DBSI Estate Litigation Trustee Wins $13.4 Million Judgment Against IRS


The Business Advisor

Summer 2016

The Internal Revenue Service’s mission is to “[p]rovide America’s taxpayers top quality service by helping them understand and meet their tax responsibilities and enforce the law with integrity and fairness to all.” In the case of the beneficiaries of the Trusts created under the 2010 DBSI Plan Debtors Joint Chapter 11 Plan of Liquidation, the IRS apparently believes that “fairness to all” includes trying to hang on to personal income tax payments made with company funds taken from thousands of defrauded investors and which the government presented as proceeds of a fraud in obtaining criminal convictions for securities and wire fraud of DBSI’s CEO, Douglas Swenson, and General Counsel.

Fortunately, in a May 16, 2016 summary judgment decision, the United States District Court for the District of Idaho concluded otherwise, ordering the IRS to return $13.4 million to one of the trusts established under the confirmed plan of liquidation for the DBSI Plan Debtors based in Boise, Idaho.

As is often the case in complex avoidance actions, this victory was obtained after a long, sustained effort by Trustee James R. Zazzali and his counsel, Gibbons P.C. Mr. Zazzali (the former Attorney General of New Jersey and retired Chief Justice of the Supreme Court of New Jersey and currently Of Counsel at Gibbons) commenced an action in November 2010, asserting claims against the IRS to avoid and recover fraudulent transfers made to satisfy the personal tax obligations of various DBSI insiders. Leading up to the Trustee’s motion for summary judgment, the Trustee had prevailed in defeating the United States’ sovereign immunity defense before the Bankruptcy Court for the District of Delaware and on appeal to the District Court.

In the course of discovery, the United States stipulated that the tax payments at issue were made with the actual intent to hinder, delay, and/or defraud DBSI’s creditors. As a result, the Trustee was entitled to avoid more than $17 million in tax payments to the IRS, subject only to the United States’ two affirmative defenses – that (i) it received the tax payments “in good faith and for value,” and (ii) it was a “mere conduit” that should not be required to repay approximately $3.6 million that it had refunded directly to Swenson and other DBSI insiders.

The Court’s Opinion
Judge Pechman began her analysis with a quote from the government’s presentencing report in CEO Swenson’s criminal case: “DBSI’s misrepresentations to investors date back to at least 2004. In April of 2005, DBSI (through FOR 1031) made a $14,115,000 payment to the Internal Revenue Service on Douglas L. Swenson’s behalf for taxes he owed. According to the government, these funds contained the proceeds of fraud.” As the Court recognized, the parties agreed that none of the tax payments were made on account of any DBSI entity’s federal tax liability and that those entities were never subject to federal income tax at the entity level. With this context, the Court proceeded to analyze the merits of the United States’ defenses.

1. Good Faith and For Value Defense

To succeed on its “good faith and for value” defense, the United States had to prove that it received the transfers in good faith and in exchange for value to the transferors. In a motion for summary judgment, the Trustee argued that the defense failed as a matter of law because the IRS could not establish that the transferors received any value.

The IRS advanced three alternate theories on how it provided “value” in exchange for the tax transfers, the “Entity” theory, the “Contingent Liability” theory, and the “Reverse Alter Ego” theory. All three theories were rejected by the District Court:

Every legal theory offered by the Government to defend its right to retain this transfer seems to ignore the fact that the money at issue here is the proceeds of a widespread and devastating fraudulent scheme, stolen from scores of investors. The IRS discusses [DBSI affiliate] FOR 1031 as if it was just another business instead of a vehicle for bilking investors, and the tax distribution as just another obligation of a legitimate enterprise instead of a money-laundering scheme for a cartel of con artists. This Court finds that equity demands the Government not be permitted to keep this money.

The IRS first argued that, because the owners could have elected to have FOR 1031 (the payor of the largest tax payment at issue) taxed at the entity level, the entity received value in the form of having its taxable income passed-through to its owners. Rejecting this Entity theory, the Court found that (i) as a limited liability company, FOR 1031 was a “pass-through” tax entity by operation of law from its inception, and, regardless of whether it later made an S election, it was never subject to entity level federal income tax; (ii) whether it could have elected different tax status was speculative and meaningless; and (iii) given that the tax payments were admittedly fraudulent, they could not possibly have made creditors better off.

Under its Contingent Liability theory, the IRS argued that FOR 1031’s operating agreement required it to make tax distributions to its members, and, therefore, the tax payments directly to the IRS constituted “value” to the company by discharging the company’s obligation to its members. The District Court found that any obligation FOR 1031 had to its members “had nothing to do with the IRS and a direct distribution to that agency was not even authorized under the agreement.” The Court further rejected the United States’ argument that the members of FOR 1031 had an enforceable right to receive the tax distributions under applicable state law.

For purposes of determining whether – from the creditors’ perspective – FOR1031 received value because it satisfied “obligations” to make tax distributions to its members, the IRS cannot have any better position than if those members had received distributions directly. Distributions to Swenson could not provide value to FOR1031 when – as the United States admits – Swenson was using FOR1031 to orchestrate a massive fraud on its investors.

With respect to the IRS’ Reverse Alter Ego theory, the District Court rejected the government’s attempt to use the equitable theory at the expense of the defrauded investors as “[i]t would be an unfair result.”

Having rejected the value component of the defense, the Court noted that judgment in favor of the Trustee was appropriate irrespective of the good faith element. The Court nonetheless addressed the United States’ good faith argument for the sake of completeness. While the Court ultimately concluded that the United States’ assertion that it accepted the tax payments in good faith raised fact issues that would have precluded entry of summary judgment in the United States’ favor, the Court did reject the United States’ argument that it was entitled to a presumption of good faith because it was executing the tax laws. Judge Pechman found that “the Government commits a logical fallacy in its attempt to justify acceptance of the FOR 1031 tax transfers … . [S]imply because the Government cannot be said to have acted unlawfully in accepting payment in ‘commercially acceptable’ form does not mean that every payment made in a commercially acceptable form is lawful.” The Court agreed with the Trustee that:

The IRS’ policies are expressly designed to facilitate the deposit of as much money as possible in the shortest amount of time. The IRS is free to adopt and implement policies with this goal, but it may not use such procedures to exempt itself from liability as the recipient of a fraudulent transfer.

2. Mere Conduit Defense

The parties agreed that approximately $3.6 million of tax overpayments and interest was subsequently refunded to the individual taxpayers. The Court found that “Congress did not intend to require the IRS to disgorge the amount of the payment twice, i.e., once to the taxpayer as a refund, and once to the Trustee.” Accordingly, the Final Judgment Against Defendant United States, entered on May 23, 2016, awarded the Trustee judgment in the amount of $13,410,442, which reflects a credit for the amounts refunded by the IRS. The United States has until July 22, 2016 to appeal from the judgment.

Zazzali said that he was gratified by United States District Judge Marsha J. Pechman’s strongly worded summary judgment opinion. Trustee Zazzali is represented in this action by Mark B. Conlan and Brett S. Theisen of the Financial Restructuring & Creditors’ Rights Department of Gibbons and Michael F. Quinn and Jennifer A. Hradil of the firm’s Business & Commercial Litigation Department.

The case is captioned Zazzali v. Swenson, et al., Case No. 13-cv-00086-MJP in the US District Court for the District of Idaho.