benefits which [Petitioners had] obtained.” (D.R.365;

Tr.740-42). Instead, the district court found that “the

limited partnership units in Alotel Associates . . . were

valueless” at the time Petitioners discovered the fraud.

(Pet.App.£13). The district court therefore instructed

the jury that Petitioners’ damages under section 10(b),

Rule 10b-5, Minn. Stat. §¢80A.23 and common law fraud

would “be equal to the amounts of monies which [Peti-

tioners had] paid out in reliance upon the false representa-

tions.” (Tr.805). The district court concluded that Peti-

tioners were “entitled to recover the consideration [they

had] paid for the limited partnership units” under section

12(2) and held that the ‘‘ out-of-pocket fand] rescissionary

measures fof damages] would yield the same results.’

(Pet.App.F7). Based upon the jury’s verdict and its own

findings, the district court awarded Petitioners Judgment

6 Petitioners had tendered their limited partnership units to

Respondents. (Pet.App.D18,E14; Ct.Ex.2,3; Tr.626,629).

in amounts equal to the amounts of their investments plus

interest’? on the amounts of their investments.’ (Pet.App.

£16,F15-F 16).

Respondents appealed, (J.A.2). An EKighth Circuit

panel affirmed the jury’s and the district court’s findings

of liability, but vacated and remanded to the district court

for a new trial on the issue of damages. The panel held

that

in a private securities fraud action involving an in-

vestment structured and marketed as a tax shelter,

where a rescissory measure of damages is applied,

evidence of any benefit derived by the plaintiff/

investor via tax savings must be permitted.

Austin I at 183-84. The panel aslo held that ‘‘the dam-

age award must be reduced by any value shown to have

heen received by plaintiffs.’’ Austin I at 181.

On remand, the district court stated:

[T]he starting point for assessing damages will

be the amount each plaintiff paid Loftsgaarden

for his investment (in other words, the plaintiff’s

consideration). To this, the court will add 8 per-

cent interest from the date the consideration was

paid to the date of this order. Finally, the amount

of each plaintiff’s tax benefits will be subtracted

from the sum of his ccusideration and interest.

(Pet.App.C5\. The district court then made the follow-

ing calculations and awards:

Plaintiff Anderson

Consideration paid June 2, 1983: $35,000.00

Plus interest at 8 percent to

February 22, 1984: $64, (87.00

Minus tax benefits: $29,615.00

Total Damages: $35,172.00

Interest was awarded pursuant to the statutory mandates

in section 12(2) and in Minn. Stat. § 80A.23, subd 2.

8 The district court denied Petitioners a return of their “loans”

to Alotel Associates. (Pet.App.A3,D10,E12,F12-F13).

Plaintiff Austin

Consideration paid June 6, 1983: $35,000.00

Plus interest at 8 per cent to

February 22, 1984: $64,610.00

Minus tax benefits: $33,333.00

Total Damages: $31,277.00

Plaintiff Ne[u]mann

Consideration paid August 21, 1973: $35,000.00

Plus consideration paid

October 19, 1973: $17,500.00

Plus interest at 8 percent to

February 2, 1984: $96,385.00

Minus tax benefits: $57,014.00

Total Damages: $39,371.00

Plaintiff Randall

Consideration paid November 13, 1973: $35,000.00

Plus interest at 8 percent to

February 22, 1984: $63,770.00

Plus consideration paid 1975: $ 2,512.00

Plus interest at 8 percent to

February 22, 1984: $ 4,203.00

Subtotal: $67,973.00

Minus tax benefits: $36,404.00

Total Damages: $31,569.00

(Pet.App.B1-B2).

Respondents again appealed. (J.A.3). The Eighth

Circuit sua sponte granted en banc consideration as to

whether Austin I should be reconsidered and as to whether

damages had een caleulated properly if Austin I had

been decided properly. Austin IJ at 951. The Eighth Cir-

cuit then held that Austin I had been decided correctly.

To compute the recovery the Eighth Cireuit adopted a

formula: add interest to the consideration paid for the se-

curity, subtract ‘‘tax benefits” received and imputed in-

terest thereon, then multiply the difference by two. The

Eighth Circuit therefore reduced the awards as follows:

Austin ($7,666), Anderson ($18,790), Neumann ($1,984)

and Randall ($506). Austin I at 961.

On September 24, 1985, Petitioners filed their Peti-

tion for Writ of Certiorari. (J.A.3). On November 12,

1985, this Court granted the Petition. (J.A.3).

SUMMARY OF THE ARGUMENT

I. In interpreting the federal securities laws, this

Court has always started with the statutory language.

See Landreth Timber Co. v. Landreth, 105 8. Ct. 2297, 2301

(1985): Teamsters v. Daniels, 439 U.S. 551, 558 (1979) ;

Ernst & Ernst v. Hochfelder, 425 U.S. 185, 197 (1976) ; Blue

Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 756

(1975) (econeurring opinion). The language of section

12(2) of the Securities Act of 1933 [hereinafter ‘‘section

12(2)’’] does not provide that the recovery of ‘‘considera-

tion paid’’ be reduced by ‘‘tax benefits.’? The ‘‘actual

damages’’ limitation of section 28(a) of the Securities Ex-

change Act ef 1934 [hereinafter “section 28(a)’’] does not

require that ‘‘tax benefits’? be subtracted from damages

awarded under section 10(b) of the Securities Exchange

Act of 1934 [hereinafter ‘‘section 10(b)’’] and Securities

and Exchange Commission Rule 10b-5 [hereinafter ‘‘Rule

10b-5’’]. The Eighth Cireuit strayed from the approp-

riate starting point when it deducted ‘‘tax benefits’? from

recoveries under such statutes.

The Eighth Circuit first strayed from the statutory

language by distinguishing between ‘‘tax shelters’’ and

other securities and by adopting a rule which applies only

to “tax shelters.’? Section 12(2), section 10(b), Rule 10b-5

and section 28(a) apply to all securities. There is no sta-

tutory language on which a special rule applicable only to

‘‘tax shelters’’ might be based.

The Eighth Circuit next strayed from the statutory

language by defining ‘‘income received’’ to include ‘‘tax

benefits.’’ In United Housing Foundation, Inc. v. For-

man, 421 U.S. 837, 855 (1975), this Court held that ‘‘pay

ment of interest, with its consequent deductibility for tax

purposes,’’ did not constitute income within the context of

the federal securities laws. In fact, ‘‘income’’ is

compensation for services, . . . gross income derived

from business, gains derived from dealings in prop-

erty, interest, rents, royalties, dividends, . . . income

from discharge of indebtedness [and] distributive

share of partuership gross income.

26 U.S.C. 461. “Tax benefits’? are not included in the

plain language of the statutory definition of ‘‘income.’’

‘‘Income”’ is taxable. See 26 U.S.C. §§ 1 & 11. ‘“Tax bene-

fits’? are not. Because ‘‘tax benefits’’ are not ‘‘income,’’

they should not be deducted from ‘‘consideration paid’’

when caleulating the recovery available to a defrauded

investor under section 12(2).

The Eighth Cirenit also strayed from the statutory

language by awarding interest on the “tax benefits.’’

Such an award rewrites ‘‘the remedial language of the

statute.’’ Johns Hopkins Univ. v. Hutton, 297 F. Supp.

1165, 1231 (D. Md. 1968), rev’d on other grounds, 422 I" 2d

1124 (4th Cir. 1970), cert. denied, 416 U.S. 916 (1974).

Section 12(2) provides only for adding ‘‘interest’’ to the

‘consideration paid.’’? The courts are not free to substi

tute their wisdom for the statutory language. /d.

The Kighth Cireuit again straved from the statutory

language in interpreting the ‘‘actual damages”’ provision

of section 28(a). The term ‘‘actual damages’’ appears

only in the context of authorizing parallel state and fed

eral remedies. It was designed only to prevent duplica-

tive recoveries based on state and federal law. F.9., Osof-

sky v. Zipf, 645 F.2d 107, 111 (2d Cir. 1981).

Il. The rule of Hanover Shoe, Inc., v. United Shoe

Mach. Corp., 392 U.S. 481, 503 (1968) and of Norfolk & W.

Ry. v. Liepelt, 444 U.S. 490, 493-94 (1980) that taxes are to

be taken into account in calculating the amount of recov-

ery only when the recovery is tax-free remains sound. An

”

investor in a ‘‘tax shelter” defers the payment of taxes.

