Amicus Curiae Brief — Randall v. Loftsgaarden

._ + ee

A Supreme Court, U.S.

}

F I L. E D

No. 85-519 AN 1@ 1986

In the Supreme Court of the UnifehSrstey ”

OCTOBER TERM, 1985

WILLIAM C. RANDALL, ET AL., PETITIONERS

v.

B.J. LOFTSGAARDEN, ET AL.

ON WRIT OF CERTIORARI TO THE UNITED STATES

COURT OF APPEALS FOR THE EIGHTH CIRCUIT

BRIEF FOR THE UNITED STATES AND

THE SECURITIES AND EXCHANGE COMMISSION

AS AMICI CURIAE IN SUPPORT OF PETITIONERS

CHARLES FRIED

Solicitor General

ROGER M. OLSEN

Acting Assistant Attorney General

LAWRENCE G. WALLACE

Deputy Solicitor General

ALBERT G. LAUBER, JR.

Assistant to the Solicitor General :

ANN BELANGER DURNEY |

TERESA E. MCLAUGHLIN ;

Attorneys '

Department of Justice .

DANIEL L. GOELZER Washington, D.C. 20580

General Counsel (202) 633-2217

PAUL GONSON

Solicitor

JACOB H. STILLMAN

Associate General Counsel

RICHARD A. KIRBY

Assistant General Counsel

MARTHA H. MCNEELY

CATHERINE T. DIXON

Attorneys

Securities and Exchange Commission

Washington, D.C. 20549

BEST AVAILABLE COPY.

QUESTION PRESENTED

Whether, in an action under the federal securities laws

for fraud committed in the sale of a security in the form

of a tax-shelter investment, the defendant is entitled to

reduce the amount of the plaintiff’s recovery by tax bene-

fits allegedly realized by the plaintiff on account of that

investment.

(1)

TABLE OF CONTENTS

Page

Interest of amici curiae l

I nensasonnens = 2

Summary of argument 7

Argument:

Where a defrauded purchaser obtains rescission of

his securities transaction under t*e federal securi-

ties laws, the defendant’s liabil’ , should not be

reduced by the tax savings, if any, realized by the

purchaser on account of his ownership of the

EES EEL ATT i)

A. At common law, the restitutionary recovery of a

rescinding purchaser would not be reduced by

ENE EL, SC 9

B. The measure of damages under Sections 12(2)

and 10(b) is at least as favorable to the plaintiff

as the common-law remedies for securities

fraud .... aks . we 14

C. The tax laws, without the aid of the court of

appeals’ tax-offset rule, will operate to ensure

that a rescinding purchaser receives no unde-

Cee csvtnenee «ee 292

D. The tax-offset rule would impede i.e administra-

tion of the federal securities and tax laws 27

Conclusion 30

TABLE OF AUTHORITIES

Cases:

Affiliated Ute Citizens v. United States, 406 U.S.

128 . 2]

Alice Phelan Sullivan Corp. v. United States, 381

F.2d 399 26

(III)

IV

Cases—Continued : Page

Bateman LFichler, Hill Richards, Inc. v. Berner,

No. 84-679 (June 11, 1985) 2, 14, 15, 27

Birdsall v. Coolidge, 93 U.S. 64 18

Boehm v. Commissioner, 146 F.2d 553, aff’d, 3: 526

U.S. 287 nos Cetera era Le TOT ee 25

Burgess Vv. Premier Corp., 727 F.2d 826 22, 30

Commnsenemar v. Glenshaw Glass Co., 348 U.S.

Coumaieniones V. Tufts, 461 U.S. 300 24

Cooper V. Hallgarten & Co., 34 F.R.D. 482 28

Crane V. Commissioner, 331 U.S. 1 24

Deckert v. Independence Shares Corp., 311 U.S

229 - 16

Dieterich Vv. ‘Rice, 124 Wash. 613, 215 P.2d 65 1]

Ernst & Ernst v. Hochfelder, 425 U.S. 185 16, 19

Falk v. Hoffman, 233 N.Y. 199, 135 N.E. 243 12

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

petition for cert. pending, No. 85-377 23, 28, 29

Frigitemp Corp. Vv. Financial Dynamics Fund, Inc.,

524 F.2d 275 19

G&R Corp. V American Secur ity & Tr ust C 0.. 523

F.2d . 164. eee eee rae 29

Globus v. Law Research Service, Inc., 418 F.2d

1276, cert. denied, 897 U.S. 913 19-20

Gould v. American-Hawaii S.S. Co., 535 F.2d 761 19

Gypsum Carrier, Inc. Vv. Handelsman, 307 F.2d

525 ‘ 13

Hackhart v. Holmes. 675 F.2d 1114 21

Hall vy. Bank of Baldwin, 143 Wis. 303, 127 N.W.

1969 9

Hanover Shoe, Inc. vy. United Shoe Machinery

Corp., 392 U.S. 481 $, 22. 23, 26

Haughton v. Blackships, Inc., 462 F.2d 788 14

Herman & MacLean Vv. Huddleston, 459 U.S. 375 15, 19

Hillsboro Nat’l Bank v. Commissioner, 460 U.S.

370 ulmconetsiunsactiviialiicdamiiaigs 25, 26

Janigan V. Taylor, 344 F.2d 781, cert. denied,

U.S. 879 . we =e 21

Johns Hopkins Univ. v. Hutton, 297 F. Supp. 1165,

aff'd in part and rev’d in part, 422 F.2d 1124,

cert. denied, 416 U.S. 916

Cases—Continued : Page

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

EROS een eee er pias 23

L.P. Larson Co. WwW m. Wrigley Co., 277 U.S. 97.. 22

Merrill Lynch, Siceee Fenner & Smith v. Curran,

156 U.S. 353 2 ie 9

Mott v. Tri-Continental F nancial Corp., 330 F

ST ikielenesiseenenansbbiinuinieeaines adeechiehes 16

Myzel v. Fields, 386 F.2d 718. ent ‘denied, 390

U.S. 951 19

Nelson v. Serwold, 576 F. 2d 1332 21

Norfolk & W. Ry. v. Liepelt, 444 U.S. 490 22

Osofsky v. Zipf, 645 F.2d 107 19

Palmer v. Connecticut Ry. & Lighting Co., 311

U.S. 544 ce , 19

Davtheoe Production Core. v. Commissioner, 144

F.2d 110, cert. denied, 323 U.S. 779 25

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

petition for cert. pending, No. 84-1447 2, 23, 27, 29

a v. Capital Gains Research Bureau, Inc., 375

U.S. 180 ........ 15

penton Wire & Mfg. Ce. Vv. A. B. Leaeh & Co. 247

N.Y. 1, 159 N.E. 700 9

Smolowe vy. Delendo Corp., 136 F.2d 231, cert. de-

nied, 320 U.S. 751 28

United Housing Foundation, Inc. v. Forman, 421

U.S. 837 17

United States v. Naftalin, 441 U.S. 768 19

Unvert v. Commissioner, 656 F.2d 483, cert. de-

nied, 456 U.S. 961 25

Wall v. Wagner, 125 F. Supp. 854, aff'd, 226 F.2d

868 ; 16

Weiss Vv. Hayden Stone, Inc., 340 F. Supp. 1074 19

Wiesenberger Vv. W.E. Putton & Co., 35 F.R.D.

556 _ 28

Wigand v. Flo-Tek, Inc., 609 F.2d 1028 15, 16

Wright v. Dickinson, 67 Mich. 580, 35 N.W. 164 1]

Zeller Vv. Bogue Electric icaiesiitin Corp., 476

F.2d 795, cert. denied, 414 U.S. 908 21

vi

Statutes and regulations: Page

Act of July 4, 1836, ch. 357, § 14, 5 Stat. 123 18

Act of Aug. 27, 1935, ch. 774, §77(b), 49 Stat.

914 a vt aie 18

Internal Revenue Code of 1954 (26 U.S.C.):

§ 48 (q) siinsengusianeuabaiensineenitens ietniemae 24

5 fr i : 28

§ 165(c) (3) cones ; 25

§ 165(e) em ciel 25, 28

§ 165 (g) 25

§ 213 (a) we ates 14

§ 301 (c) (2) 28

§ 305 (e) 28

§ 1245 ‘ceueiline 24

§ 1250 a | 24

$§ 6221-6232 5 ne. Pe 30

Securities Act of 1933, §12(2), 15 U.S.C. 77l

(2) je passim

Securities Exchange Act of 1934, 15 U.S.C. 78

et seq.:

§ 10(b), 15 U.S.C. 78j (b) 3, 4,5, 8, 9, 18, 20

$16(b), 15 U.S.C. 78p(b) 22

§ 28(a), 15 U.S.C. 78bb(a) 1, 18, 19, 20

Tax Equity and Fiscal Responsibility Act of 1982,

Pub. L. No. 97-248, Tit. IV, § 402(a), 96 Stat.

