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Menzies v. Seyfarth Shaw LLP

United States Court of Appeals, Seventh Circuit

November 12, 2019

Steven Menzies, Plaintiff-Appellant,
Seyfarth Shaw LLP, an Illinois limited liability partnership, et al., Defendants-Appellees.

          Argued May 22, 2019

          Appeal from the United States District Court for the Northern District of Illinois, Eastern Division. No. l:15-cv-3403 - John Robert Blakey, Judge.

          Before Hamilton, Scudder, and St. Eve, Circuit Judges.

          Scudder, Circuit Judge.

         Insurance executive Steven Menzies sold over $64 million in his company's stock but did not report any capital gains on his 2006 federal income tax return. He alleges that his underpayment of capital gains taxes (and the related penalties and interest subsequently imposed by the Internal Revenue Service) was because of a fraudulent tax shelter peddled to him and others by a lawyer, law firm, and two financial services firms. Menzies advanced this contention in claims he brought under the Racketeer Influenced and Corrupt Organizations Act or RICO and Illinois law. The district court dismissed all claims.

         Menzies's RICO claim falls short on the statute's partern-of-racketeering element. Courts have labored mightily to articulate what the pattern element requires, and Menzies's claim presents a close question. In the end, we believe Menzies failed to plead not only the particulars of how the defendants marketed the same or a similar tax shelter to other taxpayers, but also facts to support a finding that the alleged racketeering activity would continue. To conclude otherwise would allow an ordinary (albeit grave) claim of fraud to advance in the name of RICO-an outcome we have time and again cautioned should not occur. In so holding, we in no way question whether a fraudulent tax shelter scheme can violate RICO. The shortcoming here is one of pleading alone, and it occurred after the district court authorized discovery to allow Menzies to develop his claims.

         As for Menzies's state law claims, we hold that an Illinois statute bars as untimely the claims advanced against the lawyer and law firm defendants. The claims against the two remaining financial services defendants can proceed, however.

         So we affirm in part, reverse in part, and remand.


         The original and amended complaints supply the operative facts on a motion to dismiss. On appeal we treat all allegations as true, viewing them in the light most favorable to Steven Menzies. See Moranski v. Gen. Motors Corp., 433 F.3d 537, 539 (7th Cir. 2005).

         Menzies is the co-founder and president of an insurance company called Applied Underwriters, Inc. or AUI. In 2002 advisers from Northern Trust approached him to begin a financial planning relationship. In time these advisers pitched Menzies and his colleague and AUI co-founder Sydney Ferenc on a tax planning strategy (dubbed the Euram Oak Strategy) to shield capital gains on major stock sales from federal tax liability. Not knowing the strategy reflected what the IRS would later deem an abusive tax shelter, Menzies agreed to go along with the scheme. He conducted a series of transactions that, through the substitution of various assets and the operation of multiple trusts, created an artificial tax loss used to offset the capital gains he realized upon later selling his AUI stock.

         Northern Trust worked with others in marketing and implementing the strategy. Christiana Bank, for example, served as trustee for some of Menzies's trusts while tax attorney Graham Taylor and his law firm, Seyfarth Shaw, provided legal advice. Taylor repeatedly assured Menzies and Ferenc of the tax shelter's legality, eventually opining that there was a "greater than 50 percent likelihood that the tax treatment described will be upheld if challenged by the IRS." Taylor stood by his more-likely-than-not opinion even after being indicted in 2005 for the commission of unrelated tax fraud-a development he never disclosed to Menzies.

         In 2006 Menzies sold his AUI stock to Berkshire Hathaway for over $64 million. Nowhere in his 2006 federal income tax return did Menzies report the sale or any related capital gains. Nor did Christiana Bank, which filed tax returns on behalf of Menzies's trusts, report any taxable income from the stock sale. When the IRS learned of these developments, it commenced what became a three-year audit and found that the primary purpose of the Euram Oak Strategy was tax evasion. Facing large fines and potential adverse legal action, Menzies agreed in October 2013 to settle with the IRS, paying over $10 million in back taxes, penalties, and interest.