When the ‘‘tax shelter’’ is concluded, the investor must

pay the taxes which he deferred. Because of changes in

the investor’s other income, changes in the Internal Rev-

enue Code and variations in applicable marginal rates, the

amount of taxes the investor actually pays in a later year

may be greater or less than the amount would have been

at the time the taxes would have been due but for the ‘‘tax

shelter.’’ The ‘‘rough result of not taking account of

taxes for the year of injury but then taxing recovery’’ is

‘‘the most satisfactory outeome.’’ Hanover Shoe, Inc. v.

United Shoe Mach. Corp., 392 U.S. at 503.

III. The purpose of the Securities Act of 1933

is to protect the investing public and honest business.

The aim is to prevent further exploitation of the

public by the sale of unsound, fraudulent, and worth-

less securities through misrepresentation; to place

adequate and true information before the investor; to

protect honest enterprise, seeking capital by honest

presentation, against the competition afforded by dis-

honest securities offered to the public through crooked

promotion ....

S. Rep. No. 47, 73d Cong., Ist Sess. 1 (1933), reprinted

in 2 J. Ellenberger & E. Mahar, Lecistatrve History oF

THE Securities Act or 1933 & tHe Securttres ExcHANGE

Act or 1934 (1973); see also United States v. Naftalin, 441

U.S. 768, 775 (1979); SEC v. Capital Gains Research Bur-

eau, Inc., 375 U.S. 180, 186-87 (1963). There is ‘‘no war-

rant for narrowing’’ the safeguards created by Congress.

See United States v. Gilliland, 312 U.S. 86, 93 (1941).

The Eighth Cireuit saw the function of section 12(2),

section 10(b) and Rule 10b-5 only as one of compensating

defrauded investors “for any actual monetary loss.”’

Even if it were true that an award of $506 as of December

15, 1983, fully compensated an investor’s actual monetary

loss which had resulted from investing $35,000 in a worth

less security on November 13, 1973, the award would not

accomplish the statute’s purpose in deterring fraud.

Fraud can be deterred only if investors have sufficient

incentives to seek a recovery and thus to compel promoters

to pay damages in amounts large enough to induce full dis-

closure. F. Easterbrook & D. Fischel, Optimal Damages

im Securities Cases, 52 U. Cur L. Rev. 611, 620 (1985).

The threat of civil liability is an important mechanism for

coercing adewuate disclosure. Only if the sanction of

civil liability is sufficiently serious (and the damages suf

ficiently high) will fraud be deterred and accurate and

complete information be provided to prospective invest

ors. Note, Real Estate Limited Partnerships & Alloca-

tional Efficiency: The Incentiwe to Sue for Securities

Fraud, 63 Va. L. Rev. 669, 685 (1977).

ARGUMENT

I. THE INTERPRETATION OF SECTION 12(2)

AND THE CALCULATION OF DAMAGES UN-

DER SECTION 10(b) AND RULE 10b-5 MUST

BE CONSISTENT WITH THE LANGUAGE OF

THE STATUTES AND THE RULE.

‘‘The starting point’’ for the imterpretation of the

federal securities laws ‘‘is the language [of the statute |

itself.’ Blue Chip Stamps v. Manor Drug Stores, 421

U.S. at 756 (concurring opimon); accord, Landreth Tim-

ber Co. v. Landreth, 105 S. Ct. at 2301; Teamsters v. Dan-

tels, 429 U.S. at 558; Ernst € Ernst v. Hochfelder, 425 U.S.

at 197. In attempting to interpret section 12(2) and to

define the damages which section 28(a) permits to be re-

covered under section 10(b) and Rule 10b-5, the Eighth

Cireuit started at the wrong point. It disregarded the

clear language and effectively rewrote the statutes un-

der the guise of interpreting them.

When a court sets out to interpret a statute, it is to

determine ‘‘only what the statute means.’’ O. Holmes,

The Theory of Legal Interpretation, 12 Harv. L. Rev.

417, 419 (1898); see also S & E Contractors, Inc. v. United

States, 406 U.S. 1, 14 n.9 (1972). If the language of a

statute is plain, it is the duty of a court to enforce the

statute as written. United States v. Standard Brewery,

Inc., 251 U.S. 210, 217 (1920). Absent a clearly expressed

legislative intent to the contrary, the language of a statute

must ordinarily be regarded as conclusive. Consumer

Prod. Safety Comm’n v. GTE Sylvania, Inc., 447 U.S. 102,

108 (1980). ‘‘In construing a federal statute it is approp-

riate to assume that the ordinary meaning of the language

that Congress employed ‘accurately expresses the legis-

lative purpose.’ ’’ Mills Music, Inc. v. Snyder, 105 8. Ct.

638, 645 (1985).

A. There Is No Statutory Basis For Differentiat-

ing Between “Tax Shelters’ And Other Se-

curities.

Section 12(2) applies to all fraudulent sales of “a

security” and provides the same remedy to all defrauded

purchasers. Section 10(b) and Rule 10b-5 apply to “the

purchase or sale of any security.” Section 28(a) applies

to all suits for damages under section 10(b) and Rule

10b-5. Section 12(2), sections 10(b) and 28(a) and Rule

LOb-5 say nothing about a special rule for suits seeking

recovery on account of frauds related to “tax shelters.”

The Eighth Cireuit held that

in a private securities fraud action involving an

investment structured and marketed as a tax

shelter, where a rescissory measure of damages

is applied, evidence of any benefit derived by the

plaintiff/investor via tax savings must be per-

mitted.

Austin I at 183-84. The Eighth Cireuit expressly re-

stricted its holding “to cases involving investments that

are expressly marketed and sold as tax shelters.”? Austin

I at 183; accord, Austwm II at 954 (holding applies only to

“special case of tax shelter investments”).

Alotel Associates does not meet the definition of a “tax

shelter” established by the Internal Revenue Code. See

26 U.S.C. § 6111(c)(1) (“tax shelter’’ means an investment

represented as providing a ‘tax shelter ratio’ for an investor

“sreater than 2 to 1” during any of first 5 years). The Of-

fering Memorandum projected investment, deductions and

credits as follows:

Year Investment Deductions Credits

1973 $35,000 $20,395 $2,432

1974 14,695

1975 2,960

1976 476

1977 ( 1,929)

(PI.Ex.2 at 27; Tr.42). Thus, the “tax shelter ratio” during

the first 5 years was to be

Year Ratio

1973 72/1

1974 1.14/17

1975 1.23/1

1976 1.24/1

1977 1.18/1

See 26 U.S.C. § 6111(c)(2). Because the ratio was never rep-

resented as reaching 2 to 1, an investment in Alotel Asso-

ciates could not be characterized as a ‘tax shelter.”

That holding creates a distinction with no statutory

basis. If there were to be a rule that “income” under

section 12(2) ineludes “tax benefits” and that damages

under section 10(b) and Rule 10b-5 must be reduced by

‘‘tax benefits,’’ the rule should apply to all cases. There

is no basis for distinguishing a fraudulent sale of a se-

curity “structured and marketed as a tax shelter” from

a fraudulent sale of a security not so structured and mar-

keted. Common stock, if it becomes worthless, generates

a “tax benefit” for the investor. Yet, if the investor had

purchased the stock in reliance on a misrepresentation and

if the stock had become worthless, the Eighth Circuit would

not reduce his recovery on account of the “tax benefits”

he had obtained.”

The Eighth Circuit justified its distinction on the

ground that the “tax benefits” were “bargained for.” Aus-

tin IIT at 955. That justification ignores the obvious:

every purchase of a security includes a “bargain” con-

cerning the tax consequences. Every purchaser knows of

and accepts the holding period for capital gains treatment,

the deduction available if the security becomes worthless

10 An investor receives “tax benefits” in a variety of circum-

stances involving purchases of securities. He is permitted

to take a loss when a security, i.e., stock, bond, debenture

or note, becomes worthless. See 26 U.S.C. § 165(g). He is

permitted to reduce his taxable income on account of con-

tributions to an individual retirement account, see 26 U.S.C.

§ 219, on account of a qualified reinvested stock dividend,

see 26 U.S.C. § 305(b), on account of a contribution by a

self-employed person to a pension or profit-sharing plan,

see 26 U.S.C. $401(c), and on account of a qualified cash

arrangement by which he directed an employer to con-

tribute to a qualified trust. See 26 U.S.C. § 401(k). He is

permitted to elect to have a tax-exempt organization which

employs him reduce his income and use the monies to

purchase an annuity for him. See 26 U.S.C. § 403(b). Such

deductions defer taxes in the same manner as does a “tax

shelter” and thus create “tax benefits.”

or is sold at a loss, ete. The purchase of a “tax shelter”

differs only in the specifies of the “tax benefits” that were

bargained for.