648 SS enald 3 29-30

SEC Regulation D, 17 C.F.R. 230.501 et seq ]

Section 240.10b-5 3

Miscellaneous:

3 H. Black, A Treatise on the Rescission of Con-

tracts and Cancellation of Written Instruments

(2d ed. 1929) 10, 11

G. Clark, Equity (1954) 10

D. Dobbs. Handbook on the Law of Remedies

(1973) 9,10, 11, 12

Fleming, The Collateral Source Rule and Contract

Damages, 71 Cal. L. Rev. 56 (1983) 12

VII

Miscellaneous—Continued : Page

Ginsburg, The Leaky Tax Shelter, 53 Taxes 719

i RES Sevens ae FY eS ed SEUETA 24

H.R. Rep. 85, 73d Cong., Ist Sess. (1933) 16

5C A. Jacobs, Litigation and Practice Under Rule

10b-5 (2d ed. 1985) “ eae, 19,81; 29

Kaminsky, An Analysis of Securities Litigation

Under Section 12(2) and How It Compares With

Rule 10b-5, 13 Hous. L. Rev. 231 (1976) 16

3 L. Loss, Securities Regulation (2d ed. 1961) 19

6 L. Loss, Securities Regulation (Supp. 1969) 15

L. Loss, Fundamentals of Securities Regulation

(1983) ae 6S FB

C. McCormick, Handbook on the Law of Damages

(1935) .. ie Sa i bs > 9

1 G. Palmer The Law of Restitution (1978) 11

3 J. Pomeroy, A Treatise on Equity Jurisprudence

(5th ed. 1941) 9,11

Restatement of Restitution (1937) 10, 11, 12, 13

Restatement of Torts (1939) 12

Restatement (Second) of Torts (1979) 12, 14

Seavey & Scott, Restitution, 54 Law Q. Rev. 29

(1938) .. Po SRST: = RoR Oe : 11

SEC Directorate of Economic and Policy Analysis,

An Analysis of Regulation D (May 1984) ]

11 H. Sowards, The Federal Securities Act and the

Trust Indenture Act of 1939 (1985) 15

2 J. Story, Equity Jurisprudence (1918) 10

Thompson, The Measure of Recovery Under Rule

10b-5: A Restitution Alternative to Tort Dam-

ages, 37 Vand. L. Rev. 349 (1984) 11, 21

Iu the Supreme Court of the United States

OCTOBER TERM, 1985

No. 85-519

WILLIAM C. RANDALL, ET AL., PETITIONERS

Vv.

B.J. LOFTSGAARDEN, ET AL.

ON WRIT OF CERTIORARI TO THE UNITED STATES

COURT OF APPEALS FOR THE EIGHTH CIRCUIT

BRIEF FOR THE UNITED STATES AND

THE SECURITIES AND EXCHANGE COMMISSION

AS AMICI CURIAE IN SUPPORT OF PETITIONERS

INTEREST OF AMICI CURIAE

The Securities and Exchange Commission is responsibie

for administering and enforcing the federal securities

laws. A major purpose of those laws is to protect in-

vestors from fraudulent practices by promoters in the

offer and sale of securities. Although most tax-shelter

securities are sola in private offerings exempt from the

registration requirements of the Securities Act of 1933,

they are subject to the antifraud provisions both of that

Act and of the Securities Exchange Act of 1934.

In a recent year, about two-thirds of the 15,000 private

offerings made under SEC Regulation D, 17 C.F.R.

230.501 et seg., were limited-partnership, and thus pre-

sumably tax-shelter, ventures. SEC Directorate of Eco-

nomic and Policy Analysis, An Analysis of Regulation D,

at i-ii (May 1984). Given this volume of offerings, the

SEC lacks the resources to ensure that fraud in the offer

or sale of tax-shelter investments will be detected and

(1)

2

prosecuted. Private damage actions under the federal

securities laws are thus a necessary supplement to the

Commission’s enforcement activities. Bateman Lichler,

Hill Richards, Inc. v. Berner, No. 84-679 (June 11, 1985),

slip op. 10, 16-18.

The tax-offset rule adopted hy the court of appeals

contravenes the policies and purposes of both the securi-

ties laws and the tax laws. It undermines the deterrent

purposes of private securities actions by allowing a de-

frauding seller to retain proceeds that he has illegally

obtained from his victim, and may often deter the victim

from bringing suit at all. And its effect is to make tre

government, the source of the buyer’s tax benefits, sub-

sidize the seller’s fraud, thus granting a windfall to the

wrongdoer at the expense of taxpayers generally. At

this Court’s invitation, the United States filed a brief in

Salcer v. Envicon Equities Corp., petition for cert. pend-

ing, No. 84-1447, urging that certiorari be granted in

the present case.

STATEMENT

1. Petitioners are purchasers of interests in a real

estate limited partnership organized to construct, own and

operate a Ramada Inn in Rochester, Minnesota (Pet.

App. A3). Respondents are the promoter of the project

and three of his closely-held corporations. One of the

corporations owned the land on which the hotel was to be

built, another served as the general contractor, the third

as general partner (id. at D1-D4).

The partnership was marketed as a “tax shelter.” Its

offering memvrandum represented that the limited part-

ners would realize income tax savings as a result of

losses expected to be incurred during the partnership’s

first three years, and that the limited partners would

thereafter share in the venture’s expected profits (Pet.

App. A3). Petitioners purchased their interests in 1973

at a cost of $35,000 per unit (id. at D1, D7 n.8).

The Ramada Inn opened in 1974, several months behind

schedule, and at a construction cost substantially in ex-

cess of that projected (Pet. App. A3). The hotel subse-

3

quently incurred sizable losses due to higher-than-budgeted

operating expenses and lower-than-predicted occupancy

rates (id. at D9). The partnership ultimately defaulted

on its obligations, and foreclosure by its creditors ensued

in 1978 (id. at A38, D10).

In June 1976, petitioners brought this securities fraud

action in the United States District Court for the Dis-

trict of Minnesota, seeking recovery under Section 12(2)

of the Securities Act of 1933, 15 U.S.C. 77/(2), Section

10(b) of the Securities Exchange Act of 1934, 15 U.S.C.

78j(b), and SEC Rule 10b-5, 17 C.F.R. 240.10b-5. After

a seven-day trial, the jury found that respondents had

violated Section 10(b) and Rule 10b-5 by knowingly mak-

ing material misrepresentations and omissions in the

offering memorandum upon which petitioners had relied,

thereby causing injury to petitioners. The jury also

rendered an advisory verdict, adopted by the district

court, finding that respondents were likewise liable for

their fraud under Section 12(2) (Pet. App. A4).

The district court found that petitioners’ investments

had become worthless by the time they learned of the

fraud (Pet. App. E15). It awarded them rescissionary

damages under Section 12(2) in the amount of the pur-

chase price that each had originally paid, plus prejudg-

ment interest (7d. at E15, E16, F15). The court noted

(id. at E16) that petitioners’ Section 10(b) claim “inde-

pendently supportied]” a grant of relief, but that their

recovery under Section 10(b) would be no greater than

under Section i2(2). The court rejected, as “sophistic

malarkey,” respondents’ contention that petitioners’ dam-

ages should be reduced by the amount of tax benefits

that they had assertedly received (id. at F8).

2. The court of appeals sustained the district court’s

determination that respondents were liable under Sec-

tions 10(b) and 12(2) (Pet. App. D11-D18). It con-

cluded that “misrepresentations so permeated” the offer-

ing memorandum as to render the memorandum’s fore-

casts and projections unreasonable and misleading (id.

at D5, D14). The court of appeals also upheld the jury’s

4

finding that respondent Loftsgaarden had understated by

more than 50% the compensation that his closely-held

corporations were to receive for their roles in the venture

(id. at D9).

The court of appeals reversed the district court’s award

of damages, however, and remanded for a new trial on

that issue (Pet. App. D20-D28). It held that petitioners’

recovery, under either Section 10(b) or Section 12(2), had

to be reduced by the amount of any tax benefits that their

investment had generated. The court noted (Pet. App.

D20) that a plaintiff’s recovery under Section 10(b)

cannot be “in excess of his actual damages on account of

the act complained of” (15 U.S.C. 78bb(a)). “The actual

damages principle,” the court said, “requires that a

rescissional or restitutional award be reduced by any

value received as a result of the fraudulent transaction,”

and the court concluded that petitioners’ tax deductions

constituted “value received as a result of” their tax-

shelter investment (Pet. App. D21 (original quotation

marks omitted)). The court of appeals further noted

(id, at D21-D22) that Section 12(2) permits a defrauded

.________investor “to recover the consideration paid for [the] se-

curity with interest thereon, less the amount of any in-

come received thereon” (15 U.S.C. 77/(2)). Since peti-

tioners’ tax deductions served to reduce their taxable

income, the court reasoned, those deductions were essen-

tially the equivalent of “income received.”