         In April 2015 Menzies filed suit in the Northern District of Illinois, advancing a civil RICO claim and various Illinois law claims against Taylor, Seyfarth Shaw, Northern Trust, and Christiana Bank. The district court granted the defendants' motion to dismiss, but from there twice allowed Menzies to amend his complaint. Indeed, the district court afforded Menzies a full year of discovery to develop facts to support renewed pleading of the RICO claim that appeared in his second amended complaint in August 2017. On the defendants' motion, the district court dismissed that complaint for failure to state any claim. Menzies now appeals.


         A. The RICO Bar for Actionable Securities Fraud

         Before addressing the district court's dismissal of Menzies's RICO claim, we confront a threshold issue pressed by the defendants-whether an amendment to the RICO statute added by the Private Securities Litigation Reform Act of 1995 or PSLRA precluded Menzies from bringing a RICO claim in the first instance. We agree with the district court that the bar now embodied in 18 U.S.C. § 1964(c) did not prevent Menzies from pursuing a RICO claim on the facts alleged in his complaint.

         In enacting the PSLRA, Congress did more than seek to curb abusive practices in securities class actions by, for example, imposing a heightened pleading standard, requiring a class representative to be the most adequate plaintiff, and limiting damages. See Amgen Inc. v. Connecticut Ret. Plans & Trust Funds, 568 U.S. 455, 475-76 (2013) (describing the PSLRA). The enactment also amended RICO to prohibit a cause of action based on "any conduct that would have been actionable as fraud in the purchase or sale of securities." 18 U.S.C. § 1964(c) (emphasis added).

         Upon reviewing the allegations in Menzies's original complaint, the district court denied the defendants' motion to dismiss the RICO claim based on the bar in § 1964(c). The district court started with the observation that "nothing about the sale of his AUI stock itself was fraudulent." Menzies v. Seyforth Shaw LLP, 197 F.Supp.3d 1076, 1116 (N.D. 111. 2016) ("Menzies I"). "By selling Plaintiff a bogus tax shelter plan," the court reasoned, "[d]efendants were attempting to hide the resulting income from Plaintiff's sale of stock from the IRS," and "[i]n both form and substance" this was a "case about tax shelter fraud, not securities fraud." Id.

         The defendants urge us to reverse, contending that the RICO bar applies because the whole point of the Euram Oak Strategy was for Menzies to avoid realizing taxable gains from a stock sale. But for the stock sale, the tax shelter meant nothing, thereby easily satisfying, as the defendants see it, the requirement for the alleged fraud to be "in connection with" the sale of a security and thus actionable as securities fraud under section 10(b) of the Securities and Exchange Act of 1934, 15 U.S.C. § 78j(b), and SEC Rule 10b-5, 17 C.F.R. § 240.10b-5.

         We see the analysis as more difficult. By its terms, the bar in § 1964(c), as the district court recognized, requires asking whether the fraud Menzies alleged in his complaint would be actionable under the securities laws, in particular under section 10(b) and Rule 10b-5. See Rezner v. Bayerische Hypo-Und VereinsbankAG, 630 F.3d 866, 871 (9th Cir. 2010) (assessing the PSLRA bar and explaining that "[a]ctions for fraud in the purchase or sale of securities are controlled by section 10(b) of the Securities Exchange Act of 1934"); Bixler v. Foster, 596 F.3d 751, 759-60 (10th Cir. 2010) (adopting a similar approach); Affco Investments 2001, LLC v. Proskauer Rose, LLP, 625 F.3d 185, 189-90 (5th Cir. 2010) (same).

         Had he sought to plead a securities fraud claim under those provisions, Menzies would have had to allege a material misrepresentation or omission by a defendant, scienter, a connection between the misrepresentation or omission and the purchase or sale of a security, reliance, economic loss, and loss causation. See Glickenhaus & Co. v. Household Int'L, Inc., 787 F.3d 408, 414 (7th Cir. 2015) (citing Halliburton Co. v. Erica P. John Fund, Inc., 573 U.S. 258, 267 (2014)). The district court got it right in concluding that the allegations in Menzies's original complaint did not amount to actionable securities fraud under federal law.

