Walking the Dog, Part I

One of the problems with attempting to respond quickly to new developments is that my comments are either incomplete or not well thought out. (Some would argue that this is true of all of my comments on any issue regardless of the amount of time that I have to consider them.) Frequently, I put up a post and then subsequently think of additional comments that I should have made or comments that I might want to retract. Often, this happens during my nightly walk with my dog, Houston.

Rather than merely post updates or addenda to existing posts, I will, from time to time, be posting comments under the "Walking the Dog" subject line that represent a more distanced perspective on matters that had been the subject of earlier postings. And, it represents a great excuse to post pictures of Houston as an antidote to those detestable cat-bloggers (but see here).


In any event, some additional thoughts on Chawla and on the practice of newspapers linking (or, in the case of the Baltimore Sun, not linking) to source documents for their stories.

Chawla

Chawla is technically an unpublished opinion. That is, it is not recommended for publication in the national reporting system and has no precedential authority. However, it still presents practical difficulties for planners.

The most well-known variety of trust that is designed to hold policies of insurance on the lives of the individual who established the trust is the so-called Crummey trust. Gallons of estate planning ink have been spilled describing these trusts and praising their virtues. I suspect that the total premiums paid to insurance carriers each year from Maryland residents for policies held by Crummey trusts is far in excess of the $2.45M that was at issue in Chawla.

Notwithstanding the fact that Chawla is technically "unpublished," it has been, for all practical purposes, published. Through this weblog for instance and in weblogs such as the E-LawLibrary. Is publication via a weblog with an admittedly limited readership sufficient to put practitioners on notice that there may be a fatal defect with the Crummey trust concept? Does the discussion in other professional internet outlets and the Washington Post create a situation wherein a practitioner should know of the case?

Even though the case is not precedential. What does that mean, as a practical matter, to a planner offering advice? Can he or she simply ignore the opinion? How does the planner deal with factors in the opinion that undermine its value? For instance, in Chawla the beneficiary of the trust was a person who had previously been informed that she had no insurable interest in the life of the creator of the trust. Does that mean that a trust has an insurable interest if it has as its beneficiary a person who does have an insurable interest in the creator's life (e.g., the trust settlor's child)?

As to the first question, I do not believe that we need to stop forming trusts that hold life insurance policies. At the worst, there should be a legislative fix in place by next year since there would seem to be no overarching public policy reason for the decision other than that the Court felt that it was constrained by the statute and rules of statutory interpretation. However, we are probably now required to tell clients that there is a decided case that casts a bit of a shadow on this planning technique. I believe that we are also required to inform clients who already have trusts in place that hold insurance policies if we have continuing contact and activity with respect to the clients and the trusts. We do not, however, have to contact all clients for whom we have formed trusts that continue to hold insurance policies, since we have no continuing obligation to these clients once our representation is concluded.

As to the second question, I think that we have to read the opinion as it was delivered. That is, the opinion holds, without any qualification, that trusts cannot be the beneficiaries of life insurance policies, except as set forth in the narrow exception explicitly set forth in the statute. We can tell clients that we hope that there will be a judicial "gloss" that limits the opinion, just as we could tell clients that it is, in our opinion, unlikely that other courts will reach the same conclusion. But we should not mislead clients as to what Chawla says. It says what it says, not what we hope it says.

Linking

I attempt whenever possible to link the source of material that I am discussing. I do this because it allows the curious reader to jump to the material and determine for himself or herself whether my discussion was fair and complete. Where, as was the case with Chawla, the source material is not publicly available on the web, I post it on my website and link to that location. This procedure should be standard operating procedure for all news media.

It is all well and good for newspapers to discuss and excerpt, say, the President's State of the Union Address. But they should provide an easily available link to the text of the speech. In cases like The Sunpapers v. Ehrlich, where the documents are not freely available online, mainline media should make them available online and then link to them. In that way, the reader can make a decision as to whether he or she wants to read the reporter's views on the way in which the case is developing or to read the actual filings for himself or herself to make his or her own determination. Seen in that regard, newspapers and other media become not a final destination, but a point of embarkation.