B. The Language Of Section 12(2) Does Not Al-

low Deduction Of “Tax Benefits’ From A De-

frauded Purchaser’s Recovery.

Section 12(2)’s language is straightforward. The

statute allows a defrauded purchaser

to recover the consideration paid for such security

with interest thereon, less the amount of any income

received thereon, upon the tender of such security.

The measure of recovery for a defrauded purchaser who

still owns the security has three elements: (1) the con-

sideration paid, (2) interest on the consideration and

*) a ° .

io} LNnecomMe Tecely ed.

1. “Tax Benefits” Are Not “Income.”

The district court attempted to use “the ordinary

meaning” of the term “income” in interpreting section

12(2). Cf. Mills Music, Inc. v. Snyder, 105 S. Ct. at 645.

The district court found that there had been a timely

tender of the limited partnership units, concluded that

rescission was appropriate and refused to reduce the re-

covery under section 12(2) on account of “tax benefits.”

(Pet.App.D10,D17,F15-E16).

The Fighth Cireuit rejected the district court’s literal

reading of section 12(2). Although it acknowledged that

tax benefits received were not a form of income in a strict

accounting sense, Austin II at 955, the Eighth Cireuit nev-

ertheless held that

section 12(2)’s language “income recewed thereon”

may properly be construed as including tax benefits

bargained for and received . . .

Austin II at 958 (emphasis in original).

The Eighth Cireuit disregarded “the ordinary mean-

ing” of the word “income.” “Income” normally means

“gain derived from capital, from labor, or from both com-

bined.” Eisner v. Macomber, 252 U.S. 189, 207 (1920).

“Tax benefits” are not gain derived from capital or labor.

In interpreting a term, courts are to use a “well-

settled meaning” if one exists. See Landreth Timber Co.

v. Landreth, 105 S. Ct. at 2302. ‘‘Income” carries a ‘‘well-

settled meaning.” 26 U.S.C. 461 establishes the meaning

of “income”:

compensation for services, . .. gross income derived

from business, gains derived from dealings in prop-

erty, interest, rents, royalties, dividends, . . . income

from discharge of indebtedness [and] distributive

share of partnership gross income.

“Tax benefits” are not included within that “well-settled

meaning’’ of ‘‘income.’’”

Courts also look to “significant characteristics typi-

cally associated with” terms in attempting to interpret

them. See Landreth Timber Co. v. Landreth, 105 S. Ct. at

2302; United Housing Foundation, Inc. v. Forman, 421

U.S. at 851. “Income” has “significant characteristics.”

One of those characteristics is taxability. “Tax benefits,”

of course, are not taxable. If deductions were “income,”

every taxpayer who took a deduction in one year would

be required to include it within “gross income” on the fol-

11 One commentator noted that “Austin /1/ is without prece-

dent in classifying tax benefits received by the plaintiff as

‘income’ within the meaning of section 12(2).” Note, Aus-

tin v. Loftsgaarden: Securities Fraud in Real Estate Limited

Partnership Investments, 16 CREIGHTON L. REV. 1140,

1151 (1982).

Although “income” expressly includes a “distributive share

of partnership gross income,” 26 U.S.C. § 61(a)(1), it does

not include “tax benefits’ attributable to a distributive

share of partnership losses.

lowing year’s tax return. Austin IJ at 963 n.1 (dissenting

opinion). No reported case or revenue ruling construes

a deduction or credit as “income.” See 26 U.S.C. § 61.

In United Housing Foundation, Inc. v. Forman, 421

U.S. 837, this Court considered whether non-interest bear-

“

ing shares in a non-profit housing cooperative were “in-

vestment contracts” and therefore “securities.” as that

term is used in section 2(1) of the Securities Act of 1933.

An “investment contract” requires an “expectation of

profits.” The sellers therefore argued that the purchasers

had bought the shares to obtain housing, not to obtain

income or profits. The court of appeals disagreed, hold-

ing that profit might “be derived from the income yielded

by an investment,” id. at 855, and that one source of such

income was “tax deductions for the portion of the monthly

rental charges allocable to interest payments on the mort-

gage.” Id. at 846.

This Court reversed, stating that the conclusion that

‘

tax deductions are a “supposed source of income or profits

may .e disposed of summarily.” /d. at 855. It held that

income or profits means “either capital appreciation re-

sulting from development of the initial investment

or a participation in earnings resulting from the use of

the investors’ funds,” td. at 852, and concluded:

We know of no basis in law for the view that the pay-

ment of interest, with its consequent deductibility for

tax purposes, constitutes income or profits.

Respondents themselves did not argue that tax benefits

constituted income. Austin II at 958 (“Loftsgaarden argues

that . . . tax benefits are a return of ‘consideration paid’ ”’).

Respondents’ own expert also testified that “tax benefits’

were not “income.” (R.178). The district court took “ju-

dicial notice that [Randall] didn’t receive any income.”

(R.179).

Id. at 855. If “tax benefits” do not constitute income or

profits under section 2(1), then “tax benefits” should not

be considered income under section 12(2)."

“Tneome,” as used in section 12(2), does not include

every favorable economic consequence. In Johns Hop-

kins Univ. v. Hutton, 297 F. Supp. at 1232, payments made

by the seller to defrauded purchasers intended to be ap-

plied to taxes were held not to be “income” under section

12(2). See also M. Kaminsky, An Analysis of Securities

Intigation under Section 12(2), 13 Hous. L. Rev. 231, 281

(1976); 5C A. Jacobs, Litigation & Practice Unprer Rute

10b-5 § 260.03[e] [vi] at 11-56 n.3 (2d ed. 1985) ; 26 U.S.C.

§ 61.

The Eighth Circuit rationalized that its expansive in-

terpretation of “income” reflected “economic reality” and

that to ignore “tax benefits actually realized . . . would

be unrealistic.” Austin IT at 955 & n.9. That rationaliza-

tion flies in the face of a cardinal principle of rescission:

“(tlhe goal of rescission under section 12(2) is to return

the parties to the status quo ante.’’ Austin II at 954. The

Kighth Circuit purports to return Petitioners to the status

quo ante, but it never purports to return Respondents to

the status quo ante or to require them to disgorge their

unlawfully obtained profits. As the dissent noted:

There was evidence at trial showing Loftsgaarden

received over $100,000 profit from the investment

scheme. Under the majority’s approach, Loftsgaarden

4 ~The Eighth Circuit tried to distinguish United Housing

Foundation by characterizing the tax benefits at issue there

as “marginal” and those now at issue as “the primary mo-

tivation behind the investment.” Austin // at 955. Such a

distinction should be of no consequence. Nothing in sec-

tion 12(2) contemplates substracting substantial ‘tax bene-

fits” from damages but ignoring marginal ones.

gains both his own profit from the scheme and the

advantage of plaintiffs’ speculative tax benefits.”

Austin II at 963 (dissenting opinion).

The Eighth Cireuit’s rationalization also assumes that

“tax benefits” would provide a “windfall” to defrauded

purchasers unless those ‘‘tax benefits’? were deducted from

their recoveries. The Eighth Cirenit therefore chose to

award the ‘‘windfall’’ to defrauding sellers. Even if a de-

frauded purchaser were to obtain a windfall, it would be

‘‘more appropriate to give the defrauded party the benefit

even of windfalls than to let the fraudulent party keep

them.’ Myzel v. Fields, 386 F.2d 718, 747 (8th Cir. 1967),

cert. denied, 390 U.S. 951 (1968) ; Janigan v. Taylor, 344 F.

29d 781, 786 (1st Cir.), cert. denied, 382 U.S. 879 (1965) ; see

also Gerstle v. Gamble-Skoqmo, Inc., 478 F.2d 1281, 1305

(2d Cir. 1973); Johns Hopkins Univ. v. Hutton, 297 F.

Supp. at 1226.

The Fighth Cireuit’s rationalization also ignores the

legislative history. That history demonstrates that a de-

frauded purchaser is to obtain his recovery from the seller.

H.R. Rep. No. 85, 73d Cong., 1st Sess. 9 (1933), reprinted

in 2 J. Ellenberger & E. Mahar, Leerstative History or

rue Securities Act or 1933 & THE Securitres ExcHANGE

Acr or 1934 (1973) (defrauded purchaser can ‘‘sue for re-

covery of his purchase price’’); S. Rep. No, 47, 73d Cong.

Ist Sess.

15 The evidence showed that PDRC received no less than

$80,490, that 2361 received no less than $213,334 and that

arc-TECH, inc., received $90,000.