         The Supreme Court supplied substantial direction in SEC v. Zandford, 535 U.S. 813 (2002). The SEC brought a civil securities fraud action against a stockbroker who sold his elderly and disabled clients' securities and pocketed the proceeds. See id. at 815. The Court granted review to determine whether the stockbroker's theft, which the SEC alleged also constituted securities fraud, was sufficiently "in connection with" the sale of the clients' securities to fall within section 10(b) and Rule10b-5. The Court answered yes, explaining that both provisions "should be construed 'not technically and restrictively, but flexibly to effectuate its remedial purposes.'" Id. at 819 (quoting Affiliated Ute Citizens of Utah v. United States, 406 U.S. 128, 151 (1972)). As a practical pleading matter, the Court continued, that meant a plaintiff need not allege any misrepresentation or omission about a security's value. Nor was it necessary to allege misappropriation or, even more generally, another form of manipulation of a security. What would be enough, the Court held, are allegations where "the scheme to defraud and the sale of securities coincide." Id. at 822.

         The SEC's allegations met this standard because the stockbroker defendant, alongside affirmatively misrepresenting how he intended to manage his clients' investments-he "secretly intend[ed] from the very beginning to keep the proceeds"-acted on that intent by engaging in unauthorized securities sales. Id. at 824. This misconduct "deprived [his clients] of any compensation for the sale of their valuable securities." Id. at 822. The "securities transactions and breaches of fiduciary duty coincide[d]," the Court explained, because the "[clients'] securities did not have value for the [stockbroker] apart from their use in a securities transaction and the fraud was not complete before the sale of securities occurred." Id. at 824-25. Put another way, the SEC's allegations left no daylight between the alleged fraud and the securities sale.

         Measured by these Zandford standards, Menzies's allegations do not satisfy the "in connection with" requirement for an actionable claim under section 10(b) or Rule 10b-5. Start with the alleged fraud itself. Menzies's complaint focused not on the AUI stock sale, but instead on its tax consequences. He alleged that the defendants marketed a tax shelter that they knew was abusive-that would conceal capital gains from the U.S. Treasury-and caused him to incur not just unexpected taxes and related interest and penalties but also substantial professional fees. Yes, this may be enough to show that but for following the defendants' advice and selling his AUI stock he would not have incurred the taxes and related interest and penalties. Yet we know that such "but for" allegations do not satisfy section 10(b) under the teachings of Zandford. See Ray v. Citigroup Global Mkts., Inc., 482 F.3d 991, 995 (7th Cir. 2007) (explaining that "[i]t is not sufficient [under section 10(b) and Rule 10b-5] for an investor to allege only that it would not have invested but for the fraud" and instead the investor must go further and "allege that, but for the circumstances that the fraud concealed, the investment ... would not have lost its value") (quoting Caremark, Inc. v. Coram Healthcare Corp., 113 F.3d 645, 648-49 (7th Cir. 1997)).

         If Menzies had tried to bring a securities fraud claim, he would have had to close this pleading gap. His complaint would have had to tether more directly the fraud to the stock sale by including allegations that went beyond any "but for" link and allowed a finding that the defendants' misrepresentations more closely coincided with Menzies's sale of his AUI stock. Menzies, in short, would have needed to plead facts demonstrating that he incurred his alleged losses as a more direct consequence of misrepresentations that closely touched the stock sale itself and not just its tax consequences. That the purpose of the tax shelter aimed to maximize the profits that Menzies realized from his stock sale cannot itself bridge this gap. See Ouwinga v. Benistar 419 Plan Servs., Inc., 694 F.3d 783, 791 (6th Cir. 2012) (affirming a district court's conclusion that the RICO bar did not apply because the plaintiffs' "fraud claim relates only to the tax consequences of the Benistar Plan, and it is merely incidental that the [insurance] policies happen to be securities"); Rezner, 630 F.3d at 872 (concluding the RICO bar did not apply where, in a tax shelter fraud, "the securities were merely a happenstance cog in the scheme").

         We can come at the analysis another way. No aspect of the complaint challenged any term or condition on which Menzies sold his AUI shares to Berkshire Hathaway. The complaint all but says every aspect of the stock sale itself was entirely lawful. Even more generally, no portion of the complaint alleged that any defendant engaged in an irregularity that tainted or affected the stock-sale transaction, including, for example, by influencing the sales price or somehow causing the proceeds to be mishandled. Every indication is that Menzies received every last dollar he expected from the sale. The fraud Menzies alleged is at least one step removed-focused not on the sale of the AUI stock but on how and why he charted a particular course in his treatment of the sale for federal tax purposes and the losses he sustained by doing so.