As I mentioned at the time, I thought that the Sun was not serving it's readers well when it failed to make the source documents in its lawsuit with the Governor widely available. Obviously, in many cases, news media will be our only "eyes and ears" to current events. War reporting, for instance, cannot be formated in such a way that it can be easily linked to. But when reporting on public debates on policy issues, Social Security for instance, links to source documents should be readily available. Thus, readers should be informed that (i) the various predictions as to when, if ever, the Social Security trust fund begins to run dry were conclusions developed using a variety of statistical assumptions, (ii) that the assumptions and conclusions are set forth in lengthy reports which can be easily downloaded from the web,and (iii) the reader should be given the urls where the reports can be obtained. While most readers will lack the time or inclination to read the reports, at least the media will be acting as honest brokers in giving them a roadmap to further information.

Sweat the Big Stuff AND the Small Stuff

In Mission West Properties, L.P. v. Republic Properties Corp., the Court of Special Appeals spent a good deal of effort to establish a relatively simple proposition, namely that personal jurisdiction cannot be obtained over a limited partnership simply because personal jurisdiction can be exercised over a general partner.

In essence, a dispute broke out among a variety of parties. The dispute concerned various business ventures in California. So far as I can determine, the only connection to Maryland was that the general partner of Mission West Properties, L.P. was a REIT that was organized under Maryland law. (Actually, re-organized under Maryland law. The REIT had initially been organized under California law and had its principal place of business in that state. It subsequently reorganized under Maryland law, presumably due to this state's favorable and advanced REIT statute.)

Ultimately, the Court of Special Appeals ruled that (i) a limited partnership is a juridical entity separate and apart from its partners and (ii) due process requirements must be met with respect to the entity in order to allow the exercise of personal jurisdiction over the entity.

The most interesting aspect of the case, however, is the procedural path that it took to get the jurisdictional issue before the appellate court. It illustrates the inefficiencies of the procedural rule against piecemeal appeals, a rule that is designed to promote efficiency.

The challenge to the exercise of personal jurisdiction had been made early in the litigation process and the lower court had rebuffed the attack. Ultimately, there was a week long bench trial and numerous substantive questions at issue in the appeal. This course presumably cost the litigants a good deal of time and money, all for naught.

Indeed, the Court of Special Appeals was somewhat embarrassed by the awkwardness of this process. It noted that the statute of limitations had not been blown because a lawsuit had been filed in California and it had been stayed, essentially suspending the running of the statute. Had that not been the case, one presumes that limitations would have expired and the aggrieved party would be without a remedy.

The Mission West Properties case illustrates once again that a well drafted contract will outline the remedies available in the event that the contract breaks down, including a provision concerning the courts that have jurisdiction over any dispute and the agreement of the parties to submit to the exercise of personal jurisdiction by those courts.

Lawyers (Not) In Love

There can be significant value in reading "unpublished" judicial opinions. That is, opinions that, while available on the web, are not formally adopted by the issuing court for purposes of establishing precedent. A prime case on point is Sanders v. Mueller just handed down by the Fourth Circuit.

The case deals with the claims of Maryland attorney Robert Sanders against a Michigan law firm, Olsman, Ganos & Mueller, growing out of three product liability cases. The three cases involved allegedly defective auto airbags. All three cases had been referred to Olsman, Ganos by Sanders. He brought suit against the firm in order to recover a share of the attorneys' fees recovered by Olsman, Ganos.

In the lower court, Olsman, Ganos had been granted summary judgment in two of the cases, the Greer and Holtquist cases. In the third case, Ambrose, the lower court had set aside a jury award of $300,000 in favor of Sanders, reducing the award to $1.

In the Ambrose matter, the plaintiffs had initially been represented by local counsel. Subsequently, they sought advice from Sanders who ultimately referred them to Olsman, Ganos. The local firm and Olsman, Ganos agreed upon a 45/55 fee split.

Initially, Sanders and Olsman, Ganos had agreed to a one-third/two-thirds fee split. However, Olsman, Ganos asked to modify the fee split in light of the fee split with local counsel. Olsman, Ganos' proposed modification was to split the fee based upon the "totality of the circumstances," including how much work Sanders performed, his role in referring the client to Olsman, Ganos, how much of the litigation expenses he paid, and several other factors. This arrangement only applied where there was a fee split with local counsel, as in the Ambrose case. In other cases, the initial one-third/two-thirds arrangement would stand. It was also agreed that, in all events, Sanders would be allowed to work on the cases.