Noting that petitioners’ tax returns for 1973-1978 were

then “undergoing audits by the Internal Revenue Service,”

the court of appeals acknowledged that the damages

formula it mandated was not “entirely devoid of specula-

tion” (Pet. App. D27). “{ T]he possibility that past tax

deductions will be disallowed,” the court said, was “|[c]er-

tainly * * * relevant to the determination” of petitioners’

damages (ibid.). The court ruled that “[e]vidence of the

audit and expert opinions as to its likely results [should

be] admissible at the retrial on damages,” with “[t]he

jury [being] entitled to determine whether and to what

extent there would be a disallowance of deductions”

(ibid. ).

5

8. On remand, the district court accepted respondents’

calculation of petitioners’ tax benefits (Pet. App. C2-C4).

These calculations were based on petitioners’ federal and

state income tax returns for 1973-1978, and on a report

prepared by an IRS revenue agent, upon conclusion of

the audit, reflecting petitioners’ agreement to recognize

a certain amount of income as a result of the hotel’s

foreclosure in 1978 (C.A. App. A138, A153-A154). The

district court then calculated each petitioner’s damages

as the amount he had paid for his investment, plus 8%

simple interest from the date of his purchase, minus the

amount of his net tax benefits (Pet. App. B1-B3).

4. On cross-appeals from the district court’s judgment,

the court of appeals ordered reconsideration en bane. As

to the propriety of the tax-offset rule, the court adhered

to the original panel opinion. It held that the receipt of

tax benefits negates pro tanto a plaintiff’s “actual dam-

ages,” and it held that the “actual damages’ limitation

applicable to recoveries under Section 10(b) of the 1934

Act likewise applies to computations of restitutionary

awards under Section 12(2) of the 1933 Act (Pet. App.

A6-A8). While acknowledging that tax benefits are not

“a form of income in a strict accounting sense,” the

court expressed the view that “section 12(2)’s require-

ment that ‘income received’ be deducted in determining

rescissionary damages simply reflect[s] that all economic

benefits bargained for and received must be deducted” in

computing damages ‘Pet. App. All (footnote omitted) ).

The court accordingly held that the words “income re-

ceived” as used in Section 12(2) “should be construed as

including the tax benefits bargained for and received in

the special case of a tax shelter investment” (Pet. App.

A8).

The court then adopted an elaborate formula for com-

puting recoveries under Section 12(2) in light of the tax-

offset rule. It began by accepting the district court’s

calculation of the “permanent tax benefits” that each peti-

tioner had received (Pet. App. Al5). It agreed with the

district court that petitioners were entitled to prejudg-

6

ment interest on their rescinded investment, but reasoned

that, “[b]ecause [they] were not deprived of the use of

the entire amount of their investments over the ten year

period, prejudgment interest is due only on the amount of

money they were out-of-pocket at any given time” (id.

at A20). The court hence subtracted from petitioners’

original investment the tax benefits that they had re-

ceived each year, and then calculated prejudgment in-

terest based on that annually-declining balance (id. at

A21). For years in which petitioners’ cumulative tax

benefits exceeded their original investment, petitioners in

effect were required to pay prejudgment interest to re-

spondents (ibid.).

The court next held that it was necessary to take into

account, not only the tax savings that petitioners had

previously enjoyed, but also the tax consequences of any

securities-fraud recovery that they might receive herein.

The court “assume[{d] that each [petitioner was] still in

the fifty percent tax bracket,’’ and it assumed that each

petitioner’s recovery would be taxed to him in full as

ordinary income rather than as capital gains (Pet. App.

A22). Concluding that each petitioner therefore “must

receive twice the [previously-computed] damages and net

interest cost” in order to make his after-tax recovery

equal to his “actual damages,” the court doubled the figure

previously computed (ibid.). The court of appeals held,

in other words, that the measure of rescissionary dam-

ages prescribed by Section 12(2) is the plaintiff’s original

investment, minus his tax benefits, plus prejudgment in-

terest on his original investment, minus prejudgment

interest on his tax benefits, times two (ibid.).

1 The result of applying the tax-offset rule was to reduce consid-

erably each petitioner’s damages award compared to what it would

otherwise have been. For example, apart from any consideration of

tax benefits, petitioner Randall under the district court’s computa-

tion would have been entitled to a total recovery of $67,973 (Pet.

App. B1-B2). Under the court of appeals’ holding Randall’s recovery

was $506 (id. at A22). Petitioner Neumann’s recovery was simi-

7

Chief Judge Lay, joined by Judge Bright, dissented

(Pet. App. A25-A30). They contended that the ma-

jority’s treatment of tax benefits as “income received” for

purposes of Section 12(2) conflicted with “the clear

language of the statute’ (Pet. App. A26-A27). They

argued that a plaintiff’s alleged tax benefits should have

no role in determining his securities-fraud recovery, since

“(t]he tax transaction is between [the plaintiff] and the

government and should not affect [the defendant’s] lia-

bility” (id. at A29). And they argued that the majority’s

tax-offset rule improperly allows a defendant “to escape

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

ment” (id. at A30).

SUMMARY OF ARGUMENT

The court of appeals’ decision is wrong as a matter of

securities law, tax law and common sense. The tax-offset

rule cannot be squared with the language of Section 12

(2), which permits a rescinding buyer to recover the

consideration paid for his security, “less the amount of

any income received thereon.” Tax deductions and credits

provided by the Internal Revenue Code are not “income

received * * * on” a partnership investment.

This plain-language reading is confirmed by principles

governing the common-law remedies of rescission and res-

titution, which Section 12(2) codifies. The common law

required the rescinding buyer to restore to the seller the

contested property plus its “direct product,” that is, those

benefits derived immediately from the property without

the intervention of any independent act by the buyer.

Because tax deductions and credits are derived from the

Internal Revenue Code, not from the investment property,

and because they require independent acts of the tax-

payer (including generation of income) before they can

come into existence, they are not a “direct product” of

larly reduced from $96,385 to $1,984; petitioner Austin’s from

$64,610 to $7,666; and petitioner Anderson’s from $64,787 to

$18,790. Compare id. at B1-B2 with id. at A22.

8

the rescinded investment requiring “restoration” to the

fraudulent seller.

In adopting its tax-offset rule, the court of appeals also

took an unduly narrow view of the “actual damages” prin-

ciple as applied to recoveries under Section 10(b). That

principle permits a plaintiff to recover an amount in

excess of his actual economic loss where necessary to pre-

vent the defendant’s unjust enrichment. If a plaintiff

were ultimately to realize any net tax benefits from the

rescinded transaction, it would unjustly enrich tne de-

fendant to transfer those savings to him via the tax-

offset rule. As between the investor and the promoter

who defrauded him, the investor is plainly more equitably

situated to retain this species of publicly-funded largesse,

not only because he is the victim rather than the perpe-

trator of fraud, but also because he is the person upon

whom Congress conferred the tax benefits to begin with.

The tax-offset rule is also wrong as a matter of tax

law. In appraising a plaintiff’s aggregate tax benefits,

one must consider, not only the tax benefits previously

claimed, but also the tax consequences of his securities-

fraud recovery. The Internal Revenue Code has intricate

mechanisms that require the offset or “recapture” of

previously-claimed tax benefits upon receipt of a damages

award. This Court accordingly held in Hanover Shoe,

Inc. v. United Shoe Machinery Co., 392 U.S. 481 (1968),

that an award of damages must be based on the plaintiff’s

pre-tax loss where the award itself will be taxed. The

rationale of that decision applies equally here.

Finally, the tax-offset rule would seriously compro-

mise the deterrent value of private actions in enforcing

the securities laws. In reducing or eliminating the dam-

ages recoverable by plaintiffs defrauded in tax-shelter

schemes, it would lessen the incentives for promoters to

comply with the law by permitting wrongdoers to retain

the fruits of their fraud.

9

ARGUMENT

WHERE A DEFRAUDED PURCHASER OBTAINS

RESCISSION OF HIS SECURITIES TRANSACTION

UNDER THE FEDERAL SECURITIES LAWS, THE

DEFENDANT’S LIABILITY SHOULD NOT BE RE-

DUCED BY THE TAX SAVINGS, IF ANY, REALIZED

BY THE PURCHASER ON ACCOUNT OF HIS OWNER-

SHIP OF THE SECURITY

A. At Common Law, The Restitutionary Recovery Of A

Rescinding Purchaser Would Not Be Reduced By His

Tax Savings

In deciding what remedies are proper under the federal

securities laws, it is often appropriate to begin by con-

sidering “the state of the law at the time the legislation

was enacted” in order to ascertain “Congress’ perception

of the law that it was shaping or reshaping.” See Merrill

Lynch, Pierce, Fenner & Smith v. Curran, 456 U.S. 353,

378 (1982). It is useful here, in determining the proper

measure of restitutionary recovery in actions under Sec-

tions 10(b) and 12(2), to start by examining the common-

law doctrines of rescission and restitution as applied by

the courts contemporaneously with those statutes’ enact-

ment. Examination of these doctrines shows that the

rationale underlying the court of appeals’ tax-offset rule

is contrary to the common law.