         Do not read us to say that Menzies failed to allege fraud. He plainly did when considered through the prism of common law standards. What we cannot say, though, is that-for purposes of applying the RICO bar in § 1964(c)-Menzies's allegations amounted to actionable securities fraud under the standards the Supreme Court has told us are required by section 10(b) and Rule 10b-5.

         While not aligning with the defendants' view of the law, our holding does seem on all fours with what we see and do not see in the securities fraud case law. Our research, limited though it is to reported decisions, reveals no meaningful number of section 10(b) and Rule 10b-5 private federal securities fraud claims brought to challenge abusive tax shelters. Nor do we see an indication that the SEC has brought many enforcement proceedings alleging securities fraud to combat abusive tax shelters. None of this suggests that fraud perpetrated as part of a scheme to evade taxes can never be actionable under section 10(b). Our point is limited only to the observation that the federal reporters do not contain many examples of such actions, whether by private parties or the SEC. And perhaps that reality owes itself, at least in part, to the demanding requirements for pleading a federal securities law claim.

         Unable to conclude that Menzies's allegations of fraud would be actionable under section 10(b) or Rule 10b-5, we turn, as did the district court, to his civil RICO claim.

         B. Civil RICO Claims and the Pattern Element

         Enacted in response to long-term criminal activity, including, of course, acts of organized crime, RICO provides a civil cause of action for private plaintiffs and authorizes substantial remedies, including the availability of treble damages and attorneys' fees. See 18 U.S.C. § 1964(c). Establishing a RICO violation requires proof by a preponderance of the evidence of "(1) conduct (2) of an enterprise (3) through a pattern (4) of racketeering activity." Sedima, S.P.R.L. v. Imrex Co., 473 U.S. 479, 496-97 (1985) (interpreting § 1964(c)). It follows that a plaintiff must plead these elements to state a claim. Congress defined a "pattern of racketeering activity" to require "at least two acts of racketeering activity" within a ten-year period. 18 U.S.C. § 1961(5).

         Satisfying the pattern element is no easy feat and its precise requirements have bedeviled courts. See Jennings v. Auto Meter Prod., Inc., 495 F.3d 466, 472 (7th Cir. 2007) (emphasizing that "courts carefully scrutinize the pattern requirement"); J.D. Marshall Int'l, Inc. v. Redstart, Inc., 935 F.2d 815, 820 (7th Cir. 1991) ("Satisfying the pattern requirements-that there be continuity and relationship among the predicate acts-is not easy in practice.").

         The Supreme Court has considered the issue at least twice, and our case law shows many efforts to articulate what a plaintiff must plead to establish a pattern of racketeering activity. See, e.g., Sedima, 473 U.S. at 496; H.J., Inc. v. Northwestern Bell Tel. Co., 492 U.S. 229, 237-38 (1989); Vicom, Inc. v. Harbridge Merchant Servs., Inc., 20 F.3d 771, 779-80 (7th Cir. 1994); McDonald v. Schencker, 18 F.3d 491, 497 (7th Cir. 1994). Over these many cases the law has landed on a pleading and proof requirement designed "to forestall RICO's use against isolated or sporadic criminal activity, and to prevent RICO from becoming a surrogate for garden-variety fraud actions properly brought under state law." Midwest Grinding Co., Inc. v. Spitz, 976 F.2d 1016, 1022 (7th Cir. 1992) (citing H.J., Inc., 492 U.S. at 240-41).

         To plead a pattern of racketeering activity, "a plaintiff must demonstrate a relationship between the predicate acts as well as a threat of continuing activity" -a standard known as the "continuity plus relationship" test. DeGuelle v. Camilli, 664 F.3d 192, 199 (7th Cir. 2011). The Supreme Court announced this test in H.J., Inc. and made plain that the relationship prong is satisfied by acts of criminal conduct close in time and character, undertaken for similar purposes, or involving the same or similar victims, participants, or means of commission. See 492 U.S. at 240. The relatedness of the predicate acts often does not yield much disagreement, and much more often the focus is on the continuity prong of the test. See Vicom, 20 F.3d at 780.