16 = Petitioners will get no windfall. Any recoveries will be

subject to tax. Furthermore, it would be

reasonable to assume that if plaintiffs had not invested

in Loftsgaarden’s fraudulent scheme, they would have

invested in another legitimate project which would

have returned similar tax benefits as well as principal

and interest over the life of the investment. .. .

Austin II at 964 n.2 (dissenting opinion).

6 (1933), reprented m 2 J. Ellenberger & E. Mahar, Lects-

LATIVE History or THE Securities Act or 1933 & THE

Securities Exonance Acr or 1934 (1973) (defrauded pur-

chaser can “sue for a return of his money’) ; 77 Cong. Ree.

2913 (1933) (defrauded purchaser can get his ‘‘money

back” from seller).

2. ‘‘Interest’’ Should Not Be Added To ‘‘Tax

Benefits” Even If “Tax Benefits” Were To Be

Considered ‘‘Income Received.’’

The Eighth Cireuit compounded its error by subtract-

ing interest on the ‘‘tax benefits” from the ‘‘consideration

paid.” Austin II at 959. That further reduces a de-

frauded purchaser’s recovery under section 12(2). After

remand, the district court had stated:

The clear language of [section] 12(2) presents the

order in which to consider these items: “considera-

tion paid . . . with interest thereon, less the amount

of any income received... .” These words present

an express directive to this court, and [the] defend-

ant[s] cite no eases directly on point which hold to

the contrary.

(Pet.App.C7). The Eighth Cireuit reversed. It con-

ceded that the result of its holding as to section 12(2)

was to permit a defrauded purchaser “to recover the

amount paid for [the security] with interest, less the

amount received with interest.” Austin IT at 959, quoting

Murphy v. Cady, 30 F. Supp. 466, 470 (D. Me. 1939), aff'd

113 F.2d 988 (1st Cir.), cert. dented, 311 U.S. 705 (1940).

Section 12(2) mandates recovery of “the considera-

tion paid for the security with interest thereon, less the

amount of any income received thereon.” The Eighth Cir-

euit effectively rewrote the latter portion of the statute

to read “less the amount of any income received thereon

with interest thereon.” The words “interest thereon” mod-

iiy only “consideration paid.” The word “thereon” has

no other antecedent. Interest is to be added only to the

‘‘consideration paid,’’ and ‘‘income received’’ is then to be

subtracted from the sum. See Johns Hopkins Univ. »v.

Hutton, 297 F. Supp. at 1231 [adding interest to ‘‘in-

come received” under section 12(2) would be proper only

if court had ‘‘power, to in effect, rewrite the remedial lan-

cnace of the statute’).

C. Nothing In Section 28(a) Justifies Reducing Dam-

ages Under Section 10(b) And Rule 10b-5 By “Tax

Benefits.’’

Damages under section 10(b) and Rule 10b-5 are lim-

ited by section 28(a). Section 28(a) provides:

The rights and remedies provided by [the Securi-

ties Exchange Act of 1934} shall be in addition to any

and all other rights and remedies that may exist at law

or in equity; but no person permitted to maintain a

suit for damages under the provisions of [the Securi-

ties Exchange Act of 1934] shall recover, through sat-

isfaction of judgment in one or more actions, a total

amount in excess of his actual damages on account of

the act complained of . .

The Eighth Cireuit concluded that ‘‘a plaintiff can recover

no more than his ‘net economic loss’ ’’ and held that ‘‘net

economic loss’’

was to be equated with ‘‘actual damages.”’

Austin IT at 954; accord, Salcer v. Envicon Equities Corp.,

744 F.2d 935, 940 (2d Cir. 1984), petition for cert. filed,

53 U.S.L.W. 3688 (U.S. Mar. 13, 1985) (No. 84-1447).

That interpretation begs the question of what is in-

tended by the term ‘‘actual damages.’’ A careful examin-

ation of section 28(a) and of other statutes that use the

term and a review of judicial construction of the term

demonstrate that ‘‘actual damages” does not require a

reduction of damages on account of ‘‘tax benefits.’’

First, the sentence structure of section 28(a) suggests

that Congress meant only to prevent duplicative recoveries

when a plaintiff asserted a state law claim as well as a

federal securities law claim. The first clause of section

28(a) provides that federal remedies do not preempt state

remedies. The phrase ‘‘actual damages’’ prevents a

plaintiff from recovering more than once if he pursues

both federal and state causes of action.” F.g., Osofsky v.

Zipf, 645 F.2d at 111.

Second, although Congress did not define the term

‘‘actual damages’’ when it enacted section 28(a), the term

already had an accepted meaning. The term was used in

statutes governing patent, copyright and trademark in-

fringement. See 35 U.S.C. § 67 (1928); 17 U.S.C. § 25

(1928); 15 U.S.C. §§ 16-19 (1928).

This Court had defined the term ‘‘actual damages,’’

as used in the patent statutes, to require damages to be

‘‘viven as a compensation, recompense, or satisfaction to

the plaintiff, for an injury actually received.’ Birdsall v.

Coolidge. 92 U.S. 64 (1876). The copyright and trademark

statutes allowed a plaintiff to recover both his ‘‘injury”’

and the infringer’s ‘‘profits’’ and equated ‘‘injury” and

‘‘profits’’? with ‘‘actual damages.’’ See 17 U.S.C. § 25

(1928); 15 U.S.C. § 19 (1928).

In L. P. Larson, Jr., Co. v. William Wrigley, Jr., Co.,

277 U.S. 97 (1928), this Court refused to deduct income

taxes from a recovery for trademark infringement. This

Court held:

To review one of these questions a writ of certiorari

was granted by this court. That question is whether

17 A strict construction of section 28(a), which refers only to

“a suit for damages,” may preclude any limitation on the

equitable remedy of rescission. See Note, Insiders Liability

under Rule 10b-5 for the Purchase of Actively Traded Se-

curities, 78 YALE L.J. 864, 874 n.51 (1969).

. . the Wrigley Company should be allowed to deduct

the Federal income and excess profits taxes from the

profits with which it is to be charged.

Even if the only relief that the Wrigley Company can

get is a deduction from gross income when the amount

of its hability is finally determined, the Larson Com-

pany will have to pay a tax on the Wrigley profits

when it receives them, and in a case of what has been

found to have been one of conscious and deliberate

wrongdoing, we think it just that the further deduc-

tion should not te allowed.

Id. at 99-100. Thus, when the Securities Exchange Act of

1934 became law, the term ‘‘actual damages’’ did not re-

quire damages to be reduced because of tax consequences.'*

The reasoning behind the judicial refusal to credit an

infringer with the taxes paid on the profits being recovered

in patent, copyright and trademark cases applies equally

to securities fraud cases. Recovery for patent, copyright

or trademark infringement is not reduced by

income taxes .. . since plaintiffs will be required to

pay income taxes on any amount recovered and should

not have that amount diminished... .

Carter Prod., Inc. v. Colgate-Palmolive Co., 214 F. Supp.

383, 406 (D. Md. 1963). Recoveries in securities fraud

cases are also taxable and also should not.be diminished.

18 Subsequent patent, copyright and trademark cases contin-

ued to apply the rule and refused to consider tax conse-

quences when computing damages. See, e.g., Wolf v. Nat-

ional Lead Co., 272 F.2d 867, 873 (9th Cir. 1969) (income

taxes paid by infringer are not a proper deduction when

accounting for a trademark infringer’s profit); Alfred Bell

& Co. v. Catalda Fine Arts, Inc., 191 F.2d 99, 106 (2d Cir.

1951) (error to allow deduction when accounting for a copy-

right infringer’s profits); Sheldon v. Metro-Goldwyn Pic-

tures Corp., 106 F.2d°45, 53 (2d Cir. 1939), aff'd, 309 U.S.

390 (1940); Goodyear Tire & Rubber Co. v. Overman Cush-

ion Tire Co., 95 F.2d 978, 985 (6th Cir. 1937) (no deduction

from profits for income taxes paid by patent infringer).

Third, deducting tax benefits from damages gives a

defrauder the benefit of provisions of the Internal Rev-

enue Code that were structured to benefit investors. The

Eighth Cireuit expressed concern that, if Respondents

were to retain the ‘‘tax benefits,’’ Respondents would reap

a windfall, t.e., something in excess of their ‘‘actual dam-

ages.’’ This Court has not seen fit to interpret ‘‘actual

damages’’ to restrict recoveries in any such way. In 4ffili-

ated Ute Citizens v. United States, 406 U.S. 128 (1972),

defrauded sellers sought to recover profits earned by the

defrauder. The defrauder objected that such a recovery

was precluded by the ‘‘actual damages’’ limitation of sec-

tion 28(a). This Court held that the ‘‘actual damages’’

limitation does not prevent recoveries constituting ‘‘more

than the [defrauded] seller’s actual loss’’ in actions under

section 10(b). Jd. at 155.

