Khan v. BDO Seidman, LLP

SUPREME COURT CASES

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State: Illinois

Court: 4th District Appellate

Docket No: 4-10-0002, 4-10-0003 Cons. R

Case Date: 09/16/2010

Preview:Filed 9/16/10

NOS. 4-10-0002, 4-10-0003 cons. IN THE APPELLATE COURT OF ILLINOIS FOURTH DISTRICT

SHAHID R. KHAN; ANN C. KHAN; SRK WILSHIRE INVESTMENTS, LLC; SRK WILSHIRE PARTNERS; SRK WILSHIRE INVESTORS, INC.; THERMOSPHERE FX PARTNERS, LLC; and KPASA, LLC, Plaintiffs-Appellants, v. (No. 4-10-0002) BDO SEIDMAN, LLP; PAUL SHANBROM; MICHAEL COLLINS; DEUTSCHE BANK AG; DEUTSCHE BANK SECURITIES, INC., d/b/a DEUTSCHE BANK; ALEX BROWN; DAVID PARSE; EQUILIBRIUM CURRENCY TRADING, LLC; SAMYAK VEERA; GRANT THORNTON, LLP; GRAMERCY ADVISORS, LLC; JAY A. JOHNSTON; and MARC HELIE, Defendants-Appellees. ------------------------------------------------------------SHAHID R. KHAN; ANN C. KHAN; UVIADO, LLC; JONCTION, LLC; and LEMAN, LLC, Plaintiffs-Appellants, v. (No. 4-10-0003) BDO SEIDMAN, LLP; PAUL SHANBROM; MICHAEL COLLINS; GRAMERCY ADVISORS, LLC; GRAMERCY ASSET MANAGEMENT, LLC; GRAMERCY FINANCIAL SERVICES, LLC; TALL SHIPS CAPITAL MANAGEMENT, LLC; JAY A. JOHNSTON; MARC HELIE; DECASTRO, WEST, CHODOROW, GLICKFELD AND NASS, INC.; and FINANCIAL STRATEGY GROUP, PLC, Defendants-Appellees.

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Appeal from Circuit Court of Champaign County No. 09L140

No. 09L139

Honorable Jeffrey B. Ford, Judge Presiding.

JUSTICE APPLETON delivered the opinion of the court: In these two consolidated cases, Champaign County case Nos. 09-L-139 and 09-L-140 (Nos. 4-10-0003 and 4-10-0002, respectively, on appeal), plaintiffs are Shahid

R. Khan and his wife, Ann C. Khan, along with various business entities that the Khans formed, on the advice of their accountants at BDO Seidman, LLP (BDO), for the purpose of shuffling assets around and generating artificial tax losses. The Khans did not know, however, that they were doing anything illegal. BDO had been their accounting firm for years, and it sold them on the so-called "investment strategies" as legitimate ways to make a profit and at the same time to minimize income taxes. And to be doubly safe, the Khans went to supposedly independent law firms recommended by BDO, namely, Jenkens & Gilchrist, P.C. (Jenkens); Proskauer Rose, L.L.P. (Proskauer); and DeCastro, West, Chodorow, Glickfeld & Nass, Inc. (DeCastro), which gave the Khans opinion letters reassuring them that they could claim the losses in their income-tax returns; but the opinion letters were worthless because these law firms were in cahoots with BDO, so plaintiffs allege. The upshot is that the Khans lost a lot of money, not only the fees and premiums they paid to defendants to carry out the "investment strategies," but also the back taxes, interest, and penalties they had to pay to the Internal Revenue Service (IRS) when it disallowed the claimed losses. All this is according to the complaints, in which the Khans sue BDO and two of its employees, Paul Shanbrom and Michael Collins, along with a variety of alleged coconspirators that helped with the sham investments and other transactions necessary to the creation of the abusive tax shelters. Pursuant to sections 2-619(a)(1) and (a)(9) of the Code of Civil Procedure (Code) (735 ILCS 5/2-619(a)(1), (a)(9) (West 2008)), BDO, Collins, and Shanbrom moved either to dismiss the complaints or to stay the actions, on the ground that the Khans and BDO had entered into an arbitration agreement that encompassed plaintiffs' claims. The -2-