         Just so here: the battleground in this appeal is whether Menzies adequately pleaded the continuity dimension of the continuity-plus-relationship test. Doing so requires "(1) demonstrating a closed-ended series of conduct that existed for such an extended period of time that a threat of future harm is implicit, or (2) an open-ended series of conduct that, while short-lived, shows clear signs of threatening to continue into the future." Roger Whitmore's Auto Servs., Inc. v. Lake County, III., 424 F.3d 659, 673 (7th Cir. 2005).

         Do not let the labels create confusion. The big picture question is whether Menzies adequately alleged that the challenged conduct occurred and went on long enough and with enough of a relationship with itself to constitute a pattern. Answering that question is aided by focusing on two, more particular, inquiries. One of those inquiries-designed to ascertain the presence of a so-called "closed-ended" series of misconduct-asks whether there were enough predicate acts over a finite time to support a conclusion that the criminal behavior would continue. See Vicom, 20 F.3d at 779-80. The focus, therefore, is on "the number and variety of predicate acts and the length of time over which they were committed, the number of victims, the presence of separate schemes and the occurrence of distinct injuries." Id. at 780 (quoting Morgan v. Bank of Waukegan, 804 F.2d 970, 975 (7th Cir. 1986)).

         The alternative continuity inquiry-applicable to an "open-ended" series of misconduct-focuses not on what acts occurred in the past but on whether a concrete threat remains for the conduct to continue moving forward. See id. at 782. This can be done by showing that a defendant's actions pose a specific threat of repetition; that the predicate acts form part of the defendant's ongoing and regular way of doing business; or that the defendant operates a long-term association for criminal purposes. See Empress Casino Joliet Corp. v. Balmoral Racing Club, Inc., 831 F.3d 815, 828 (7th Cir. 2016). On these fronts, it is not enough to base an open-ended continuity theory on just one prior predicate act and an otherwise unsupported assertion that criminal activity will continue into the future. See Gamboa v. Velez, 457 F.3d 703, 709 (7th Cir. 2006) (explaining that when "a complaint explicitly presents a distinct and non-recurring scheme with a built-in termination point and provides no indication that the perpetrators have engaged or will engage in similar misconduct, the complaint does not sufficiently allege continuity").

         Added complexity enters where, as here, a plaintiff seeks to plead RICO's pattern element through predicate acts of mail or wire fraud. When that occurs the heightened pleading requirements of Fed.R.Civ.P. 9(b) apply and require a plaintiff to do more than allege fraud generally. See Jepson v. Makita Corp., 34 F.3d 1321, 1327 (7th Cir. 1994) ("Of course, Rule 9(b) applies to allegations of mail and wire fraud and by extension to RICO claims that rest on predicate acts of mail and wire fraud."). Rule 9(b) requires a plaintiff to provide "precision and some measure of substantiation" to each fraud allegation. United States ex rel. Presser v. Acacia Mental Health Clinic, LLC, 836 F.3d 770, 776 (7th Cir. 2016). Put more simply, a plaintiff must plead the "who, what, when, where, and how" of the alleged fraud. Vanzant v. Hill's Pet Nutrition, Inc., 934 F.3d 730, 738 (7th Cir. 2019).

         Given these heightened pleading standards and Congress's insistence that a RICO claim entail a clear pattern of racketeering activity, we have cautioned that "we do not look favorably on many instances of mail and wire fraud to form a pattern." Midwest Grinding, 976 F.2d at 1024-25 (quoting Hariz v. Friedman, 919 F.2d 469, 473 (7th Cir. 1990)); see also Jennings, 495 F.3d at 475 (explaining that this court "repeatedly reject[s] RICO claims that rely so heavily on mail and wire fraud allegations to establish a pattern"). We can leave for another day a more fulsome articulation of the interrelationship of RICO's pattern requirement and mail and wire fraud as predicate acts. Our focus here is whether Menzies, within the four corners of his complaint, alleged with sufficient particularity the acts of mail and wire fraud he believes demonstrate a pattern of racketeering activity.