Thus the ‘‘actual damages’’ limitation does not pre-

vent a plaintiff from recovering a ‘‘windfall,’”’ Myzel v.

Fields, 386 F.2d at 747; Janigan v. Tayior, 344 F.2d at 786,

nor does it prevent a plaintiff from recovering more than

his ‘factual loss.’’ Affiliated Ute Citizens v. United

States, 406 U.S. at 155. Neither should the limitation pre-

vent a plaintiff from recovering damages in reduction by

‘*tax benefits.’’

II. PERMITTING DEFRAUDED PURCHASERS TO

RECOVER THEIR ‘‘CONSIDERATION PAID

. . . WITH INTEREST” WITHOUT A REDUC-

TION FOR “TAX BENEFITS” IS CONSISTENT

WITH PRECEDENT.

A. The Eighth Circuit’s Decision Fails To Defer

To This Court’s Precedent.

The Eighth Cireuit’s decision that recoveries for se-

curities fraud must be reduced by ‘‘tax benefits’? canuoi

he reconciled with this Court’s decisions. The impact of

taxes on recovery is the subject of a number of significant

opinions.

In Hanover Shoe, Inc. v. Umted Shoe Mach. Corp.,

392 U.S. 481, this Court first addressed a party’s argument

part; gi

that an adversary’s damages must be reduced to the “aft-

er-tax profits that [the adversary] failed to receive.’’ Jd.

at 503. This Court held that

to diminish the actual damages by the amount of taxes

that [a plaintiff] would have paid had it received

greater profits in the years it was damaged would be

to apply a double deduction for taxation, leaving [the

plaintiff] with less income than it would have had if

[the defendant] had not injured it.

Id. This Court, recognizing the changing rates of tax-

ation, expired statutes of limitation and difficulties in re-

computing taxes that would have accrued over a period

of years, stated that

the rough result of not taking account of taxes for the

year of injury but then taxing recovery when received

seems the most satisfactory outcome,

id., and held that damages should equal pre-tax profits

and that the IRS should be permitted to tax the recovery.

Id.

In Norfolk € W. Ry. v. Lrepelt, 44 U.S. 490, this Court

held that it was necessary to instruct a jury that a dam-

age award would not be taxable. Jd. at 4°1. This Court

recognized that an injured individual’s after-tax income,

not his gross income before taxes, was the relevant factor

in calculating the damages sustained by his dependents

when he died. Jd. at 493-94. This Court again recognized

the complexities in predicting the many variables; never

theless, it held that the danger of overcompensation based

on an erroneons assumption concerning taxability required

the admission of expert testimony concerning income tax

liability for future wages and the giving of an instruction

that a judgment would not be taxable. Jd. at 497-98.

In Jones & Laughlin Steel Corp. v. Pfeifer, 462 U.S.

523 (1983), this Court offered guidance to those seeking

to reconcile Hanover Shoe with Liepelt. This Court stated

that, when the damages award itself is to be tax-free, the

evidence to be considered is that concerning ‘‘after-tax’’

amounts. It implied that, when the damage award itself

is taxable, evidence of taxes paid or to be paid should be

excluded. fd. at 547-51.

The Eighth Cireuit applied Litepelt to Petitioners’

claims for damages even though it recognized that each

would ‘‘have to pay taxes on his award.’’ The Eighth

Cireuit failed to consider Hanover Shoe or Pfeiffer. In

doing so, the Eighth Cireuit glossed over Liepelt’s predi-

cate that its holding applied only when an award of dam-

ages is not taxable.

B. The Eighth Circuit’s Decision Fails To Defer

To Other Precedent.

Jourts interpreted the federal securities laws and

provided remedies to defrauded purchasers for over thirty

years before the deductibility of tax benefits surfaced as

an issue in a reported decision. See Cooper v. Hallgarten

€ Co., 34 F.R.D. 482 (S.D.N.Y. 1964). When defendants

first argued that a plaintiff’s recovery should be reduced

by an amount equal to the tax benefits flowing from an

investment, court uniformly rejected those arguments.

See, e.g., Rhode v. Hershberger Explorations, Inc., 349 F.

Supp. 993, 994 (D. Minn. 1972); Johns Hopkins Univ. v.

Hutton, 297 F. Supp. at 1232; Wiesenberger v. W. E. Hut-

ton & Co., 35 F.R.D. 556, 557 (S.D.N.Y. 1964); Cooper

v. Hallgarten & Co., 34 FR.D. at 484; see also Chris-Craft

Indus., Inc., v. Piper Aircraft Corp., 480 F.2d 341, 391

(2d Cir.), cert. denied, 414 U.S. 910 (1973) (‘‘party seek-

ing rescission must return any proceeds... received from

the transaction being rescinded [but] the proceeds that

must be returned are [only] those received from the other

party’’).

Some courts eventually permitted discovery concern-

ing ‘‘tax benefits’’ because information discovered might

be relevant to issues other than damages. Courts which

permitted such discovery considered it relevant to valua-

tion of the investment, see Dupuy v. Dupuy, 551 F.2d 1005,

1025 (5th Cir.), cert. dented, 434 U.S. 911 (1977); Smith

v. Lader, 83 F.R.D. 4387, 439 (S.D.N.Y. 1979); cf. Berg

v. Xerxes-Southdale Office Bldg. Co., 290 N.W.2d 612,

615 (Minn. 1980), to misrepresentation of tax benefits,

Bridgen v. Scott, 456 F. Supp. 1048, 1062 (S.D. Tex.

1978) ; Bayoud v. Ballard, 404 F. Supp. 417, 426 (N.D. Tex.

1975), to causation, see Houlihan v. Anderson-Stokes, Inc.,

78 F.R.D, 232, 234 (D.D.C. 1978), to reliance, see Smith v.

Bader, 83 F.R.D. at 439; Sharp v. Coopers & Lybrand, 83

I’. R.D. 343, 352 (E.D. Pa. 1979), rev’d on other grounds,

649 F.2d 175 (3d Cir. 1981), cert. denied, 455 U.S. 938

(1982), and to laches. See Hickman v. Groesbeck, 389 F.

Supp. 769, 780 (D. Utah 1974). Other courts continued

to consider tax benefits wholly irrelevant. E.9., Spatz v.

Borenstein, 513 F. Supp. 571, 576-86 (N.D. Ill. 1981); see

also Borovoy v. Bursar Realty Corp., 86 Mich. App. 732,

738, 273 N.W.2d 545, 548 (1979) (tax consequences ‘‘do

not enter into the computation of damages’’ under Michi

gan’s securties laws); G & R Corp. v. American Sec.

Trust Co., 523 F.2d 1164, 1173-74 (D.C. Cir. 1975) (con

tract damages not to be offset by tax benefits).

The Eighth Cireuit was the first to require that a

recovery be reduced by tax benefits. Austin I at 183; Note,

Austin v. Loftsgaarden: Securities Fraud in Real Estate

ee ee

ee Cet ee

——

ee ee en ee

—_—

Iimited Partnership Investments, 16 Creicuton L. Rev.

at 1151. Most other courts rejected the Highth Cir-

euit’s approach. E.g., Western Fed. Corp. v. Erickson,

739 F.2d 1489, 1444 (9th Cir. 1984); Burgess v. Premier

Corp., 727 F.2d 826, 837-38 (9th Cir. 1984); Koehler v.

Pulvers, [Current] Ferp. Sec. L. Rep. (CCH) { 92,232

at 91,671 (S.D. Cal. 1985); Hokama v. EF. F. Hutton & Co.,

566 F. Supp. 636, 847-48 (C.D. Cal. 1983); see also Eisen-

berg v. Gagnon, 766 F.2d 770, 782 (3d Cir. 1985) (deduct-

ibility of losses net to be considered in assessing damages) ;

Danzig v. Jack Grunberg & Assoc., 161 Cal. App. 3d 1128,

1139-40, 208 Cal. Rptr. 336, 343-44 (1984), cert. denied, 106

S. Ct. 67 (1985) (limited partners’ tax consequences ir-

relevant to their rescissionary recovery based upon mis-

representation); Harris v. Metropolitan Mall, 112 Wis.