trial court granted the BDO defendants' motion to compel arbitration in the two cases, holding that all of the claims came within the scope of the arbitration clause. Plaintiffs appeal from this ruling on a number of grounds, and we agree with one of their arguments, namely, that the arbitration agreement does not cover the claims that plaintiffs assert in their complaints. Or, more precisely, it does not cover all of the claims. The only claims we find to be subject to arbitration are those for breach of contract, which plaintiffs plead in the alternative. We find no evidence, in the text of the contract, that plaintiffs ever agreed to arbitrate the other claims, such as those for breach of fiduciary duty, negligent misrepresentation, fraud, and civil conspiracy. According to the contractual language, a claim is subject to arbitration only if it relates to, or arises from, BDO's "performance" of the contract. (Actually, there are several contracts, called "consulting agreements," but they are identical in their germane provisions.) In the complaints in the two cases, plaintiffs frame their claims in a variety of legal theories, but when one reduces the claims to their essence, they mostly relate to tasks that the consulting agreements expressly exclude from BDO's promised performance. Essentially, in both cases, plaintiffs sue the BDO defendants for harming them financially in three ways: (1) giving them dishonest investment advice, (2) preparing defective incometax returns for them, and (3) conspiring with law firms to issue bogus opinion letters attesting to the legality of losses claimed in the tax returns. The second item folds into the third item because, according to the consulting agreements, the client is supposed to confirm the correctness of the tax returns by conferring with a law firm and, in fact, the consulting agreements make clear that although BDO will prepare the client's tax returns, BDO will not thereby offer any legal opinions or tax opinions and that the client should not -3-

understand BDO as doing so. The consulting agreements disavow not only legal opinions but also "investment advice" as being part of BDO's performance. It follows that only the alternative counts for breach of contract, or failure to perform, fall within the scope of the arbitration clause. Therefore, we affirm the trial court's judgments in part, reverse them in part, and remand these two cases for further proceedings. I. BACKGROUND A. Case No. 09-L-140 1. The 1999 Digital Options Strategy a. BDO Promotes the Digital Options Strategy to Shahid Kahn Beginning in approximately 1993, BDO performed auditing services for Chromecraft, a company of which Shahid Khan was part owner. Michael Collins, a partner at BDO, was in charge of auditing services for Chromecraft, and by 1999, he had been one of Khan's trusted accountants and advisors for some six years. In 1999, Khan requested his own partner at Chromecraft to ask Collins if he knew anyone who could advise him on purchasing foreign currency. Khan needed foreign currency because he was in negotiations to purchase a Canadian company that manufactured plastic automobile bumpers and the Japanese owners of the company wanted to be paid in Japanese yen. Collins referred Khan to Paul Shanbrom, who was a member of BDO's Tax Solutions Group and reputedly an expert in foreign-currency trading, and in September 1999, Khan and one of his estate-planning advisors had a meeting with Collins and Shanbrom. The meeting went beyond the subject of simply purchasing foreign currency. Shanbrom introduced Khan to an "investment strategy" involving the purchase and sale of -4-

digital options on foreign currency (the Digital Options Strategy), a strategy which, according to Shanbrom, not only gave Khan a chance to double his money but which also allowed him to claim a tax loss if he lost money on his investments in foreign currency. When someone buys an option, that person buys the right, but not the obligation, to buy or sell a given quantity of assets (in this case, foreign currency) at a fixed price, or "strike price," within a specified time, regardless of the market price, or "spot price," of the assets. An option is "digital," or "binary," if the investor stands to win or lose a predetermined amount in full: in other words, the payout will be all of the predetermined amount or nothing (1 or 0, in binary terms). Essentially, a digital option is an all-or-nothing wager that the spot price will be at or above a given price on a certain date--or it can be an all-or-nothing wager that the spot price will be beneath the given price on that date. If the investor is betting that the spot rate will be at or above the given price on a certain date, the investor has a long option. On the other hand, if the investor is betting that the spot rate will be at or below the given price on a certain date, the investor has a short option. b. The Consulting Agreement of November 12, 1999 On November 12, 1999, BDO and Flex-N-Gate Corporation, of which Shahid Khan was president, entered into a contract entitled "Consulting Agreement," and this contract contained an arbitration clause. (We learn the details of the consulting agreements from BDO's motion for dismissal, to which the consulting agreements are attached as exhibits; the rest of the information in Part I of this order comes from plaintiffs' complaint.) The arbitration clause embraces all claims arising in connection with the performance or breach of the consulting agreement; and in the parts of the agreement defining BDO's -5-