At common law, a person induced by a false prospectus,

report or other promotional document to buy stock could

sue the seller for rescission of the transaction and resti-

tution of the consideration paid. See, e.g., Seneca Wire &

Mfg. Co. v. A.B, Leach & Co., 247 N.Y. 1, 159 N.E. 700

(1928); Hall v. Bank of Baldwin, 143 Wis. 303, 127

N.W. 1969 (1910); 3 J. Pomeroy, A Treatise on Equity

Jurisprudence § 881 (5th ed. 1941). Rescission was the

act of voiding the original transaction. Restitution im-

plemented the return of property to each party in order

to restore, as nearly as possible, the status quo ante.

See C. McCormick, Handbook on the Law of Damages

§ 121, at 448 (1935); D. Dobbs, Handbook on the Law of

Remedies § 4.1 (1973).

10

Under principles of common-law restitution, the seller

was required to surrender the consideration that he had

received from the rescinding buyer, together with interest

thereon. See Restatement of Restitution §§ 28, 151, 156

(1937); 3 H. Black, A Treatise on the Rescission of

Contracts and Cancellation of Written Instruments § 632

(2d ed. 1929). In exchange for the return of his con-

sideration, the buyer was required to relinquish the

property that he had received from the seller, together

with any earnings on that property.? If the buyer had

sold the security before bringing suit, he could obtain a

money judgment approximating his purchase price, plus

interest, minus the proceeds of his sale and minus any

income that he had earned on the security while he

owned it.*

In calculating a restitutionary award at common law,

the courts uniformly held that the “earnings” with which

the defendant was to be credited were those that repre-

sented the “direct product” of the buyer’s security own-

nership, such as dividends received on corporate stock or

interest paid on corporate bonds. Restatement of Restitu-

tion §§ 157, 205 (1937). According to the Restatement

(id. § 157 comment b) :

The phrase “direct product”? means that which is de-

rived from the ownership or possession of the prop-

erty without the intervention of an independent

transaction by the possessor.

Credit to the seller, in other words, was limited to

return of the property itself (including, in certain cir-

cumstances, compensation for depreciation in its value),

plus any benefits conferred directly upon the purchaser

“Restatement of Restitution §$§1, 65, 157(1)(a) (1937); G.

Clark, Equity 445 (1954); 3 H. Black, supra, § 617, at 1495 (citing

cases); 2 J. Story, Equity Jurisprudence §§ 936-938, 962-966

(1918); 5C A. Jacobs, Litigation and Practice Under Rule 10b-5,

{ 260.03{c][vi], at 11-56 (2d ed. 1985) (discussing common-law

doctrines).

* Restatement of Restitution §§ 4(f), 66, 150, 157 (1987); D.

Dobbs, supra, § 9.4, at 622-628. See 2 J. Story, supra, §§ 963-965.

11

by the property (such as income generated by it or the

fair market value of its use).* It thus followed that a

defrauded purchaser at common law was entitled to re-

tain any benefits that originated from a source inde-

pendent both of the property and of the seller. For ex-

ample, if a dentist had rendered services at his premises,

and if his purchase of that realty were later rescinded,

he would not have been required at common law to

“restore” to the seller any portion of the fees received

for his labor. Those benefits, while related in a way to the

property, would obviously not represent the direct and

immediate product of its ownership.

The common-law doctrines of rescission and restitu-

tion had strong roots in equity. Inherent in the restitu-

tionary remedy was the prevention of either party’s un-

just enrichment by his retention of property belonging to

the other.” Where necessary to prevent a wrongdoer’s un-

just enrichment, moreover, restitution permitted a plain-

tiff to recover an amount that exceeded his actual eco-

nomic loss. As between the wrongdoer and his victim,

any doubt concerning entitlement to the benefits of a

4 See 1 G. Palmer, The Law of Restitution §§ 3.12 to 3.14 (1978) ;

3 H. Black, supra, §§ 633-634; Restatement of Restitution § 157

comment b (1937) (upon rescinded purchase of realty, seller is

entitled to credit for buyer’s interim use and occupancy, including

rents and compensation for diminution in value). Accord, e.g.,

Dieterich v. Rice, 124 Wash. 613, 215 P. 65 (1923) (deduction from

buyer’s restitutionary award of property’s reasonable rental value) ;

Wright vy. Dickinson, 67 Mich. 580, 35 N.W. 164 (1887) (same,

value of timber cut from property).

5 See Restatement of Restitution §$1 & comment e, 3, 28(c)

(1937); 3 J. Pomeroy, supra, § 873; D. Dobbs, supra, § 4.1, at 224-

229; Thompson, The Measure of Recovery Under Rule 10b-5: A

Restitution Alternative to Tort Damages, 37 Vand. L. Rev. 349, 365-

367 (1984) (discussing common-law doctrines); Seavey & Scott,

Restitution, 54 Law Q. Rev. 29, 29-31 (1938

6 Restatement of Restitution § 1 & comment e (1937); D. Dobbs,

supra, at 224, 243-244, 629; Seavey & Scott, supra, at 37.

12

rescinded transaction was resolved at common law in

favor of the defrauded party.’

These principles of restitution had a counterpart in

the common-law tort doctrine generally known ‘as the

“collateral sources” rule. Under that rule, a wrongdoer’s

liability to pay damages was not reduced on account of

“Tp]ayments made to or benefits conferred on the in-

jured party from other sources,” even where such collat-

teral payments “cover[ed] all or part of the harm for

which the tortfeasor [was] liable.” Restatement (Sec-

ond) of Torts §920A(2) & Reporter’s Note (1979).

See Restatement of Torts §§ 920 comment e, 924 com-

ment ¢ (1939); D. Dobbs, supra, § 8.10. The “collat-

eral sources” doctrine applied, not only in comput-

ing recoveries against tortfeasors, but also in calculating

certain contract damages, particularly where there had

been a fraudulent breach. See id. at 185; Fleming, The

Collateral Source Rule and Contract Damages, 71 Cal. L.

Rev. 56, 64 (1983). The doctrine was justified on the

ground that “a benefit that is directed to the injured

party should not be shifted so as to become a windfall for

the tortfeasor,” at least where the benefit “did not come

from the defendant or a person acting for him.” Restate-

ment (Second) of Torts §920A(2) comment b (1979).

Like the unjust-enrichment aspects of common-law resti-

tution, the “collateral sources’ rule was rooted in prin-

ciples of fairness. It might in certain situations “permit

a double recovery, but it [did] not impose a double bur-

den. The tortfeasor |bore| only the single burden for his

'E.g., Falk v. Hoffman, 233 N.Y. 199, 185 N.E. 243 (1922)

(Cardozo, J.) (defrauded seller of stock permitted to recover not

merely the difference between the value of the stock and the

amount paid by the defendants, but the proceeds of resale even if

such proceeds exceeded its value). See Restatement of Restitution

$3 (19387) (“A person is not permitted to profit by his own wrong

at the expense of another.”); id. §§ 66 & comment b, 142 (de-

preciation in value of property, as between innocent buyer and

fraudulent seller, need not be restored to seller); D. Dobbs, supra,

§ 9.4, at 923-925, 928.

13

wrong.” Gypsum Carrier, Inc. v. Handelsman, 307 F.2d

525, 534 (9th Cir. 1982).

2. The doctrines discussed above, which were current

at the time the federal securities laws were enacted,

make it clear that a defendant in respondents’ position

could not have eliminated or reduced, by reference to his

victim’s tax savings, his liability for fraud at common

law. In the language of restitution, such tax savings

would not have been deemed the “direct product’ of the

investment fairly creditable to the defendant’s account.

Entitlement to tax deductions and credits is conferred,

not by the property itself or by its promoter, but by the

federal government through the Internal Revenue Code.

Since tax benefits do not emanate from the seller or from

the property, and since the seller under the tax laws has

no claim to these benefits, it makes little sense to say

that they should be “restored” to him upon rescission of

the transaction.

Moreover, even if tax benefits were thought in some

sense to be “derived from the [plaintiff’s] ownership or

possession of the property,” they are not a “direct prod-

uct” of the investment because they require “the inter-

vention of an independent transaction by the possessor”

before they can come into existence. Restatement of

testitution § 157 comment b (1937). The right to tax

deductions in and of itself has no economic value. What

makes tax deductions beneficial is the investor’s inde

pendent generation of income through his own labor or

capital, which in turn enables him to take advantage of

deductions made available by the tax-shelter venture. The

investor himself in another respect also plays a signifi-

cant role in generating the tax deductions claimed, since

it is his capital contributions, together with those of

his co-investors, that give rise to the venture in the first

place. While the promoter may have rendered services in

connection with the partnership, those services play only

a partial and indirect role in securing the plaintiff’s tax

savings. For all these reasons, a buyer’s tax savings

would not have been viewed as a “direct product” of his

$$ Ee

14

rescinded investment requiring restoration to the de-

frauding seller at common law.