2d 487, 501-02, 334 N.W.2d 519, 526 & n.21 (1983) (tax

consequences of ‘‘tax shelter’’ do not reduce restitutionary

recovery). The Second Circuit, however, adopted the

Eighth Cirevit’s approach. See Freschi v. Grand Coal

Venture, 767 F.2d 1041, 1050-51 (2d Cir. 1985), petition for

cert. filed, 54 U.S.L.W. 3154 (U.S. Sent. 6, 1985) (No. 85-

377); Salcer v. Envicon Equities Corz., 744 F.2d at 940-44.

C. Deducting “Tax Benefits” From Recoveries

For Securities Fraud Disregards The Collat-

eral Source Rule.

The Eighth Cireuit’s decision vitiates the ‘‘collateral

source’’ rule. The rule is set forth in RestaTeEMENT (SEc-

onpD) or Torts § 920A(2) (1979):

Payments made to or benefits conferred on [an] in-

jured party from other sources are not credited

against the tortfeasor’s liability, although they cover

all or a part of the harm for which the tortfeasor is

liable.

The rule means that

a benefit that is directed to the injured party should

not be shifted so as to become a windfall for the tort-

feasor. If the plaintiff was himself responsible for

the benefit, as by maintaining his own insurance or

by making advantageous employment arrangements,

the law allows him to keep it for himself. If the bene-

fit was a gift to the plaintiff from a third party or

established for him by law, he should not be deprived

of the advantage that it confers. The law does not

differentiate between the nature of the benefits, so long

as they did not come from the defendant or a person

acting for him.

Td. comment b.

The Eighth Cireuit held that

the tax benefits of plaintiffs’ investments are not a

collateral source because ‘‘although paid by the gov-

ernment, [they] emanate directly from the tax shelter

sought by the plaintiffs and provided by defendants,

without which plaintiffs could not have realized any

tax benefits. Benefits resulting directly from a trans-

action under attack must be credited toward the dam-

age award.

Austin II at 956, quoting Salcer v. Envicon Equities Corp.,

744 F.2d at 941-42. That analysis misconstrues the nature

of a ‘‘collateral source.’’”

Every collateral source results ‘‘directly’’ from the

tort or transaction at issue: otherwise, no defendant could

claim to reduce his obligation based on a payment from

’

the ‘‘collateral sourece.’’ Health and disability insurance

’

payments come from a ‘‘collateral source’’ and do not re-

19 The analysis fails to acknowledge that there would be no

“tax benefits” but for a defrauded purchaser’s income from

other sources.

duce the damage for which the tortfeasor is liable even

though the injury and hence the insurance payments result

‘‘directly’’ from the tort. The rule applies even if the

tortfeasor contributes to a fund which provides the bene-

fits. E.g., Eichel v. New York Cent. R.R., 375 U.S. 253,

254-55 (1963); NLRB v. Gullett Gin Co., 340 U.S. 361, 364

(1951); Kauffman v. Sidereal Corp., 695 F.2d 343, 346-47

(9th Cir. 1982).

The proper question is whether the benefit is conferred

on an injured party from a source other than the defen-

dant. Kestatement (Seconp) or Torts 4 920A(2). Pe-

titioners’ ‘‘tax benefits’? come from a third party, 1.e., the

government, and are calculated based on Petitioners’ other

income. R. Thompson, The Measure of Recovery under

Rule 10b-5, 37 Vanp. L. Rev. 349, 390 (1984) (‘‘plaintiff who

receives a tax benefit obtains his advantage from the gov-

ernment, not from the defendant’’). Petitioners’ ‘‘tax bene-

fits’? do not come from Respondents. Because the ‘‘tax ben-

efits’’ were established for [them] by law,’’ Petitioners

‘‘should not be deprived of the advantage’’ created. See

RestaTEMENT (Seconp) or Torts § 920A(2) comment b;

Funston v. Umited States, 513 F. Supp. 1000, 1010

(M.D. Pa. 1981) (‘‘tax benefit conferred by [the state]

is from a collateral source’); Jowa-Des Moines Nat’l

Bank v. Schwerman Trucking Co., 288 N.W.2d 198, 205

(lowa 1980) (‘‘tax saving [is to be] treated as a collateral

source’’); Cereal Byproducts Co. v. Hall, 16 Ill. App. 2d

79, 81, 147 N.E.2d 383, 384, aff’d, 15 Til. 2d 313, 155 N.E.2d

14 (1958) (tax consequences of theft loss treated as being

from collateral source); Lumber Terminals, Inc. v. Nowa-

kowski, 36 Md. App. 82, 97, 373 A.2d 2 *, 291-92 (1977)

(‘*[t]axes are strictly between plaintiff as taxpayer and

the government as collector, and are of no legitimate con-

cern of the defendants’’).

III. PUBLIC POLICY CONSIDERATIONS REQUIRE

THAT ‘‘TAX BENEFITS’ NOT BE SUB-

TRACTED FROM SECURITIES FRAUD RE-

COVERIE&.

This Court often considers practical factors and con-

siderations of policy in explicating congressional intent.

See Blue Chip Stamps v. Manor Drug Stores, 421 U.S.

at 749. All practical and policy considerations require

courts to disregard ‘‘tax benefits’’ in calculating recoveries

under the federal securities laws.

A. Subtracting ‘‘Tax Benefits’’ From Securities

Fraud Recoveries Undermines The Disclosure

Requirements Of The Federal Securities Laws.

In 1933 President Roosevelt ay pealed to Congress in

seeking passage of the Securities Act of 1933:

This proposal adds to the ancient rule of caveat

emptor, the further doctrine, “Let the seiler also be-

ware.” It puts the burden of telling the whole truth

on the seller. Jt should also give impetus to honest

dealing in securtties . .

(7 Cong. Rec. 937 (1933) (emphasis added). The preamble

to the Securities Act states that its purpose is to

provide full and fair disclosure of the character of

securities sold in interstate and foreign commerce and

through the mails, and to prevent frauds in the sale

thereof ....

47 Stat. 74 (1933) (emphasis added). When it became

law, the Securities Act of 1933 created “a system of full

disclosure.’’ T. Hazen, Taz Law or Securities REGULATION

§ 1.2 at 7 (1985) ; see also 1 L. Loss, Securrrizs Reeutarion

184 (2d ed. 1961). The Securities Exchange Act of 1934

is intended to regulate all aspects of the public trading of

securities, bars material misstatements and omissions and

requires full disclosure. T. Hazen, Tae Law or Securities

REGULATION § 1.2 at 7; see also 1 L. Loss, Securities Recu-

LATION 184.

The Securities Act of 1933 and the Securities Exchange

Act of 1934 implement the requirement of full disclosure

by five primary means: (1) SEC examination of registra-

tion documents to determine compliance with the laws’

disclosure requirements, (2) SEC initiation of injunction

proceedings, (3) SEC administrative hearings and sanc-

tion procedures, (4) criminal prosecutions and (5) private

litigants’ suits for restitution and damages. T. Hazen,

Tae Law or Securirms Recuiation §1.3 at 10-11; 1 L.

Loss, Securitres Reeuratrion 302-03; 2 L. Loss, Securities

Reeuxation 845-57 (2d ed. 1961); T. Hazen Administrative

Enforcement: An Evaluation of the SEC’s Use of Injunc-

tions & Other Enforcement Methods, 31 Hasttnas L..J. 427

(1979); S. Rep. No. 47, 73d Cong., Ist Sess. 6 (1933), re-

printed im 2 J. Ellenberger & E. )‘ahar, Lecistative His-

TORY OF THE Securities Act oF 1933 & THE SECURITIES

Excuance Act or 1934 (1973); see also United States v.

Naftalin, 441 U.S. at 778; Red Bank Oil Co., 20 S.E.C. 863,

866 (1945).

The Securities Act of 1933 exempts certain securities

from its registration requirements because of the “small

amount involved” or because of the limited character of

the public offering, 15 U.S.C. §77c, and exempts certain

transactions because of the nature of the transactions or

the participants. 15 U.S.C. § 77d. Most limited partner-

ship offerings” fall within one or more exemptions.”!

Therefore, the SEC has no opportunity to examine cocu-

ments prior to sale. Because neither the SEC nor the

Department of Justice has the resources to police all of

the fraudulent activity by organizers of limited partner-

ships,” the primary tool in enforcing the disclosure re-

quirements is the private civil action. Note, Real Estate

Limited Partnerships & Allocational Efficiency: The In-

centive to Sue for Securities Fraud, 63 Va. L. Rev. at 670-

71.

The incentive to make full disclosure thus is in direct

relation to the likelihood and risk of a suecessful suit.