performance, certain clauses limit or qualify other clauses. On the one hand, BDO will provide consulting services in conjunction with the buying and selling of investments, but, on the other hand, BDO will provide no "investment advice or services." Similarly, on the one hand, BDO will help with structuring investment transactions so as to achieve the most beneficial tax results and will prepare the client's income-tax returns, but, on the other hand, legal opinions or tax opinions are not part of BDO's agreed-on performance. The consulting agreement reads as follows: "WHEREAS, the Client is interested in selling various investments and in making certain other investments ('the Transactions'); WHEREAS, BDO is in the business of providing accounting and consulting services; and WHEREAS, the Client desires BDO to provide certain Consulting Services in connection with the Transactions, and BDO desires to provide such services to the Client, all upon the terms and conditions herein. NOW THEREFORE, for good and valuable

consideration, the receipt and sufficiency of which is hereby acknowledged, the parties agree as follows: 1. Term. Unless earlier terminated as provided

hereunder, the term of this Agreement shall commence on the Effective Date and continue through December 31, 2000 when this Agreement shall automatically expire (the 'Term'). -6-

2. Services.

During the Term [of the consulting

agreement], BDO agrees to provide the following consulting services to the Client (the 'Services'): consulting services in conjunction with Transactions, including assistance in determination of sales prices and allocations thereof, assistance in structuring the Transactions, assisting the Client and/or his advisors in structuring the Transactions to attain the most beneficial tax results, preparation of the 2000 and 2001 income tax returns for the Client and/or its shareholders, and assisting the Client and/or his representatives in its discussions and/or negotiations with potential purchasers or sellers, on a specifically requested basis, as well as in income and estate tax planning and other personal financial planning. BDO is not in the business of providing investment advice or services, thus, none of the services to be rendered are to be considered as investment advice, and it is understood that the Client is not relying upon BDO for investment advice or services. 3. Fees. (a) In consideration for the Services, the Client shall pay BDO the following fee: $1,580,000.00 (One Million Five Hundred Eighty Thousand dollars) (the 'Consulting Fee'). *** -7-

*** 6. No Warranty. *** BDO's Services hereunder do not include, and BDO assumes no responsibility whatsoever for, any legal and/or tax opinions regarding any strategies that may be implemented, and has advised the Client to retain a law firm for legal and/or tax opinions on any strategies or transactions they enter into. *** 7. Dispute Resolution. *** (d) If any dispute, controversy or claim arises in connection with the performance or breach of this agreement and cannot be resolved by facilitated negotiations (or the parties agree to waive that process) then such dispute,

controversy or claim shall be settled by arbitration in accordance with the laws of the State of New York, and the then current Arbitration Rules for Professional Accounting and Related Disputes of the American

Arbitration Association ('AAA'), except that no pre-hearing discovery shall be permitted unless specifically authorized by the arbitration panel, and shall take place in the city in which the BDO -8-

office providing the relevant Service exists, unless the parties agree to a different locale. *** 10. Governing Law. This Agreement shall be governed and construed in accordance with the laws of the State of New York, except for its conflict of law principles. *** 12. Entire Agreement. This Agreement sets forth the entire agreement between the parties with respect to the subject matter herein, suspending all prior agreements, negotiations or understandings, whether oral or written, with respect to such subject matter. This Agreement may not be amended or modified except in writing signed by duly authorized representatives of the Client and BDO." (Emphases in original.) Hence, in this fully integrated consulting agreement that can be modified only in a writing signed by both parties, the term "Transactions" means selling investments and making investments. BDO proposes providing consulting services to the client in