The “collateral sources” rule at common law would

have yielded the same result. Benefits are deemed “col-

lateral” under that rule depending on their character

and purpose. See Haughton v. Blackships, Inc., 462 F.2d

788, 790-791 (5th Cir. 1972). The tax benefits at issue

here were conferred upon investors by Congress for the

purpose of stimulating certain kinds of real estate activ-

ity deemed socially desirable. The fraudulent promoter,

being the mere incidental beneficiary of Congress’s lar-

gesse, has no legitimate claim to those tax savings. Any

tax benefits accruing to the investor would thus consti-

tute “benefits conferred on the injured party from other

sources” (Restatement (Second) of Torts § 920A(2)

(1979) ). It is true that a tax-shelter promoter functions

in a sense as the but-for cause of deductions that the

investor claims, and it is likewise true that tax consid-

erations loom large in the typical investor’s mind. But

those facts do not make the plaintiff’s tax benefits any

less “collateral” in their origin. A doctor who provides

medical services may be the but-for cause of his patient’s

claim to reimbursement from an insurance company, as

well as of his patient’s claim to a tax deduction for the

medical expenses not so reimbursed, See Internal Reve-

nue Code of 1954 (I.R.C.) § 213(a). In an action seek-

ing recovery for medical malpractice, however, both types

of benefits, being “benefits conferred on the injured party

from other sources,’ would be deemed by the common

law to emanate from “collateral sources” and sence

would not serve to reduce the deferdant’s liability for

damages.

B. The Measure Of Damages Under Sections 12(2) And

10(b) Is At Least As Favorable To The Plaintiff As

The Common-Law Remedies For Securities Fraud

Private remedies under the federal securities laws

were designed to supplement and enhance, not to dimin-

ish, the remedies available at common law. See Bate-

man Eichler, slip op. 8-11. In adopting its tax-offset

os

15

rule, the court of appeals has afforded the perpetrators

of securities fraud a defense unknown to the common law

and thus has given the federal remedial provisions an

unduly narrow construction. That restrictive reading

has scant support in the statutory language, and it is

contrary to this Court’s mandate that the securities laws

be construed liberally to effectuate their remedial and

deterrent purposes. Herman & MacLean v. Huddleston,

459 U.S. 375, 386-387 (1983) ; SEC v. Capital Gains Re-

search Bureau, Inc., 375 U.S. 180, 195 (1963). Far from

“eschew|[ing] rigid common-law barriers in construing

the securities laws” (Bateman Eichler, slip op. 10), the

court of appeals has erected novel barriers tc a plain-

tiff’s recovery, obstacles that would severely compromise

the statutory objective of deterring fraud.

1. Section 12(2) of the 1933 Act, 15 U.S.C. 771(2),

provides that an investor who has been induced to pur-

chase a security by a misleading prospectus or mislead-

ing oral communication

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 thereon, upon tender

of such security * * *.

Section 12(2) alternatively permits a defrauded investor

to sue “for damages if he no longer owns the secu-

rity.” Although the statute does not prescribe the

mode of computing damages in the latter situation, courts

and commentators have uniformly viewed Section 12(2)’s

restitutionary formula as governing the computation of

all monetary awards thereunder.®

8 See Wigand v. Flo-Tek, Inc., 609 F.2d 1028, 1034-1086 (2d Cir.

1979) ; 11 H. Sowards, The Federal Securities Act and the Trust

Indenture Act of 1989, §904[5], at 9-26 (1985); 6 L. Loss,

Securities Regulation 1221 (Supp. 1969). Contrary to the court of

appeals’ statement (Pet. App. Al2 & n.11), it is irrelevant under

Section 12(2) whether a plaintiff seeks “actual rescission” or

“rescissionary damages,” since Section 12(2)’s restitutionary for-

mula is the same in either event.

16

By enacting Section 12(2), Congress made available to

defrauded investors a statutory version of the common-

law remedies of rescission and restitution. In so doing,

moreover, Congress substantially liberalized the, common-

law cause of action. Section 12(2) eliminated the com-

mon-law requirement that an investor prove reliance on

the fraudulent representations. It relaxed the strict priv-

ity requirements of common law by permitting suit

against persons other than the immediate seller. And it

significantly eased the plaintiff’s burden of proof by

shifting to the defendant the burden of showing due

eare. See Ernst & Ernst v. Hochfelder, 425 U.S. 185, 209

n.27, 212-214 (1976); Deckert v. Independence Shares

Corp., 311 U.S. 282, 288 (1940); H.R. Rep. 85, 72d

Cong., Ist Sess. 23-24 (1933); L. Loss, Fundamentals of

Securities Regulation 1024-1025 (1983).

Congress did not specify, either in the text of the stat-

ute or in its legislative history, what constitutes “isicome

received * * * on” a security for purposes of Section

12(2). Courts and commentators alike, however, have in-

terpreted those words to mean payments (whether in cash

or in valuable property) generated directly by the secu-

rity itself, such as dividends or distributions on stock, in-

terest on bonds or on other evidences of indebtednegs

royalty payments on mineral interests, or production pa)

ments on oil and gas leases.* This construction of the

words “income received thereon” is consistent with the

doctrine of common-law restitution, under which a re-

scinding purchaser, in order to recover his consideration,

was required to restore to the seller only the original

property and its “direct product.” See page 10, supra.

* See, e.g., Wigand v. Flo-Tek, Inc., 609 F.2d at 1037 n.9; Mott

Vv. Tri-Continental Financial Corp., 330 F.2d 468, 470 (2d Cir.

1964) ; Johns Hopkins Univ. v. Hutton, 297 F. Supp. 1165, 1231-1233

D. Md. 1968), aff’d in part and rev’d in part, 422 F.2d 1124 (4th

Cir. 1970), cert. denied, 416 U.S. 916 (1974); Wall v. Wagner,

125 F. Supp. 854, 858 (D. Neb. 1954), aff’d, 226 F.2d 868 (8th

Cir. 1955). See also Kaminsky, An Analysis of Securities Litiga-

tion Under Section 12(2) and How It Compares with Rule 10b-5,

13 Hous. L.Rev. 231, 281 (1976).

17

This construction is likewise faithful to the common-sense

meaning of the words “income received.”

In holding that tax benefits claimed by an investor

ecnstitute “income received * * * on” his limited partner-

ship investment, the court of appeals has done consider-

able violence to the English language. A limited partner-

ship investment, of course, mey generate “income” of

various kinds—rent, royalties, interest and capital gains

are typical examples—and a limited partner’s distributive

share of those items would obviously constitute “income

received * * * on” his investment for purposes of Section

12(2). The tax benefits made available by such an invest-

ment, however, are not “income received thereon.” Rather,

those tax benefits take the form of deductions and credits

that an investor may use to offset the income that he

receives from other sources, or to reduce the tax that he

would otherwise owe on income independently generated.

Indeed, the court of appeals itself acknowledged that tax

benefits received are not “a form of income in a strict

accounting sense” (Pet. App. All (footnote omitted) ).'°

The notion that tax benefits are “income received”’

likewise does violence to Congress’s remedial purposes in

enacting Section 12(2). As we have shown (pages 13-14,

supra), a defrauded investor’s tax savings would not have

reduced a defendant’s liability to pay damages at com-

mon law. When Congress codified the common-law reni-

edy of rescission and restitution in Section 12(2), it took

1 This Court’s statements in United Housing Foundation. Inc.

v. Forman, 421 U.S. 837 (1975), are relevant in this respect. The

court of appeals there had held that shares in certain housing

projects constituted an “investment contract,” reasoning that such

shares incorporated “an expectation of income” owing to “the

deductibility for tax purposes of the portion of the monthly rental!

charge applied to interest on the mortgage” (421 U.S. at 852).

Reversing the court of appeals, this Court wrote: “We know of no

basis in law for the view that the payment of interest, with its

consequent deductibility for tax purposes, constitutes income or

profits” (ibid.). The Court added that, “[elven if * * * tax deduc-

tions were considered profits, they would not be the type associated

with a security investment since they do not result from the man-

agerial efforts of others” (id. at 855 n.20).

18

steps to liberalize that cause of action so as to remove

common-law barriers to recovery. See page 16, supra.

Given that expansive purpose, Congress can scarcely have

intended that Section 12(2) should be interpreted to

erect a barrier to recovery that the common law itself

did not recognize.