         C. Menzies's Allegations of Racketeering Activity

         In his second amended complaint, Menzies detailed chapter and verse the fraud the defendants allegedly perpetrated on him. He told of the defendants approaching and pitching him the tax benefits of the Euram Oak Strategy. Reassured multiple times of the shelter's legality, Menzies relied on the defendants' representations, executed the strategy's component steps through transactions with trusts and the like, and ultimately sold his AUI stock for over $64 million to Berkshire Hathaway. Again relying on the defendants' assurances, he then filed his 2006 tax return without reporting his AUI stock sale as a taxable event.

         Menzies sought to plead RICO's pattern element by including allegations that the defendants marketed the identical or a substantially-similar tax shelter to three others-his business partner and co-founder of AUI, Sydney Ferenc, and two other investors, one in North Carolina and another in Arizona.

         Menzies alleged that Northern Trust contacted him and Ferenc at the same time to develop a financial advisory relationship. See SAC ¶¶ 25, 42, and 43. The complaint provides substantial detail on the defendants' interactions with Ferenc, including the dates and content of phone calls, emails, and meetings geared toward selling and advancing the scheme. See SAC ¶¶ 58, 62, 63, 76, 81, 86, 88, and 115. By way of example, consider these two factual allegations detailing the timing and substance of Ferenc's interactions with attorney Graham Taylor:

• "On September 30, 2003, Taylor provided Ferenc with an outline of the pre-arranged steps of the Euram Oak Strategy via email, assuring Ferenc that the strategy was legitimate tax planning." SAC ¶ 81.
• "On or about August 5, 2004, August 11, 2004 and August 18, 2004, Taylor sent Ferenc a revised version of the tax opinion letter via e-mail assuring Ferenc (and Menzies) that the Euram Oak Strategy was legitimate tax planning." SAC ¶ 115.

         From there Menzies alleged that Ferenc ultimately "entered into a transaction substantially similar" to the one undertaken by Menzies, including by receiving a loan from Euram Bank, establishing a grantor trust, and maneuvering various assets in anticipation of a major stock sale-all in accordance with the instructions supplied by Taylor and others. SAC ¶ 91.

         While the complaint clearly alleges the defendants marketed the same fraudulent tax shelter to Ferenc, Menzies stopped short of alleging whether Ferenc followed through with his sale of AUI stock and incurred substantial capital gains tax liability and related penalties and interest as a result of subsequent IRS scrutiny. The absence of such allegations in no way meant that Menzies failed to plead a predicate act of mail and wire fraud involving Ferenc, however. See United States v. Koen, 982 F.2d 1101, 1106 (7th Cir. 1992) (explaining that mail fraud under 18 U.S.C. § 1341 requires not actual and successful deception but only "(1) a scheme to defraud and (2) use of the mail for the purpose of executing, or attempting to execute, the scheme to defraud").

         Menzies further alleged an Arizona investor fell victim to the defendants' scheme. The second amended complaint alleged that the Arizona investor received legal opinions from Taylor and Seyfarth Shaw regarding the Euram Oak Strategy sometime in 2004. From there, though, the complaint says little more, alleging only that it is "reasonable to assume that any such opinion letter asserts the legality of the [Euram Oak] Strategy." SAC ¶ 162. On "information and belief," the complaint then alleges that the Arizona investor incurred unspecified damages from the tax deficiency that resulted from the scheme, penalties and interest, professional and attorneys' fees, and the lost opportunity to invest in a legitimate tax planning vehicle. See SAC ¶ 165.

         In much the same way, Menzies included similar allegations of fraud against a North Carolina investor. According to the complaint, the defendants approached this investor not with the Euram Oak Strategy but with a different abusive tax shelter of the same nature called the Euram Rowan Strategy. See SAC ¶¶ 166, 167. With the exception of Northern Trust, the other defendants pushed the Euram Rowan Strategy, which "involved a series of integrated, pre-arranged, and scripted steps designed to provide a taxpayer who had significant ordinary or capital gain with a non-economic ordinary or capital loss." SAC ¶ 167. Here too, however, the second amended complaint adds few details. In 2003 the North Carolina investor received legal opinions from Taylor and Sey-farth Shaw-leaving Menzies to allege that "it is reasonable to assume that any such opinion letter asserted the legality of the transaction." ...

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