Id. at 671; see also F. Easterbrook & D. Fischel, Optimal

Damages in Securities Cases, 52 U. Cur. L. Rev. at 614

30. The Eighth Cireuit’s decision makes it unlikely that

20 ~The total invested in limited partnerships in 1983 was es-

timated to be $8.4 billion. TIME, Nov. 26, 1984 at 26. The

total invested in 1984 was estimated to be $19 billion. 4

R. Haft & P. Fass, TAX SHELTERED INVESTMENTS vii (3d

ed. 1985). In 1980 there were approximately 211,000 real

estate limited partnerships in existence. Bureau of Nat'l

Affairs, Inc., Daily Report for Executives (Feb. 21, 1984).

21 In a 12 month period during 1975-1976 only 10 limited

partnerships were registered with the SEC. [1976] 5 FED.

SEC. L. REP. (CCH) at 64,214. In a similar period during

1984-1985 less than 60 real estate limited partnerships were

registered. [1985] 6 FED. SEC. L. REP. (CCH) Br. 5 & 6

at 64,264-77.

Fraud continues to grow despite the efforts of federal and

state enforcement agencies. Washington Post, Jun. 4, 1984,

at A-11.

defrauded investors will sue and minimizes the risk to the

fraudulent promoter in the unlikely event that they do

sue. Note, Real Estate Limited Partnerships & Alloca-

tional Efficiency: The Incentive to Sue For Securities

Fraud, 63 Va. L. Rev. at 671-72. One commentator de-

scribed the Eighth Circuit’s message to potential pro-

moters:

Relax. Should a violation of the securities law occur,

promoters in the Eighth Circuit apparently need only

assure themselves that the investors get a large enough

tax deduction.

Note, Austin v. Loftsgaarden: Securities Fraud in Real

Estate Limited Partnership Investments, 16 CreicHTon

L. Rev. at 1152.

Allowing the Eighth Cireuit’s decision to stand en-

courages promoters to omit or to misrepresent information

material to potential investors. Like Loftsgaarden, those

promoters will hope to pocket in excess of $100,000, see

Austm IT at 963 (dissenting opinion), to keep all of the

money for twelve years and then to return less than $30,000.

The decision will discourage investors who look at Randall

and see only a man who invested $35,000 as a result of a

fraud, who spent $7,500 in loans and other thousands of dol-

lars trying to salvage his investment and who was left with

nothing but an expenditure of more than ten years and

additional thousands of dollars in attorney’s fees in pur-

suit of his recovery of $506.

This Court must insist on the disclosure required by

statute. To do so, it must insure the continued viability

of the express and implied remedies for violations of the

securities laws’ disclosure requirements. To do otherwise

is to undercut the protective purpose of the securities laws.

See R. Thompson, The Measure of Recovery under Rule

10b-5, 37 Vanp. L. Rev. at 390 (‘‘[fjocusing ‘on the de-

fendant and resolving doubts against the party committing

the frand is consistent .. . with the dual deterrent/com-

pensatory purposes of the federal securities laws’’ and

requires that there be no deduction for tax benefits) ;

United States v. Naftali, 441 U.S. at 774-77.

B. Subtracting ‘‘Tax Benefits’’ From Securities

Fraud Recoveries Effectively Transfers Mon-

ies From The Treasury To The Defrauder.

By crediting a promoter who defrauded investors with

‘‘tax benefits’’ conferred by the government, the Eighth

Circuit makes the ‘‘government...the banker for fraudu-

lent tax shelter activity.’’ Burgess v. Premier Corp., 727 F.

2d at 838. Because a defrauded purchaser’s recovery is tax-

able, he will not retain all of it. Taxation will transfer a

part of the recovery to the public treasuries from which

the ‘‘tax benefits’’ first came.

[T]o simply subtract the tax benefits from damages

would place an unfair burden on taxpayers generally

. Such a result leaves the government bearing

the costs of [a seller’s] fraud. A better result is to

set damages equal to [the defrauded purchaser’s]

losses exclusive of tax benefit.

Id.

In calling for enactment of the Securities Act of 1933,

President Roosevelt cautioned that

the Federal Government cannot and should not take

any action which might be construed as. . . guaran-

teeing that newly issued securities are sound in the

sense that their value will be maintained.

—

TCs AMOI iy te ee

ee I Ee te

77 Cong. Rec. 937 (1933). The securities laws still do not

guarantee the ‘‘value”’ of securities. However, the Eighth

Circuit’s

holding provides the wrongdoer a surety by which to

avoid liability, allowing the fraudulent party to use

the United States Treasury for security in any fraud-

ulent transaction. To the extent a defendant can, by

his ngful act, create a tax loss for the innocent

victim, the defendant will be allowed to escape liabil-

ity, shifting the burden of the loss onto the govern-

ment.

Austin IT at 964 (dissenting opinion). That is something

neither President Roosevelt nor the Congress would ever

have imagined: the government now provides a guarantee,

not for the investor, but for the fraudulent promoter.

C. Subtracting ‘‘Tax Benefits’ From Securities

Fraud Recoveries Creates Anomalous Damage

Awards.

The Eighth Circuit decision creates anomalous dam-

age awards. Investors in different tax brackets, but iden-

tically situated in every other way, would receive awards

which vary widely. The differences are based upon fac-

tors which have nothing to do with the investments or with

the frauds which occasioned the awards. Even though

Randall, Austin and Anderson each invested $35,000 in

Alotel Associates and even though none received any cash

or cash equivalent as a return on his investment, Randall

is to recover $506, Austin $7,666 and Anderson $18,790.

Id, at 961; compare Hayden v. McDonald, 742 F.2d 423, 425,

439 (8th Cir. 1984) (56 plaintiffs and presumably 56 dif-

ferent results). Disparate treatment of investors based

upon differences in their taxable income undermines the

purposes of the federal securities laws. See Herman & Mac-

Lean v. Huddleston, 459 U.S. 375, 390 (1983) (defrauded

investors are persons securities laws seek to protect).

Furthermore, the Eighth Cireuit decivion enables

plaintiffs and defendants to manipulate the amount of

damages. Because ‘‘tax benefits’? depend upon an in-

vestor’s ordinary income and marginal tax bracket, a

plaintiff may control the timing of his receipt of ordinary

income and thereby increase his damages. A defendant

may also control the amount of ‘‘tax benefits’’ (and of

damages) by his own ability to make elections. S. Banoff,

To What Extent Will Benefits from Tax Shelters be Per-

mitted to Offset Rescission Damages, 57 J. TAXATION

154, 155-56 (1982).

D. Subtracting ‘Tax Benefits’ From Securities

Fraud Recoveries Does Not Fully Compensate

Defrauded Investors.

The Eighth Circuit held that the words ‘‘income re-

ceived’”’ in section 12(2) include all economic benefits bar-

gained for and received, including ‘‘tax benefits.’’* Aus-

tin II at 955. The holding misapprehended the nature and

effect of a ‘‘tax shelter.’’

The ‘‘tax benefits’’ which an investor obtains through

a ‘‘tax shelter” are no more than a deferral of taxes. Aus-

2. «~The Eighth Circuit never considered Respondents’ tax con-

sequences. Payment of rescissionary damages will result

in a business expense which can be deducted from ordinary

income; actual rescission will result in a short-term capital

loss. Both will result in “tax benefits” to Respondents. If

the Eighth Circuit’s reasoning is to be followed, Petitioners,

as the ones who bestowed the “tax benefits” on Respond-

ents, should be able to recover them from Respondents.

tin II at 963 (dissenting opinion). The district court found

that Petitioners ‘‘were not actually going to make any

money because of tax losses’’ and were getting only a tax

deferral. (Pet.App.F6). Indeed. the Eighth Circuit panel

recognized that Petitioners’ investments in Alotel Asso-

ciates served ‘‘only to defer taxation until the investment

is liquidated and each partner receive[d] his . . . propor-

tional share of the proceeds of the sale.” Austin I at 174.

The Eighth Circuit treated ‘‘tax benefits’’ as ‘‘perm-

anent’’ because the relevant tax years were ‘‘closed.”

Austin IT at 955. The Internal Revenue Code does contain

a three-year statute of limitation, 26 U.S.C. § 6501(a), and

more than three years have passed, (Def.Ex.1A,1B,1C; R.

42-43,62), but the final tax consequences of the original

investment and the subsequent recovery are not yet deter-

mined.