Sanders rendered substantial services in the Ambrose case, by his calculation working 1,500 hours over a two year period. At one point, he worked full-time on the case for a three month period. Days before the trial in Ambrose, the case settled. A total of $1M in attorneys' fees were paid, $550,000 ot Olsman, Ganos. Although Sanders had no agreement with the local firm involved, that firm gratuitously paid him $20,000 in appreciation for his efforts. However, his efforts to reach a deal with Olsman, Ganos broke down completely. Not only did Olsman, Ganos refuse to pay him a fee in the Ambrose case, it barred him from performing any work on the Greer and Holtquist cases. Subsequently, those two cases settled and Olsman, Ganos recovered attorneys' fees in both cases.

The Ambrose Case Claim

The lower court overturned the jury award with respect to the Ambrose case, holding that Sanders had failed to present evidence that would have allowed the jury to determine with any "reasonable degree of certainty" the fair value of his services in excess of the $20,000 he received from the local counsel. Thus, the lower court concluded that Sanders had proven liability, but not damages.

Sanders' claim with respect to the Ambrose case fee was based upon the theory of quantum meruit. The Fourth Circuit distinguished between two types of quantum meruit claims, one based upon an implied-in-fact contract, usually referred to as quantum meruit, and the other based on an implied-in-law contract, generally referred to as unjust enrichment. In the first type, the award is the reasonable value of the work performed by the plaintiff. In unjust enrichment cases, the award is based upon the gain bestowed upon the defendant. The Court held that Sander's claim was in the nature of a "true" quantum meruit claim. As applied to the facts of the case, the issue could then be reduced to the time and effort Sanders expended compared to the time and effort expended by all of the other attorneys in the case. Since there was evidence that Sanders' time and effort represented as much as 50% of the total time and effort of all of the attorneys, which would have supported an award of $500,000, the Court reinstated the $300,000 judgment awarded by the jury.

The Claims in the Greer and Holtquist Cases.

The district court had rejected Sanders' claims in the Greer and Holtquist cases because it concluded that the arrangement between Sanders and Olsman, Ganos constituted a "clear and flagrant" violation of Rule 1.5(e) of the Maryland Rules of Professional Conduct. That rule regulates agreements concerning fee divisions between attorneys. It requires (i) that the division be proportional to the services rendered by each lawyer or, by written agreement with the client, each lawyer assumes joint responsibility for the representation, (ii) that the client be advised of the participation of all of the lawyers involved, and (iii) that the total fee be reasonable. While it may extend to holding fee-sharing agreements in clear and flagrant violation of the rule unenforceable, a violation of the rule is not a per se defense to the enforceability of a fee-sharing agreement. Rather, it is in the nature of an equitable defense.

The Fourth Circuit held that a two-step analysis had to be conducted to determine whether Rule 1.5(e) should be applied to bar a claim for a fee-split. First, there has to be a finding that the rule had actually been violated. Second, if the rule had been violated, seven factors had to be weighed to reach a conclusion that the agreement is unenforceable.

Because there was no written agreement with respect to the fee split, Sanders had to show that his claim was proportional to the total work expended on the cases. However, Olsman, Ganos had prevented him from working on these cases. The Fourth Circuit rejected Olsman, Ganos' bootstrapping efforts and ruled that it was estopped to raise the proportionality requirement since Sanders' lack of work was due to Olsman, Ganos' actions. The appellate court also found that the clients had been informed of Sanders' participation and that there was no evidence that they objected. Since both sides agreed that the total fee was reasonable, the final element of the rule was met.

Significantly, the Court went on to state that, even if it had concluded that there had been a violation of Rule 1.5(e), it would have reversed the summary judgements since several, if not all, of the enumerated factors "militate in favor of enforcing the fee-sharing agreement." In particular, the Court ruled that a reasonable fact-finder could conclude that Olsman, Ganos was at least equally culpable for the violation of the rule as was Sanders and that Olsman, Ganos had raised the defense simply to escape an otherwise valid contractual obligation. The Court thus reversed the claims with respect to these two cases for further proceedings in the district court.

Finally, the Court rejected Sanders' quantum meruit claims in the Greer and Holtquist cases. He had based those claims on the contention that his work in the Ambrose case benefitted the prosecution of the two later cases. The court felt that he had not presented any evidence to support this contention.

A Few Comments

The case now goes back to the district court. Sanders has at least a $300,000 judgment in his pocket and a reasonable expectation as to an award in the second two cases.