2. The court of appeals’ tax-offset rule is equally in-

appropriate in computing damages under Section 10(b)

of the 1934 Act, which the district court held would “‘in-

dependently support[]” (Pet. App. E16) a grant of re-

lief here. Section 10(b) prosecribes the use of manipula-

tive and deceptive practices “in connection with the pur-

chase or sale of any security” (15 U.S.C. 78i(b)). Re-

coveries under Section 10(b) and Rule 10b-5 in turn are

subject to Section 28(a) of the 1934 Act, which states (15

U.S.C. 78bb (a) ):

The rights and remedies provided by this chapter

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 this chapter shall recover,

through satisfaction of judgment in one or more

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

ages on account of the act complained of.

Although the term “actual damages” is not defined in

the securities laws, it had a well-established meaning

when the Securities Exchange Act was enacted. The term

“actual damages” was generally understood in 1934 to

permit any appropriate recovery of nonspeculative, com-

pensatory damages."? Section 28(a) has consistently been

117—n suits for patent infringement, for example, the statutory

measure of damages had long been based on the “actual damages

sustained” by the plaintiff. Act of July 4, 1836, ch. 357, §14, 5

Stat. 128. Construing that term in Birdsall v. Coolidge, 93 U.S.

64, 70 (1876), this Court held that “[c]ompensatory damages and

actual damages mean the same thing.” Similarly, in interpreting a

1935 amendment to the Bankruptcy Act that used the term “actual

damage” (Act of Aug. 27, 1935, ch. 774, §77(b), 49 Stat. 914),

this Court understood it to mean “compensatory damages,” noting

19

interpreted in the same fashion. The statute has thus

been held to permit recovery under traditional principles

for determining compensatory damages, including the res-

titutionary measure familiar to the common law. See,

e.g., Myzel v. Fields, 386 F.2d 718, 740-742 (8th Cir.

1967), cert. denied, 390 U.S. 951 (1968); 5C A. Jacobs,

supra, § 260.03[c]. In view of the limitation of a plain-

tiff’s recovery to his “actual damages,” Section 28(2) has

been read to bar duplicative recoveries, as where a plain-

tiff asserts both federal and state claims arising out of

the same course of conduct; * to preclude the award of

punitive, as opposed to compensatory, damages; ‘* and to

preclude compensation for such non-economic losses as

pain and suffering, emotional distress, and loss of image

or prestige."

In construing the statute to require reduction of a

plaintiff’s restitutionary award on account of his tax

benefits, the court of appeals took an unduly narrow view

of the concept of “actual damages” under Section 28(a).

As this Court has recently emphasized, “[t|he Securities

Act of 1933 and the [Securities Exchange] Act of 1934

‘constitute interrelated components of the federal regula-

tory scheme governing transactions in securities.’ ”’

Herman & MacLean v. Huddleston, 459 U.S. at 380

(quoting Ernst & Ernst v. Hochfelder, 425 U.S. at 206).

See United States v. Naftalin, 441 U.S. 768, 778 (1979).

The remedial provisions of the two statutes should there-

fore be read in pari materia. See Globus v. Law Research

tnat “|t]he ways compensatory damages may be proven are many.”

Palmer v. Connecticut Ry. & Lighting Co., 311 U.S. 544, 560-561

(1941).

12 See, e.g., Osofsky v. Zipf, 645 F.2d 107, 111 (2d Cir. 1981);

3 L. Loss, Securities Regulation 1624 n.5 (2d ed. 1961).

13 See, e.g., Osofsky Vv. Zipf, 645 F.2d at 111; Gould v. American-

Hawaii S.S. Co., 535 F.2d 761, 781 (3d Cir. 1976).

14 See Osofsky v. Zipf, 645 F.2d at 111; Frigitemp Corp. v.

Financial Dynamics Fund, Inc., 524 F.2d 275, 281 (2d Cir. 1975) ;

Weiss Vv. Hayden Stone, Inc., 340 F. Supp. 1074, 1075 (E.D.N.Y.

1972); L. Loss, Fundamentals of Securities Regulation 1140-1141

(1983).

20

Service, Inc., 418 F.2d 1276, 1286 (2d Cir. 1969), cert.

denied, 397 U.S. 913 (1970); L. Loss, Fundamentals of

Securities Regulation 1147 (1983). As we have shown

above, a plaintiff who receives a restitutionary recovery

under Section 12(2) of the 1933 Act may not have his

award reduced by reference to his tax benefits, both be-

cause tax benefits do not constitute “income received”

within the meaning of that Section and because tax ben-

efits would not have affected his recovery at common

law. Where a restitutionary recovery is appropriate un-

der Section 28(a) for a violation of Section 10(b), there-

fore, the measure of damages should be at least as broad

as that under the common law and under Section 12(2).

3. In holding that restitutionary recoveries under Sec-

tions 12(2) and 10(b) must be reduced by tax benefits,

the court of appeals reasoned that a contrary result would

“penalize defendants” by awarding the plaintiff an

amount in excess of his “actual monetary loss” (Pet. App.

A13). As we explain more fully below (pages 22-27),

the court of appeals proceeded from an erroneous prem-

ise. The Internal Revenue Code incorporates detailed

mechanisms for preventing undeserved windfalls to tax-

payers in situations of this sort. The tax-offset rule is

thus unnecessary.

Even if the court of appeals’ premise were correct,

however, its tax-offset rule would still be unjustifiable.

The tax-offset rule confers a windfall on the wrongdoer

by letting him-keep the fruits of his fraud. In calculat-

ing damages under the securities laws, courts must take

care to avoid unjustly enriching defendants. The remedy

of rescission and restitution at common law permitted a

plaintiff to recover an amount in excess of his actual eco-

nomic loss where necessary to prevent the wrongdoer’s

unjust enrichment; as between the wrongdoer and his vic-

tim, any doubt concerning entitlement to the benefits of a

rescinded transaction was resolved in favor of the latter.

See pages 11-12, supra. This Court has recognized that a

measure of damages that prevents defendants from re-

taining their ill-gotten gains is fully appropriate under

91

the federal securities laws. Affiliated Ute Citizens v.

United States, 406 U.S. 128, 155 (1972). Courts measur-

ing damages in securities-fraud cases have regularly

looked to the defendant’s profit rather than to the plain-

tiff’s loss where necessary to prevent unjust enrichment,

correctly reasoning that “[i]t is more appropriate to give

the defrauded party the benefit even of windfalls than

to let the fraudulent party keep them.” Janigan Vv.

Taylor, 344 F.2d 781, 786 (1st Cir.), cert. denied, 382

U.S. 879 (1965). In short, “[t]he damages ceiling im-

posed by [Section] 28(a) in terms of ‘actual damages on

account of the act complained of’ does not foreclose a

windfall recovery based on the defendant’s benefit rather

than the plaintiff’s loss.” L. Loss, Fundamentals of Se-

curities Regulation 1134 (1983).

These equitable principles show the error of the court

of appeals’ tax-offset rule. If there should remain, at the

end of the day, any permanent tax benefits stemming

from the rescinded investment, those benefits will have

come at the expense of the public fisc. If those benefits

are used to reduce the plaintiff’s securities-fraud recovery,

the effect is to transfer this species of publicly-funded

largesse, dollar-for-dollar, from the plaintiff to the de

fendant. Such a result would produce unjust enrichment

because, as between the plaintiff and the defendant who

defrauded him, the plaintiff is plainly more equitably

situated to retain the benefits that Congress has provided.

The investor is not only the victim rather than the wrong-

doer, but he is the party upon whom Congress conferred

the tax benefits in the first place. If there is to be a wind-

fall, the deterrent purposes of private actions under the

'* Accord, e.g., Hackbart v. Holmes, 675 F.2d 1114, 1122 (10th

Cir. 1982) (“[p]reventing unjust enrichment is a well-recognized

exception to the rule limiting damages to the out-of-pocket loss”) ;

Nelson Vv. Serwold, 576 F.2d 1332, 1338 (9th Cir. 1978) (“recent

trend looks to defendant’s profits, rather than to plaintiff’s losses,

in measuring damages”). See also Zeller v. Bogue Electric Manu-

facturing Corp., 476 F.2d 795, 802 (2d Cir.), cert. denied, 414 U.S.

908 (1973) ; 5C A. Jacobs, supra, § 260.03[a], at 11-18; Thompson,

supra, 37 Vand. L.R. at 372, 378-79.

22

securities laws mandate that it come to rest where Con-

gress originally put it—with the plaintiff and not with

the defendant.’

C. The Tax Laws, Without The Aid Of The Court Of

Appeals’ Tax-Offset Rule, Will Operate To Ensure That

A Rescinding Purchaser Receives No Undeserved

Windfall

Besides interpreting erroneously the rules governing

damages in securities cases, the court of appeals’ decision

is wrong as a matter of tax law. In appraising a de-

frauded plaintiff’s overall tax benefits, it is necessary to

consider, not only the tax benefits previously claimed, but

also the tax consequences of the fraud recovery itself.