connection with the Transactions, that is, in connection with the selling and making of investments. These consulting services include determining the sales price of investments, structuring the sale or making of investments, and negotiating with potential buyers or sellers of investments. Nevertheless, BDO will not provide "investment advice or services." Likewise, BDO will prepare the client's income-tax returns and will suggest how to structure -9-

investment transactions so as to achieve the optimal tax outcome, but the client is advised to consult a law firm to confirm the correctness of BDO's tax analyses, and it is understood that BDO will offer no legal or tax opinions. c. Implementation of the Digital Options Strategy We now will describe the Digital Options Strategy as we understand it from the complaint. We might be slurring over some nuances, but the details or finer points of the strategy seem unimportant to this appeal. All that is necessary, at this point, is to have a general conception of the strategy so as to understand the nature of the various acts of wrongdoing of which plaintiffs accuse defendants in their complaint. Roughly speaking, here is how the Digital Options Strategy worked. The Khans entered into a private contract with Deutsche Bank whereby the Khans, through SRK Wilshire Investments (Wilshire Investments), bought from Deutsche Bank a long option on foreign currency and sold to Deutsche Bank a short option. Thus, there came into existence an opposing pair of options, one long and the other short. These options were designed to cancel each other out. The strike prices of the two options were only a fraction of a penny apart, and the premium that the Khans paid Deutsche Bank for the long option, though large, was almost entirely offset by the premium Deutsche Bank agreed to pay the Khans for the short option (almost but not quite: the Khans paid a net premium to Deutsche Bank of $350,000, the difference between the $35 million that the Khans paid for the long option and the $34,650,000 that Deutsche Bank agreed to pay them for the short option). Because the strike prices of the opposing options were so close together and because Deutsche Bank had the contractual right to select the applicable spot rate from a range of currency rates, it was a virtual certainty that the transaction would be close to a - 10 -

wash--Deutsche Bank would see to that. So, pursuant to this scheme that was calculated to be a wash on the investment side (and, as we will explain, a capital loss on the tax side), the Khans formed the necessary business entities and transferred assets between them, all under the guidance of BDO. On November 17, 1999, the Khans formed Wilshire Investments and SRK Wilshire Partners (Wilshire Partners). On November 24, 1999, through Wilshire Investments, the Khans bought and sold the opposing options, which had expiration dates of December 23, 1999. On November 26, 1999, Wilshire Investments contributed its interest in the as of yet unexpired options to Wilshire Partners as a capital contribution. On December 10, 1999, Wilshire Partners purchased a quantity of Canadian dollars as an investment. On

December 23, 1999, both the long option and the short option terminated "out of the money": they became worthless, based on the spot rate that Deutsche Bank chose. Of course, both the Khans and Deutsche Bank got to keep the premiums they had paid each other, but Deutsche Bank's premium was $350,000 greater than the premium it had paid to the Khans (or Wilshire Investments). On December 27, 1999, the Khans contributed their interest in Wilshire Partners to Wilshire Investments, causing the dissolution and liquidation of Wilshire Partners. As a distribution in liquidation of Wilshire Partners, all of the investments in foreign currency were distributed to Wilshire Investments. Consequently, for tax purposes, the Khans' interest in Wilshire Investments had a basis equal to the amount they had paid to Deutsche Bank for the long option, but that amount was not offset as a result of the assumption by Wilshire Investments of the Khans' obligation to Deutsche Bank on the short option, apparently because the short option was only a contingent liability. (There are also corporate plaintiffs that have an - 11 -