The opinion by the Fourth Circuit is helpful because of its discussion of the concept of quantum meruit and because of its discussion of how Rule 1.5(e) operates in a fee-splitting dispute. As to the later issue, it correctly rejected a reflexive per se application of a Rule 1.5(e) bar in fee-splitting cases. This makes sense, since the rule was designed to protect clients, not as a sword for attorneys trying to wriggle out of arrangements that they had agreed to with other attorneys. Even if it does not establish explicit precedent, the opinion should be read at least as a partial road map for any attorney dealing with a fee-split dispute.

Quit While You're Ahead.

Older practitioners in Maryland will sometimes make reference to "Maryland Rule 2"--"Quit while you're ahead." Meaning, stop arguing when it's obvious that the Court is preparing to rule in your favor. (Maryland Rule 1 is, well, Rule 1.)

A recent decision from the U.S. District Court for Eastern District of Virginia, Chawla v. Transamerican Occidental Life Insurance Co. (February 3, 2005) serves to prove that judges would be well-advised to adhere to the spirit, if not the precise letter, of the rule. In that case, the Court had more than adequate grounds to apply well-accepted legal principles to decide cross motions for summary judgment. Then, the Court broke new ground merely to bolster its ruling. This additional basis for the Court's ruling, if widely adopted, would threaten the widely used estate planning technique of having a trust own life insurance policies.

In May of 2000, Geisinger, the decedent, applied for a $1M life insurance policy naming Ms. Chawla as the sole beneficiary. Transamerican refused to issue the policy on the basis that Chawla had no insurable interest in Geisinger's life. In response, Geisinger established a trust, with himself and Chawla as trustees, and had the trust purchase the policy. Later that year, the trust purchased additional insurance on Geisinger, bringing the total death benefit to $2.45M. Geisinger died in late September, 2001.

At the time that the policy was initially issued, Geisinger had serious health issues: In October of 1999, he had been operated on for the partial removal of a brain tumor. Thereafter, he suffered from a variety of residual neurological affects. Also, in October of 1999, he was diagnosed with "chronic alcohol poisoning in conjunction with known chronic alcohol abuse." In the period leading up to the point at which the initial insurance policy was issued, he was hospitalized on several occasions due to both the brain tumor and the alcoholism. After the issuance of the policy, Geisinger suffered further serious incidents due to the alcoholism. Of course, none of these issues were disclosed on the application for the insurance policy or the application for the increased death benefit. After the Geisinger's death, Transamerican acted to rescind the policy and refunded all of the premiums previously paid.

Applying Maryland law (the insurance contracts were entered into in Maryland), the Court had no difficulty in concluding that the policy and the increase in the death benefit had been procured through a material misrepresentation. After all, Geisinger's health was on a clear downward trajectory and he failed to disclose any of the relevant facts on his application. (It is worthy of some note that Ms. Chawla's husband, a physician, had examined Geisinger and his report was submitted with the insurance application. The report did not refer to the brain tumor or the alcoholism and confirmed Geisinger's "good health.")

The evidence to support the Court's ruling on the basis of Geisinger's misrepresentation was more than sufficient to allow the Court to rule in favor of Transamerican. The Court should have stopped there. Instead, the Court went on to offer an alternative basis for its decision, namely that the trust lacked an insurable interest in Geisinger's life.

For a variety of reasons, most significantly the minimization of estate taxes, individuals will often form a trust and have the trust acquire an insurance policy on their life. This is a fairly standard planning tool. The Court's ruling, if allowed to stand and broadly applied, would destroy this tool completely. (A practitioner quoted in an article in the Washington Post notes that the statute upon which the ruling was based has analogues in a "half-dozen" other states. While I am not an expert in this area, I suspect that the number of states with similar statutes may actually be higher.)

The Court's alternative holding is simply gratuitous. Even though the action was brought in a federal court in Virginia, choice of law principles should have been invoked to require the Court, if not counsel, to apply Maryland Rule 2.

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

Judge Quarles issued his opinion in the case The Baltimore Sun and two of its journalists filed against Governor Ehrlich. The opinion rejected all of the claims of the plaintiffs.

The rationale behind the relatively short opinion is neatly summarized in the following passage:

It is clear from the Nitkin and Olesker declarations, that their complaints--e.g., refusal of officials to comment on statements of legislators, refusals to comment on contracts between private firms and the state, refusals to provide information or views for columns, refusals to provide background discussions to identify issues or topics of interest to readers, and refusals to provide personal reasons or justifications for declining comment--are far beyond any citizen's reasonable expectations of access to his or her government. The enforcement of the Governor's memorandum has been implemented in a way that is reasonably calculated to ensure the Sun's access to generally available public information. The Sun seeks a privileged status beyond that of the private citizen; that desire is not a cognizable basis for injunctive relief.

