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KLINE v. FIRST WESTERN GOVT. SECS.

May 5, 1992

ERNEST P. KLINE and EUGENE F. KNOPS
v.
FIRST WESTERN GOVERNMENT SECURITIES, et al.



The opinion of the court was delivered by: VANARTSDALEN

 VanARTSDALEN, S.J.

 INTRODUCTION

 Plaintiffs invested in forward contracts through First Western Government Securities (First Western). As part of the promotional materials received from First Western, they received tax opinion letters drafted by Arvey, Hodes, Costello & Burman (Arvey Hodes or Arvey). When they did not receive the favorable tax consequences they expected, plaintiffs brought suit against Arvey Hodes, among others, alleging violations of Rule 10b-5, RICO, and pendent state law claims. Arvey Hodes now moves for summary judgment. For the reasons explained below, the motion will be granted in part, and denied in part.

 FACTUAL BACKGROUND

 Between these two parties, few facts are seriously in dispute. The facts outlined in this memorandum, however, are not to be considered as findings of fact with respect to any other parties who may dispute them.

 First Western, a business operated by Sidney Samuels, dealt in forward contracts. A forward contract for securities is a contract to purchase or sell securities made on one date, for delivery and payment on a specified later date. (Req. for Admis. 53, attached as Ex. D.) *fn1" Forward contracts may be entered into in pairs, where a speculator agrees to buy one interest-market-sensitive security on some future date and also agrees to sell a different interest-market-sensitive security on some future date. Differences in the terms of the contracts create a "spread" position that generates economic gain or loss depending on whether market interest rates rise or fall.

 Before entering into a set of forward contracts with First Western, each speculator determined how he wished to bias the spread by predicting whether market interest rates would rise or fall. (Req. for Admis. 68 & 72, attached as Ex. D.) First Western and the speculator then entered into one or more sets of forward contracts biased toward that prediction.

 Plaintiffs Kline and Knops invested in forward contracts with First Western. They had read the June 1979 and November 1980 tax opinion letters before entering into their forward contracts. (Req. for Admis. 26-28, attached as Ex. D.) Cancellation of the loss side of forward contracts was part of their income tax strategy from the beginning, and they canceled forward contracts that incurred losses. (Req. for Admis. 58, attached as Ex. D.) They took deductions for these losses and the IRS disallowed the deductions. Their dispute with the IRS has now been settled. (Req. for Admis. 88, attached as Ex. D.)

 PROCEDURAL BACKGROUND

 On March 3, 1983, plaintiffs Wojdak, Kline, and Knops filed their complaint. *fn2" On September 20, 1983, plaintiffs moved for certification of a plaintiff class. On July 30, 1984, Arvey Hodes filed its motion for summary judgment. In the meantime, several investors in the First Western program were pursuing litigation with the IRS regarding the deductibility of the losses incurred by the cancellation of forward contracts. The parties agreed that the outcome of that litigation would have a substantial effect on the suit in this court. Consequently, by agreement of all parties, the case was placed in suspense pending final determination of the IRS litigation.

 The IRS litigation proceeded to the United States Supreme Court, and was finally resolved on June 27, 1991. The trial judge concluded that "the transactions between First Western and its customers were illusory and fictitious and not bona fide transactions. . . . Even if the transactions were bona fide transactions, the transactions were entered into primarily, if not solely, for tax-avoidance purposes." Therefore, he held that the investors were liable for additional taxes. Freytag v. Commissioner of Internal Revenue, 89 T.C. 849, 875-76 (1987), aff'd, 904 F.2d 1011 (5th Cir. 1990), aff'd, 111 S. Ct. 2631, 115 L. Ed. 2d 764 (1991).

 Upon completion of the IRS litigation, this case was removed from civil suspense. The plaintiffs responded to Arvey Hodes's motion for summary judgment. Arvey Hodes filed a reply, and plaintiffs filed a "sur reply." I have considered all pleadings and exhibits filed with respect to this motion.

 Further briefing on the class certification motion has been postponed until after disposition of this summary judgment motion. However, for the purposes of this motion, it is useful to consider the proposed class. Plaintiffs seek to have a class certified of "all investors purchasing forward contracts in government securities through First Western during the period from January 1978 through the date of the filing of this Complaint." (Proposed Order attached to Mot. for Class Certification.)

 SUMMARY JUDGMENT STANDARD

 A motion for summary judgment is appropriate only when there is no genuine issue of material fact, and one party is entitled to judgment as a matter of law. Williams v. West Chester, 891 F.2d 458, 463-64 (3d Cir. 1989). In a motion for summary judgment, the court may examine evidence beyond the pleadings. The court must always consider the evidence, and the inferences from it, in the light most favorable to the non-moving party. United States v. Diebold, Inc., 369 U.S. 654, 655, 8 L. Ed. 2d 176, 82 S. Ct. 993 (1962); Tigg Corp. v. Dow Corning Corp., 822 F.2d 358, 361 (3d Cir. 1987); Baker v. Lukens Steel Co., 793 F.2d 509, 511 (3d Cir. 1986). If a conflict arises between the evidence presented by both sides, the court must accept as true the allegations of the non-moving party. Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 255, 91 L. Ed. 2d 202, 106 S. Ct. 2505 (1986).