Where, as here, the award will be subject to tax, it is

obviously improper to base that award on an after-tax

estimate of the plaintiff’s loss. In Hanover Shoe, Inc. V.

United Shoe Machinery Corp., 392 U.S. 481 (1968), a

case involving the computation of antitrust damages, this

Court held that a plaintiff’s award for lost profits must

be based on what its pre-tax profits would have been ab-

sent the antitrust violation, given the fact that the anti-

trust award would itself be taxable in the plaintiff’s

hands. To reduce the plaintiff’s damages by the taxes

that would have been payable on the lost profits, the

Court held, “would be to apply a double deduction for

taxation” (392 U.S. at 503). Compare L.P. Larson Co.

v. Wm. Wrigley Co., 277 U.S. 97, 100 (1928) (award for

lost profits based on pre-tax earnings where award is tax-

able), with Norfolk & W. Ry. v. Liepelt, 444 U.S. 490, 496

(1980) (award for lost income based on after-tax earn-

16 The conclusion that tax savings should not offset the defraud-

ing seller’s duty to refund the buyer’s consideration under Section

12(2) also dictates that tax savings should not affect the seller’s

duty to pay “interest thereon” (15 U.S.C. 771(2)). The court of

appeals below thus erred (Pet. App. Al9-A21) in computing peti-

tioners’ prejudgment interest. Although the Ninth Circuit has

rejected the tax-offset rule in other respects (e.g., Burgess V.

Premier Corp., 727 F.2d 826, 837-838 (1984) ), it likewise has erred

in holding that a plaintiff’s tax savings may offset his prejudgment

interest (id. at 838).

23

ings where award is not taxable), and Jones & Laughlin

Steel Corp. v. Pfeifer, 462 U.S. 523, 534 (1983) (same).

The court of appeals recognized (Pet. App. A22) that

the application of its tax-offset theory, without more,

would have imposed a double burden on petitioners by

reducing, with reference to past tax savings, a damages

recovery that would itself be taxed. In apprehending that

fact, the Eighth Circuit identified an egregious error

committed by other courts that have considered this ques-

tion.*’ Given the chance to avoid one error, however, the

court of appeals proceeded to commit two. The court de-

clined to follow this Court’s reasoning in Hanover Shoe,

under which a taxable award of damages should be based

on the plaintiff’s pre-tax loss. Instead, the court of ap-

peals persisted in appiying its tax-offset rule, basing its

tentative award of damages on petitioners’ after-tax loss,

and then, in order to reflect the award’s taxability (Pet.

App. A22), arbitrarily doubled the amount previously

computed.

As a matter of tax law, not to mention common sense,

the court of appeals’ approach is seriously flawed. Its

approach is inherently arbitrary, since it is based (Pet.

App. A22) on unsubstantiated assumptions about peti-

tioners’ tax brackets and about how their awards will be

taxed. The court’s two errors, while seemingly symmetri-

cal conceptually, do not cancel each other out in practical

effect, but rather yield awards that are small fractions of

what they would have been if the tax consequences were

ignored altogether. See pages 6-7 note 1, supra. Most

fundamentally, the Internal Revenue Code incorporates

sophisticated mechanisms for preventing undeserved wind-

falls to taxpayers in circumstances like those here. Those

mechanisms, unaided by the court of appeals’ tinkering,

will achieve the result that the court of appeals desired,

and will do so in the manner that Congress has ordained.

17 See Salcer v. Envicon Equities Corp., 744 F.2d 985 (2d Cir.

1984), petition for cert. pending, No. 84-1447; Freschi v. Grand

Coal Venture, 767 F.2d 1041 (2d Cir. 1985), petition for cert. pend-

ing, No. 85-377.

24

1. The anticipated “tax benefits” stemming from a real

estate tax shelter principally include losses that pass

through from the partnership to the partners and become

available as deductions against otherwise-taxable income

on the partner’s individual return. Such losses also serve

to reduce, dollar-for-dollar, the partner’s cost, or tax

“basis,” of his investment. A real estate tax shelter typi-

eally employs leveraged financing, permitting investors to

secure current deductions in excess of their cash outlay.

These deductions are counterbalanced in the year the in-

vestment is sold by the requirement that the investor in-

clude in his “amount realized,” for purposes of computing

his taxable gain, the amount of debt from which he is

thereby discharged. Commissioner Vv. Tufts, 461 U.S. 300

(1983): Crane v. Commissioner, 331 U.S. 1 (1947). Gen-

erally speaking, a partner’s gain on disposition of his

investment will be taxable at preferential capital gains

rates. However, some of the tax benefits generated dur-

ing a tax shelter’s early years—such as accelerated de-

preciation and investment tax credits—are subject to

“recapture” as ordinary income upon that disposition.

See, e.g., I.R.C. $$ 47, 48(q), 1245, 1250; Commissioner

v. Tufts, 461 U.S. at 303 n.2. In sum, tax shelters gen-

erally provide a form of tax deferral and, in certain cir-

cumstances, conversion of ordinary income into capital

gain, rather than a means of permanent tax avoidance.

See Ginsburg, The Leaky Tax Shelter, 53 Taxes 719

(1978).

2. If an investor who has successfully claimed such

tax-shelter benefits subsequently obtains a recovery in a

securities-fraud suit, the effect of that recovery under the

Internal Revenue Code will be to offset, in whole or in

part, the tax benefits previously received. The precise

manner in which this offset will be accomplished depends

on several variables—whether the investor’s tax returns

have been audited by the IRS, what steps he has previ-

ously taken with respect to his investment, and what kind

of recovery he obtains in the securities action. Under any

scenario, however, the tax laws will require the partner

25

to settle his accounts with the I[RS—once all the facts sur-

rounding his unhappy investment are finally determined

—gso as to eliminate the possibility of his garnering any

undeserved windfall.

If the defrauded partner wins relief in the nature of

rescission, some if not all of his recovery will probably be

taxed to him as ordinary income under the “tax benefit

rule.” As this Court recently observed, the tax benefit

rule operates to “cancel out an earlier deduction” when

a subsequent event is “fundamentally inconsistent with

the premise on which the deduction was initially based.”

Hillsboro Nat’l Bank v. Commissioner, 460 U.S. 370, 383

(1983) (original quotation marks and footnote omitted).

See, e.g., Unvert v. Commissioner, 656 F.2d 483 (9th Cir.

1981), cert. denied, 456 U.S. 961 (1982) (requiring tax-

shelter investor to recognize income on recovery of funds

from promoter, where amounts had been deducted in pre-

vious tax year). Alternatively, if the defrauded partner

wins out-of-pocket damages, the damage award generally

will serve to reduce the basis of his partnership interest.

If he has already disposed of his interest, or if he has

reduced his basis to zero by previously-claimed deductions,

the entire damage award will represent taxable income

when received. Such an award might be taxed, in whole

or in part, as ordinary income under the tax benefit rule

or under the Code’s various “recapture” provisions. The

manner in which the recovery will be taxed may also

depend on the taxpayer’s earlier treatment of his invest-

ment for tax purposes, e.g., on whether he had previously

deducted it in full as a worthless security or as a theft

loss. See I.R.C. § 165(e) (3), (e) and (g); Boehm v.

Commissioner, 146 F.2d 553 (2d Cir.), aff’d, 326 U.S.

287 (1945). Any portion of the recovery not taxed as

ordinary income would be taxed at capital gains rates.

See Raytheon Production Corp. v. Commissioner, 144 F.2d

110 (1st Cir.), cert. denied, 323 U.S. 779 (1944).

As the court of appeals perceived, the mechanisms de-

scribed above are unlikely in any case to eliminate the

economic value of tax benefits previously enjoyed. A de-

duction in year one, coupled with the inclusion in income

—E =| en

26

of an identical amount in year ten, will rarely yield pre-

cisely offsetting economic consequences, owing to the time

value of money, possible changes in tax rates, and inter-

vening changes in the investor’s tax bracket. See Alice

Phelan Sullivan Corp. v. United States, 381 F.2d 399

(Ct. Cl. 1967). As this Court has explained, however,

the purpose of the tax benefit rule is not to achieve

mathematical perfection but “to achieve rough transac-

tional parity in tax” (Hillsboro Nat’l Bank, 460 U.S. at

383). It would surely be more accurate, from a @ncep-

tual point of view, not to tax a restitutionary award upon

receipt, but instead to reopen the taxpayer’s earlier years

and disallow all deductions and credits predicated on his

ownership of the now-rescinded investment. As this Court

noted in Hanover Shoe, however, “the statute of limita-

tions frequently will bar the Commissioner from recom-

puting for earlier years,” and such recomputations in any

event would be “immensely difficult or impossible when

a long period has intervened” (392 U.S. at 503). For

these reasons, and because of the well-established ‘‘annual

accounting principle,” the IRS “in practice * * * has

taxed recoveries for tortious deprivation of profits at the

time the recoveries are made, not by reopening the earlier

years.” Ibid. (citing Commissioner v. Glenshaw Glass Co.,

348 U.S. 426 (1955)). While this result may lack con-

ceptual purity in the eyes of some, and while it may often

permit an injured plaintiff ultimately to recover an

amount somewhat in excess of his actual economic loss,

Congress has determined, and this Court has agreed, that

“the rough result of not taking account of taxes for the

year of injury, but then taxing [the] recovery when re-

ceived, seems the most satisfactory outcome” (Hanover

Shoe, 392 U.S. at 503). The court of appeals had no

license to opt for a different calculus, even if equity sup-

ported that choice, which it does not.