The central premise of the opinion is that the plaintiffs were seeking some sort of special status. Here, Judge Quarles misses the point.

Assume that the Governor, in a fit of pique after reading one of my weblog postings, directs all executive branch employees not to speak to me. In such a case, the intent would be to chill my exercise of first amendment rights. The harm that would be suffered in such a case would be the blocking of my access to governmental officials, a right that I share with all citizens, not just journalists. Moreover, journalists, in common with all other citizens, have a reasonable expectation that the right to speak to governmental officials will not be limited due to their exercise of their First Amendment rights. In other words, Judge Quarles is correct in stating that the plaintiffs' rights are basically equal to that of ordinary citizens. He failed to recognize, however, that those rights were violated here.

Needless to say, the decision is being appealed.

Without Pay or Reward.

My eldest son is an undergraduate at the University of Maryland at College Park. He is an Eagle Scout.

My youngest son is a high school senior who will probably attend college at a state school in Maryland next year. He is a Life Scout and will hopefully attain Eagle rank by the cutoff deadline of his 18th birthday.

For both of my sons and for other men that I know, both young and now not-so-young, Scouting has been an extraordinarily valuable learning experience. It is troubling to me that the number of boys participating in Scouting is either stagnant or declining. Given that background, one might think that I would have responded immediately to the email that I received this afternoon requesting that I respond to a poll on the website of WBAL television asking readers whether they supported or opposed a bill pending before the Maryland General Assembly, HB 296.

HB 296 would waive tuition and fees at all Maryland colleges and universities for Eagle Scouts and recipients of the Girl Scout Gold Award. The fiscal note that accompanies the bill indicates that the cost of the bill in fiscal year 2006 would be between $2M and $2.9M. (Note: I don't put a high value on the accuracy of fiscal notes concerning bills before the Maryland General Assembly. This is not a knock against the people who prepare the fiscal notes. It seems more to be a result of a lack of sufficient resources.) Not only did I not cast my vote early and often in support of HB 296, I sent a reply email indicating that I opposed the bill.

First, as a matter of general public policy, I do not believe that private institutions, such as the Boy and Girl Scouts, should act as the gatekeepers to public benefits. There are innumerable problems giving private organizations this role. By way of example, the private organization would not be directly answerable to the public with respect to the standards it would require of, for instance, the award of Eagle. There would be immense pressure to water down the requirements given the significant financial benefits that would accrue with the award. Yet, there is no mechanism for public accountability.

Second, given the position of the Boy Scouts with respect to participation in Scouting by gay scouts and leaders, it would seem to me that Scouting, as an institution, should oppose the bill. In the case of Boy Scouts of America v. Dale, the Scouts succeeded in overturning a New Jersey statute that would have forced them to admit openly gay Scouts and Scout leaders. The Supreme Court's opinion rested on the Scouts' right of expressive free association. That is, as a private organization, the Scouts can accept or reject anyone they desire regardless of the reason for inclusion or exclusion. If the government were to offer significant financial rewards for participation in Scouting, the movement would, in essence, become a quasi-public organization and the premise that underlies Dale would disappear.

I believe that the policy of Scouting with respect to gay Scouts and leaders is wrong in principle and will ultimately weaken the Scouting movement. That, however, is an argument for another day. Suffice it to say for now that public funds should not be awarded based upon successful participation in the program of an organization that discriminates. Just as importantly, a private organization, if it wants to remain a private organization, cannot be a conduit for the award of public benefits based upon successful completion of its programs.

Update: Sometimes when addressing "hot" current questions, we miss more established issues. I certainly did here. HB 296 is clearly unconstitutional, at least as applied to the Boy Scouts, because the Boy Scouts require that their members profess a belief in some supreme being. There may be some debate as to whether the state can exclude gays and lesbians from receiving state benefits, but there is no question but that the state cannot direct benefits to the religious and exclude atheists and agnostics. (I don't know whether Girl Scouts require their members to profess a belief in a supreme being. I understand, however, that they do not have an exclusionary policy against lesbians.)

This Fiesta Ain't No Party

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

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

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

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

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

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

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

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

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

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

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

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

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

Contingent Attorneys' Fees Not Really Deductible

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

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

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

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

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

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

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

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

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

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

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

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

There are actually three disturbing aspects to this case.