 SECTION 10b-5 PRIMARY LIABILITY

 In order to establish 10b-5 liability, *fn3" plaintiffs must prove that Arvey Hodes (1) made a misstatement or omission of material facts; (2) with scienter; (3) in connection with the purchase or sale of securities; (4) upon which plaintiffs relied; and (5) that the reliance proximately caused plaintiffs' injuries. In re Phillips Petroleum Sec. Litig., 881 F.2d 1236, 1244 (3d Cir. 1989). Defendant Arvey Hodes contends that summary judgment should be granted in its favor because plaintiffs cannot prove any element except (3). Arvey Hodes claims that there were no misrepresentations in its opinion letters, that there was no knowledge or recklessness on its part, and that plaintiffs did not justifiably rely on any misstatements to their detriment.

 I. MISREPRESENTATION

 Arvey Hodes contends that there was no misrepresentation in its opinion letters because they correctly stated the risks involved in the cancellation of forward contracts. Plaintiffs respond that it is not Arvey Hodes's opinion of the tax consequences which they are challenging, but instead the factual description of First Western's trading program which appears in the opinion letters.

 A. Correctly Stated Risks

 Arvey Hodes's opinion letters contained explicit disclaimers that while it was Arvey Hodes's opinion that the losses would be deductible as ordinary loss, both the IRS and the courts could take a contrary position. (Ex. A at 6, Ex. B at 6, Ex. C at 3.) The warnings were more explicit. For example, Arvey Hodes stated that "if a court should feel that tax deferral or conversion is the primary purposes [sic] of such transactions, it may be inclined to hold in favor of the Service. . . . " (Ex. C at 16.) Arvey Hodes argues that since it explicitly warned of the risks which actually did manifest, it cannot be held liable.

 Plaintiffs argue that

 
Arvey has completely misconstrued plaintiffs' claim for fraud and misdirects the Court's attention. Plaintiffs do not hold Arvey liable because the law firm misrepresented the tax implications involved in the recognition of gains or losses. These risks are not what was misrepresented. Rather the opinions were false and/or misleading and Arvey knew they were false and/or misleading because they were based on misrepresented and omitted facts.

 (Pls.' Resp. at 26-27.) *fn4" Therefore, it is the underlying facts which I must consider.

 The facts which plaintiffs allege n5 (Footnote omitted) Arvey misrepresented or omitted are the following:

 
(1) that delivery of the underlying securities was never contemplated by First Western's trading program;
 
[Instead, it is alleged that Arvey's opinion letters stated that the forward contracts contemplated delivery of the underlying securities.]
 
(2) that the prices of First Western's forward contracts were artificially set by First Western with no relation to the real market and that First Western set the prices of its contracts to move in tandem so as to eliminate any risk of economic loss which might be caused by the type of independent price movements which occur on the normal securities market;
 
[Instead, it is alleged that Arvey's opinion letters stated that the prices of First Western's forward contracts moved independently so as to create a reasonable expectation of economic gain and a risk of loss.]
 
(3) that First Western's customers' monetary losses would be limited to their initial margin deposits and that customers would not be required to pay additional margins to cover their additional liabilities to First Western;
 
[Instead, it is alleged that Arvey's opinion letters stated that the customers would be required to pay additional margin deposits to First Western to cover their additional liabilities.]
 
(4) that First Western charged its customers a set cancellation fee to cancel forward contracts prior to the settlement date and that the cancellation fees were not calculated in relation to First Western's risk or the administration costs incurred in connection with the cancellation;
 
[Instead, it is alleged that Arvey's opinion letters stated that First Western's cancellation fees were calculated in relation to First Western's risk and the administration costs incurred by First Western in connection with the cancellations.]
 
(5) that, by design, transactions would be entered into by First Western to obtain a desired tax loss and not with a reasonable expectation of economic gain;
 
[Instead, it is alleged that Arvey's opinion letters stated that Samuels had represented to Arvey that the transactions would be entered into by First Western with a reasonable expectation of economic gain.]
 
(6) that beginning at least as early as the Spring of 1980, the IRS had begun large-scale audit activity in connection with First Western's customers; that on October 20, 1980, First Western and affiliated companies were served with numerous IRS summonses for trading records; that First Western was not cooperating in this audit activity; that IRS summons enforcement proceedings were likely; and that ...

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