The Eighth Cireuit itself acknowledges that a de-

frauded purchaser who recovers will be taxed on his re-

covery. Austin II at 960. At the time of recovery taxes

may be imposed as a result of a purchaser’s amendment

of his earlier tax returns. Taxes may be imposed under

the mitigation provisions of the Internal Revenue Code,

which permit correction of the effect of an error even if

the statute of limitation woul! otherwise prevent correc-

tion. 26 U.S.C. §§ 1311-14. Taxes may be imposed under

the tax benefit rule’s requirement that a recovery be

taxed as ordinary income.

The Ninth Cireuit correctly understood the conse-

quences of a ‘‘tax shelter’’; it held:

While we agree that consideration of tax consequences

is relevant for certain purposes, we decline to make

the government the banker for fraudulent tax shelter

activity. Judge Hardy’s analysis in Western Federal

Corp. v. Davis, 553 F. Supp. 818, 820 (D. Ariz. 1982)

is correct in discerning that the economic benefit by

way of tax deductions is ates because amended

returns will have to be filed .

Id.; accord, Western Fed. Corp. v. Brickoon, 739 F.2d at

1444; Rhode v. Hershberger Explorations, Inc., 349 F.

Supp. at 994 (‘‘[t]o the extent recovery is had, amended

income tax returns will have to be filed’’).

Rescission may invoke the mitigation provisions.

Section 12(2) allows a defrauded purchaser to rescind.

Wigand ». Flo-Tek, Inc., 609 F.2d 1028, 1035 (2d Cir. 1979).

Section 29(b) of the Securities Exchange Act of 1934, 15

U.S.C. § 78ee(b), declares contracts ‘‘made in violation

of’’ section 10(b) or Rule 10b-5 to be ‘‘void.’’ Thus, a

defrauded purchaser who can demonstrate a violation of

section 10(b) or Rule 10b-5 can sue for and obtain recis-

sion. E.g., Mills v. Electric Auto-Lite Co., 396 U.S. 375,

387-88 (1970); Regional Properties, Inc., v. Financial &

Real Estate Consulting Co., 678 F.2d 552, 558 (5th Cir.

1982). Recission voids the underlying transactions from

the inception and returns the parties to the sittus quo

ante. Brown v. Producers Livestock Loan Co., 469 F.

Supp. 27, 31 (D. Utah 1978); 5C A. Jacobs, Lirication &

, 7, Paacrice Unver Rute 10b-5 § 260.03 [e][vi] at 11-56.

ex. When a ‘‘court of competent jurisdiction’’ enters a

‘final “ judgment, decree, or other order’’ which “deter-

mines the basis of property’’ or ‘‘of any transaction on

‘ “which [the]basis [for valuing an asset] depends’’ and the

~ basis is different from the basis claimed by a taxpayer,

see 26 U.S.C. §§ 1312-13, the ‘‘effect of the error shall be

corrected’’ despite the restriction otherwise imposed by

the statute of limitation. See 26 U.S.C. §1311(a). A

judgment rescinding a purchase of a ‘‘tax shelter’’ and

declaring it void ‘‘from the inception’’ would be a deter.

mination of a transaction on which the purchaser’s basis

depended and requires correction of “the effect of the er-

ror... by an adjustment.’’ See 26 U.S.C. §1311(a).

The IRS may invoke the tax benefit rule. See 1 J.

Mertens, Law or Freperat Income Taxation § 7.34 at 7-115

& § 7.37 at 7-129 to -130 (1985) (taxpayer who claims de-

duction resulting in tax benefit one year and who obtains

recovery or repayment in later year must include recovery

or repayment as ordinary income in the year of recovery).

Invocation of the tax benefit rule ‘‘ ‘eliminates’ [a defraud-

ed] purchaser’s tax benefits.’’ A. Blankenheimer, Tax

Consequences of Rescission: The Interplay Between Pri-

vate & Public Law, 42 U. Cut. L. Rev. 562, 588 (1975). If

the rule is invoked, ‘‘a court ordering recission has no

grounds for awarding the seller an offset.’’ Id.

E. A Securities Fraud Action Is Not An Appro-

priate Proceeding In Which To Litigate The

Tax Consequences Of An Investment Induced

By Fraud.

It is undisputed that Petitioners’ investments in

Alotel Associates and their recoveries, if any, did and

will create tax consequences for them. It is also undis-

puted that Respondents’ sales of limited partnership units

and payments of judgments, if any, did and will create

tax consequences for them. It is also undisputed that

those tax consequences will be determined. However, a

securities fraud action is not an appropriate proceeding

in which to determine those consequences.

A number of factors indicate that a securities fraud

trial is not the time to determine tax consequences. First,

the language of section 12(2), of section 10(b) and of Rule

10b-5 does not contemplate making tax adjustments. Sec-

ond, this Court has indicated that, where a recovery will

be subject to taxes, any adjustments should be deferred

to the appropriate taxing authorities. Hanover Shoe, Inc.

~®. United Shoe Mach. Corp., 392 U.S. at 503. ‘Third, the

collateral source rule requires that ‘‘tax benefits’’ not be

subtracted from recoveries. Finally, the facts necessary

to make a proper determination of all tax consequences of

the transaction and the resulting recovery can never be

known at the time of trial.

It is impossible for a trier of fact to make an accurate

allocation beeause all necessary facts can never be known.

The year in which the judgment will finally be collected

is unknown. A plaintiff’s income and his tax bracket in

that year are unknown. A defendant’s income and tax

bracket in that year are unknown. The tax laws and tax

rates in that year are unknown. In the face of all the un-

certainty, it is impossible at the time of trial to accurately

predict the tax consequences of the fraudulent sale and

resulting recovery.

A speculative approximation is, of course, possible.

However, it is unnecessary, and it is redundant. Congress

intended the IRS and the courts to make the determina-

tions after all the relevant facts were known. When the

IRS and the courts do make those determinations, they

will make them with precision and in accordance with ap-

plicable law.% Foisting that responsibility on triers of fact

who can never have the necessary facts will yield only spec-

ulation.

4 No taxing authority can be bound by the result of a securities

fraud action to which it is not a party. See A. Blankenheimer,

Tax Consequences of Rescission: The Interplay Between

Public & Private Law, 42 U. CHI. L. REV. 562.

The approach that yields mere speculation also adds

substantial complexity to already complex securities law

eases. The Eighth Circuit held:

Evidence of [an IRS] audit and expert opinions as

to its likely results are admissible at the retrial on

damages. Certainly the possibility that past tax de-

ductions will be disallowed is relevant to the determi-

nation of the extent of any benefit actually received

by plaintiffs from those deductions. The jury is en-

titled to determine whether and to what extent there

would be a disallowance of deductions.

Austin I at 183. Presumably, the jury will also be required

to consider and determine the probability and likely out-

come of IRS appeals, Tax Court or district court litigation

and further judicial review.

Such a procedure creates a dilemma for the defrauded

investor. Proving the weakness of his ‘‘tax shelter bene-

fits’? creates a road map for an IRS audit, but failing to

offer proof reduces the damages available. D. Korn, A

Taxing Quandry: Should Investors Deprived of Shelter

Sue, Barron’s, Jun. 17, 1985, at 39.

Section 12(2) was designed ‘‘to provide relatively

easy civil relief to [defrauded] purchasers.’’ M. Kamin-

sky, An Analysis of Securities Litigation under Section

12(2), 13 Houston L. Rev. at 280. The Eighth Circuit

has converted it into a labyrinth.

ty.

—

CONCLUSION

The judgment of the Highth Circuit should be re-

versed insofar as it requires ‘‘tax benefits’’ to be con-

strued as ‘‘income,’’ which reduces recovery of a de-

frauded purchaser who rescinds pursuant to section 12(2).

The judgment also should be reversed insofar as it re-

quires ‘‘tax benefits’’ to offset damages under section

10(b) and Rule 10b-5. This Court should remand for the

entry of judgment awarding Petitioners the consideration

paid, interest on the purchase prices from the dates of

purchase through the date of judgment and a reasonable

attorney’s fee.

Respectfully submitted,

Rosert ArtHUuR Brunia

O’Connor & Hannan

3800 IDS Tower

80 South Eighth Street

Minneapolis, Minnesota 55402

Telephone: (612) 343-1200

Tep S. Mere

Freprikson & Byron, P.A.

1100 International Centre

900 Second Avenue South

Minneapolis, Minnesota 55402

Telephone: (612) 347-7000

Terence M. FrutH

Fruta & AnruHony, P.A.

1350 International Centre

900 Second Avenue South

Minneapolis, Minnesota 55402

Telephone: (612) 349-6969

Wusur F. Dorn, Jr.

Dorn Law Fem, Lop.

300 East Main Street

Anoka, Minnesota 55303

Telephone: (612) 427-5903

January 6, 1986.

This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.