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

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

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

Malpractice Corrective

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

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

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

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

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

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

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

Genug Ist Genug!

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

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

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

Acting Responsibly

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

The Court began its analysis by acknowledging that:

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

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

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

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

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

Who's On First?

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

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

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

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

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

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

The Write Stuff

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

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


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


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


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


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


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


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


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


• Use strong subtitles that summarize.


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


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


• Write in a simple, direct style.


• Avoid long sentences.


• Minimize passive voice.


• Avoid or minimize introductory clauses.


• Stress subject-object-verb format.


• Write unambiguously. Check all pronouns for ambiguity.


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


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


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

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

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

Gee, It Really Was Educational

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

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

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

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


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


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

The SDAT contended that:

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

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

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

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

See Mom and Dad, whaddid I tell ya'.

Is That Reasonable, Part II

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

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

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

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

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

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


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

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

All the News That's Fit to Link

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

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

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

Performance Enhancing Drug Update I

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

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

Now where have I heard that before?

Not Snarky

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

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

No Infinite Arm

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

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

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

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

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

No Conflict In Their Interest

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

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

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

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

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

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

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

Let the Mishegaas Begin

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

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

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

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

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

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

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

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

Calling Arliss Michaels

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

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

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

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

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

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

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

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

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

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

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

Knee Jerk Under-Reaction

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

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

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

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

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

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

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

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

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

Subjective Objective

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

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

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

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

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

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

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

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

(Emphasis by the Court of Appeals.)

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

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

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

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

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

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

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

I'm Coming Back

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

Why We Do What We Do

I receive regular e-mails from a private mailing list run by an attorney in Los Angeles. (I won't identify the attorney because the list is, as I said, private.) The list generally focuses on issues in tax law of relevance to practitioners in partnership and real estate tax.

One of the frequent discussion topics is reform of the federal tax system. As part of that discussion, there is a thread that regularly appears, albeit in different guises. Specifically, comments by some of the participants indicate that they have a suspicion that what they do on a daily basis is of waste of their not insubstantial intellectual resources. Recently, I offered some observations on those comments.

I said that the thread and two other, seemingly unconnected developments, have only heightened the feeling that I think I share with others on the mailing list that what we do, day to day, is somewhat of a waste of our talents. (I noted that the talent, in my case, was rather moderate, but that is was rather significant for most other members of the group.)

The first "unrelated" development was the opinion in the Blakelee Realty case which I commented on here. That opinion upheld the publication requirement imposed on LLCs in that state.

Something has continued to bother me about the opinion which, as I said, in a narrow sense (i.e., courts should not step on leglislative perogatives), might be correct, but in a broad sense (can anybody really defend the underlying policy behind the requirement without a smirk) is totally unjustified. Yet, substantial intellectual capital was expended by the litigants and the court in determining the issue of whether or not the Emperor really had no clothes.

The second "unconnected event" was the appearance of a new organization called the Public Library of Science. This organization will publish on-line journals containing referred papers concerning various aspects of scientific research. Access to the journals will be free and open to the public. It is hoped that the effort will spawn a host of competing publications that will replace the subscription based system currently in place for the publication of scientific papers. The costs of those subscriptions significantly limits the access of researchers, particularly in poorer countries, to research material.

Now, as I said, these two events would seem to be totally unconnected. Yet, somehow they connected by being so different.

On the one hand, the Blaklee Realty case represented an expenditure of significant intellectual effort to determine whether the state could extract money from one group and give it, on the flimsiest of pretexts, to another. The intellectual capital expended, on all sides, including that of the members of the court, adds little to the sum of human knowledge and, except for the newspaper publishers and their families, happiness.

On the other, PLOS represents an expenditure of effort which will, over time, greatly increase the diffusion of real knowledge and, as a result, improve the human condition.

This brings me back to the tax code issue. I believe that taxes are necessary. Indeed, I would argue that a fair and equitable tax system contributes to the improvement of the human condition. And yet I still get the feeling that what we do on a daily basis is not all that socially beneficial.

Perhaps what I am missing is that, in a larger sense, lawyers, including tax lawyers, are really no different than plumbers. Plumbing is, after all, not a glamorous profession. However, indoor plumbing and modern waste management has contributed mightily to human health and, indeed, civilization. Our sanitation system would break down in no time if there were no plumbers.

Viewed in that light, maybe what we, as lawyers, are are the plumbers of the social contract, making certain that social order is maintained.

In any event, I invite comments.