3. The above discussion is not intended as an exhaus-

tive catalog of tax consequences, which can be extremely

complex and take years to resolve. The point is simply

that the Internal Revenue Code, left to its own devices,

will prevent the plaintiff from receiving any “undeserved

27

windfall” (Salcer, 744 F.2d at 942). If a defendant has

defrauded a plaintiff, the damages should be measured by

the plaintiff’s loss on his investment. The tax ramifica-

tions of the award are a matter between the plaintiff and

the IRS. Once the securities lawsuit is over, and the

relevant facts are finally determined, those ramifications

will be sorted out, on a case-by-case basis, under well-

established tax principles. If, when the dust has settled,

the plaintiff emerges with net tax benefits, and if that is

considered a “windfall” to him, the windfall is not “un-

deserved.” It is not undeserved because it reflects the

customary operation of tax rules that Congress has de-

signed specifically to deal with the situation at hand.

And it is not undeserved because the plaintiff in any

event is the victim rather than the perpetrator of fraud.

D. The Tax-Offset Rule Would Impede The Administra-

tion Of The Federal Securities And Tax Laws

In insisting upon the offset of previously-claimed tax

benefits, the court of appeals has opted for an imprac-

tical and inequitable result that would have a significant

adverse impact on administration of the federal securi-

ties and tax laws. Just last Term, this Court emphasized

once again the important deterrent value of private ac-

tions, observing that they “provide a most effective

weapon in the enforcement of the securities laws.” Bate-

man Eichler, supra, slip op. 10 (original quotation marks

omitted). By improperly reducing—and often, as was

true in Salcer, eliminating entirely—the damages recov-

erable by plaintiffs who have been defrauded in tax-

shelter schemes, the tax-offset rule would necessarily

lessen the incentives for promoters to comply with the

securities laws by permitting wrongdoers to retain the

fruits of their fraud.

The tax-offset rule is particularly noxious because the

perimeters of its application are so unclear. The court of

appeals purported to restrict its applicability to “the spe-

cial case of a tax shelter investment” (Pet. App. A8),

but we see no principled basis for that limitation, even if

it were possible to say which tax-preferred investments

28

are “shelters” and which are not. Although tax advan-

tages are particularly prominent in the case of real es-

tate partnerships like that involved here, tax considera-

tions play a significant role in countless investment deci-

sions, from the purchase of municipal bonds and of inter-

ests in oil wells to investment in IRA accounts and “all-

savers certificates.”” People may be motivated to buy com-

mon stocks rather than bonds because of the annual divi-

dend exclusion (I.R.C. § 116); they may be motivated to

buy low-yielding growth stocks rather than high-yielding

blue chips in the hope of having their profits taxed as

long-term capital gain rather than ordinary dividend in-

come; and they may be motivated to buy shares of public

utilities in the hope of receiving return-of-capital distri-

butions (I.R.C. § 301(c)(2)) or avoiding current taxa-

tion on “qualified reinvested dividends” (I.R.C. § 305(e) ).

While it had previously seemed settled that a plaintiff’s

tax savings argirrelevant in computing damages where

such investments are concerned,’* the court of appeals’

analysis would make the outcome most unclear.

Besides being applicable to routine securities invest-

ments, the tax-offset rule is expandable to routine tax

deductions. The Eighth Circuit below reduced petition-

ers’ damages on account of tax benefits passed through

to them by the limited partnership itself. In Freschi v.

Grand Coal Venture, 767 F.2d 1041 (1985), petition for

cert. pending, No. 85-377, however, the Second Circuit

reduced a plaintiff’s damages because he had previously

deducted his worthless tax-shelter investment as a “theft

loss.” See I.R.C. § 165(e); 767 F.2d ai 1051. In extend-

ing the tax-offset rule to deductions claimed by taxpayers

for losses suffered on disposition of investment assets, the

Second Circuit’s approach would affect the computation

—

18 See, e.g., Wiesenberger V. W.E. Hutton & Co., 35 F.R.D. 556,

558 (S.D.N.Y. 1964) (action for rescission of participation in oil

venture) ; Cooper Vv. Hallgarten & Co., 34 F.R.D. 482, 486 (S.D.N.Y.

1964) (action for rescission of investment in oil and gas lease-

hold). Cf. Smolowe v. Delendo Corp., 136 F.2d 231, 238 (2d Cir.),

cert. denied, 320 U.S. 751 (1943) (liability for “short-swing” trad-

ing profits under 15 U.S.C. 78p(b)).

29

of damages in virtually all securities transactions. The

injustice of that approach is manifest: the promoter of

a fraudulent investment is permitted to pocket the pro-

ceeds of his fraud because of a tax loss that his very

fraud has generated. It had once seemed clear that tax

savings of this sort are irrelevant in computing damages.

See, e.g., G & R Corp. v. American Security & Trust Co.,

523 F.2d 1164, 1176 (D.C. Cir. 1975) (refusing to allow

offset of tax savings stemming from bad-debt deduction).

But the court of appeals’ analysis, particularly in light

of the Second Circuit’s adaptation of it,’® is u. such un-

certain dimensions as to place the outcome in doubt.

From a tax perspective, the decision below is equally

troubling. It will often happen, at the commencament of

a securities action, that the tax returns on which the

plaintiff claimed his deductions will be under audit by

the IRS. In such circumstances, obviously, the plaintiff’s

“tax benefits” will be wholly speculative, and any effort

to offset the damage award thereby will lapse into a tail-

spin of circular reasoning.”® Most significantly, the court

19 The Second Circuit’s approach in Freschi is equally pernicious

in applying the tax-offset rule in computing “out-of-pocket” dam-

ages, which are based on the difference between the price paid for

the security and its actual value at that time. The tax-offset rule

is plainly at odds with the out-of-pocket measure of damages,

under which the plaintiff keeps the security and is entitled to retain

benefits stemming directly or indirectly from its ownership. See 5C

A. Jacobs, supra, §§ 260.02 & n.3, at 11-13, 260.03[c] [ii], at 11-29.

*° It is no answer to suggest, as did the panel opinion be!>w, that

“le|vidence of the audit and expert opinions as to its likel, result”

should be introduced at trial, with “(t]he jury [being]! entitled to

determine whether and to what extent there would be a disallowance

of deductions” (Pet. App. D27). The prospect of juries guessing

about the outcome of complicated tax audits is altogether impracti-

cal. Nor is it any answer to demand, as did the Second Circuit in

Salcer, that the IRS speed up its audit procedures “rather than

attempt to place the issue in limbo indefinitely” (744 F.2d at 943).

The difficulties attending audits of tax shelters, which may have

thousands of ‘nvestors nationwide, are formidable, and recently

prompted Congress to enact detailed remedial legislation. See Tax

Equity and Fiscal Responsibility Act of 1982, Pub. L. No. 97-248,

30

ia)

of appeals’ tax-offset rule “make|s] the government

the banker for fraudulent tax shelter activity.” Burgess

v. Premier Corp., 727 F.2d 826, 838 (9th Cir. 1984).

There is no reason why a defendant’s liability for his

fraud should be diminished at the expense of his victims,

or at the expense of the Nation’s taxpayers generally.

CONCLUSION

The judgment of the court of appeals should be re-

versed.

Respectfully submitted.

CHARLES FRIED

Solicitor General

ROGER M. OLSEN

Acting Assistant Attorney General

LAWRENCE G. WALLACE

Deputy Solicitor General

ALBERT G. LAUBER, JR.

DANIEL L. GOELZER Assistant to the Solicitor General

General Counsel ANN BELANGER DURNEY

PAUL GONSON TERESA E. MCLAUGHLIN

Solicitor Attorneys

JACOB H. STILLMAN

Associate Gener Counsel

RICHARD A. KIRBY

Assistant General Counsel

MARTHA H. MCNEELY

CATHERINE T. DIXON

Attorneys

Securities and Exchange Commission

JANUARY 1986

Tit. IV, § 402(a), 96 Stat. 648-669 (enacting I.R.C. §§ 6221-6232).

We have been informed by the IRS that more than 30,000 tax

shelter cases are currently pending in the Tax Court, representing

almost 40% of that court’s docket.

W UV. S. GOVERNMENT PRINTING OFrice, 1966 491507 20128