Jones Swanson spends a good bit of its commercial litigation group’s energy focused on a particular niche of litigation over tax strategies which have been found by the Internal Revenue Service to have been abusive. No matter how many times we are involved in these cases on behalf of those individuals who were sold the abusive tax strategies, one question always arises from the defense bar: can wealthy, smart, sophisticated people be defrauded by their lawyers?
Earlier this year, in a suit arising out of a nearly two decades-old tax strategy transaction, New York’s intermediate appellate court answered yes to that question (Johnson v. Proskauer Rose LLP, 2015 NY Slip Op 03626 (April 30, 2015)). According to the allegations made by the plaintiffs, who are heirs to the Johnson & Johnson fortune, lawyers from Proskauer Rose made an unsolicited proposal to plaintiffs’ advisor that would permit plaintiffs to sell their Johnson & Johnson stock without incurring a significant tax burden. The Proskauer lawyers met with the plaintiffs, explained the strategy and represented that the strategy “would withstand IRS scrutiny since it had ‘a legitimate and bona fide business and economic purpose.’” Although plaintiffs were not in a rush to sell their stock, the Proskauer lawyers told them they would be “foolish” not to because the strategy was not likely to be open-ended and was only offered to them as “favored clients” of the firm.
In late 2000, Plaintiffs executed an engagement letter with Proskauer and in exchange for payment of approximately $425,000, in June 2001, received a 63-page opinion letter from Proskauer that concluded that “it was more likely than not” that the strategy would not be subject to penalties if disallowed by the IRS. Soon after the plaintiffs received the opinion letter, the IRS began investigating the strategy and in 2002, offered an amnesty program for taxpayers who participated in the strategy. According to plaintiffs, Proskauer never informed them of this amnesty opportunity.
Ultimately, plaintiffs filed suit against Proskauer and the individual lawyers involved, alleging claims of legal malpractice, fraud and unjust enrichment and to seek recovery of the excessive legal fees they paid. In their efforts to dismiss plaintiffs’ claims, the Proskauer defendants argued in part that plaintiffs must be held to a higher standard when alleging fraud because they are themselves sophisticated and wealthy. This defense echoes that of many defendants, including lawyers, accountants and other professionals, in similar cases.
In a strongly worded opinion, the appellate court upheld the trial court’s rejection of this proposition stating: “…defendants were required to place plaintiffs’ interests above all else, without regard to their perceived pedigrees, fortunes or business savvy. Indeed, the mere facts that plaintiffs were wealthy and could afford high-priced counsel are insufficient for us to draw the conclusion that, as a matter of law, they should have known that there was almost a 50% possibility that the tax strategy would not succeed. On this record, defendants cannot establish the specific backgrounds of plaintiffs and their familiarity with the tax code and IRS practices such that defendants can argue that plaintiffs were not justified in relying on defendants’ advice. Ironically, this argument by defendants bolsters plaintiffs’ excessive fee claim, since it invites the question why, if they were truly so sophisticated, they needed a $425,000 opinion from Proskauer to convince them to pursue the TDG/Proskauer strategy. Further, it is worth noting that one of the things a sophisticated investor is presumed to know to do before entering a transaction is to consult with its attorney. That is precisely what plaintiffs did, and they were entitled to rely on defendants’ advice.”
While Proskauer’s ultimate liability is yet to be decided, New York courts have sent a strong message by allowing plaintiffs’ fraud and punitive damages claims to proceed. That message dispels any illusion that wealthy investors cannot be defrauded by their advisors.