interest in this matter, but we are referring to them all as "the Khans," for simplicity's sake.) In other words, the long option counted for purposes of the basis the Khans had in Wilshire Investments, but the short option, which greatly reduced the economic significance of the long option, supposedly did not count. Upon the disposition of the Khans' partnership interest in Wilshire Investments, the expensive long option had expired "out of the money" and had lost all its value, so the Khans claimed a tax loss equal to the premium they had paid for the long option, even though (because of the offsetting short option) they did not really incur an economic loss in that amount. d. The Legal Opinion From Jenkens on the 1999 Digital Options Strategy Both Shanbrom and Collins assured Shahid R. Khan that the Digital Options Strategy was perfectly legal and that it would pass muster with the IRS. Nevertheless, Shanbrom told Khan that getting a legal opinion to that effect would be advisable before actually implementing the Digital Options Strategy and using it in his tax returns. This legal opinion, Shanbrom said, should come from an "independent" and reputable law firm with expertise and experience in the Digital Options Strategy. Such an opinion would provide Khan with "absolute penalty protection" from the IRS, Shanbrom said, and the law firm most qualified to issue this protective legal opinion was Jenkens. Khan followed Shanbrom's recommendation and went to Jenkens, and on March 20, 2000, Jenkens issued to Khan an opinion letter confirming the legality of the 1999 Digital Options Strategy. The letter opined that plaintiffs' "basis in their interest in the Partnership after contribution of the Options [would] include the cost of the Long Option contributed, without adjustment for the Short Option." Jenkens further opined that "[t]he step transaction, sham transaction, and economic substance doctrines [would] not - 12 -

apply to disallow the results of the transactions described herein." Further, IRS Notice 1999-59, which warned against transactions lacking economic substance and having no apparent purpose other than to generate a fake capital loss, was simply "'inapplicable to the transactions at issue here.'" Little did plaintiffs know, however, that BDO had an arrangement with Jenkens. Not only Jenkens but another law firm to which BDO eventually would refer plaintiffs, Proskauer, had an agreement with BDO whereby BDO could promise prospective clients that they would receive legal opinions from Jenkens and Proskauer certifying the soundness and legality of the investment and tax strategies that BDO proposed, including the Digital Options Strategy. These legal opinions were not specifically tailored to the client's particular financial situation "but were merely 'fill in the blank' boilerplate opinions provided to Plaintiffs as part of a 'pre-wired' scheme." Nonetheless, Jenkens collected a substantial fee from the clients for these legal opinions. "In addition, Jenkens & BDO were involved in fee 'kickbacks' between themselves and with third parties who convinced clients to execute an Investment Strategy with Jenkens, Deutsche Bank, BDO, and others." e. The Preparation and Filing of Plaintiffs' 1999 Income Tax Returns After the publication of IRS Notice 1999-59 on December 27, 1999, BDO prepared and signed plaintiffs' 1999 federal and state income-tax returns. Specifically, on April 1, 2000, BDO signed the 1999 federal tax returns for Wilshire Investments and Wilshire Partners, and on April 1, 2000, BDO signed plaintiffs' 1999 federal individual tax returns. These tax returns contained the losses supposedly generated by the 1999 Digital Options Strategy. Advising plaintiffs that the tax returns were "properly prepared in accordance with professional standards," BDO recommended that plaintiffs add their - 13 -

signatures to the returns and file them with the IRS. Plaintiffs did so, relying on the representations and assurances that defendants had made to them during the promotion, sale, and implementation of the 1999 Digital Options Strategy and also relying on the opinion letter from Jenkens. The filing of these returns was the final step of the 1999 Digital Options Strategy. f. The Publication of IRS Notice 2000-44 On August 11, 2000, before plaintiffs filed their 1999 individual federal tax returns, the IRS published IRS Notice 2000-44, entitled "Tax Avoidance Using Artificially High Basis" and describing transactions similar to those described in IRS Notice 1999-59-transactions that "'purport[ed] to generate tax losses for taxpayers.'" One of the examples that IRS Notice 2000-44 gave closely resembled the Digital Options Strategy: the taxpayer purchased call options and simultaneously wrote (or sold) offsetting call options, transferred the option positions to a partnership, and claimed that his or her basis in the partnership interest was "'increased by the cost of the purchased call options but [was] not reduced under [Internal Revenue Code]

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