Professional Malpractice, Punitive Damages Addressed by the Kentucky Supreme Court

Professional Malpractice, Punitive Damages Addressed by
the Kentucky Supreme Court

      In a December ruling from the Kentucky Supreme Court, it addressed claims against the Grant Thornton LLP accounting firm with respect to allegations of professional misconduct involving a discredited tax shelter. The trial court found that the accounting firm had engaged in professional malpractice, and in addition to awarding compensatory damages of some $20 million awarded punitive damages in the amount of $80 million. The Court of Appeals affirmed the determinations of liability and the compensatory damages, but reduced the punitive damages to $20 million, creating equivalency (a ratio of 1:1) between the compensatory and punitive damages. On its review, the Kentucky Supreme Court affirmed the determination of professional malpractice and the compensatory damages award of $20 million. It reversed, however, the reduction of the punitive damages award and reinstated them in the amount of $80 million. Yung v. Grant Thornton, LLP, 563 S.W.3d 22 (Ky. Dec. 13, 2018).

      In 2000, the Yungs purchased from Grant Thornton the “Grant Thornton Leverage Distribution Product,” otherwise referred to as “Lev301,” with the aim of repatriating from the Cayman Islands significant accumulated earnings garnered through the ownership and operation of hotels and casinos. Grant Thornton represented to Yungs, that through the use of the Lev301 shelter, those funds could be repatriated without being subject to federal tax. As recounted by the Kentucky Supreme Court:

As to the Yungs, the Lev301 involved moving money from the Cayman Islands into the U.S. by distributing the Cayman corporations’ profits to the shareholders as fully encumbered securities. First, the Cayman corporations bought $30 million in Treasury notes (T-notes) using borrowed money, with the T-notes serving as security for that debt. Next, the corporations transferred the T-notes to the shareholders in the U.S.  Because they were 1005 encumbered, the T-notes ostensibly had no taxable value, and accordingly, the shareholders would not report the distributions on their federal tax returns.  The Cayman corporations would then pay off the debt six months to a year later, but the loan repayment would also not result in reportable income to the shareholders because they were not co-obligors for the loan’s repayment. This tax shelter strategy, Lev301, theoretically allowed the shareholders to avoid tax consequences on $30 million in profits brought into the U.S. by means of the eventually unencumbered T-notes. 563 S.W.3d at 32.

      The Supreme Court then reviewed various elements of IRS scrutiny and rejection of tax shelters including the BOSS Notice and the various disclosures required with respect to purchasers of tax shelters. Notice 99-59, 1999-52 I.R.B. 761; T.D. 8875, 2000-11 I.R.B. 761. The Supreme Court also cited an article by Lee Shepperd from Tax Notes, which it says Grant Thornton was aware of, in which she suggested that transactions similar to that employed in Lev301 would be disallowed by the IRS. Still, with those limitations already in place, as well as concerns with respect to other issues including a business purpose and economic substance, Grant Thornton promoted the Lev301 Program to the Yungs by means of a meeting with their CFO: In connection therewith, Grant Thornton:

They did not disclose that Lev301 was substantially similar to the BOSS; that the February 2000 tax shelter regulations imposed disclosure and listing requirements on corporate participants in such transactions; that the Treasury would likely retroactively make Arthur Andersen’s equivalent “Bossy” product unlawful; or that GT believed that there was a 90% chance that the IRS would disallow the Lev301 tax benefits on audit. 536 S.W.3d at 35.

      The marketing efforts continued including presentations to members of the Yung Family. During the pendency of the considerations, Great Thornton represented a “worst-case scenario” by which there would be impose taxes and interest on the repatriated funds but there would not be interest., This in opposition to the known treatment of transactions falling within the scope of the BOSS Notice. When Yung indicated they did not want to be the first out of the gate and therefore the “guinea pig” on the Lev301 structure, it was thereafter represented to him, “without any factual basis” that two local companies had used the strategy. 536 S.W.3d at 37.

      Then, notwithstanding additional action by the IRS and an article in the Wall Street Journal, it was represented to the client that there was not a problem. This was done even though Grant Thornton had otherwise suspended efforts to sell the Lev301 product. Also, Grant Thornton made a “business decision” to not maintain the required list of investors and did not advise the client of that IRS imposed obligation. Likewise not disclosed to the client was that the outside law firm retained to review the Grant Thornton “more likely than not opinion refused to endorse it on bases including that the transaction did not satisfy business purpose, economic substance and separate transaction issues. Still, the closing on the transaction proceeded on December 29, 2000 with Grant Thornton committing to deliver a “more likely than not” opinion letter notwithstanding that, internally, they could not come to that level of confidence.

      Within days thereafter, the Treasury Department issued temporary and proposed regulations that invalidated the Lev301 structure, they collectively invalidating the suggestion that the recourse liability to the company making the distribution would reduce, as to the shareholder, the value of the distributed assets. Even in the base of that authority, Grant Thornton made several representations to the Yungs that the transaction was not in trouble.

      Ultimately, by means of an audit of Grant Thornton, the IRS learned of the Yungs’ participation in the Lev301 transaction. They were in turn audited, and the IRS assessed back taxes and penalties, resulting in a settlement. The Yungs then initiated suit against Grant Thornton.

      A bench trial lasting 22 days and more than 600 documents, as well as 40 witnesses, yielded a return to the Yungs of the $900,000 engagement fee paid to Grant Thornton, taxes, interest and penalties of approximately $19 Million, an additional $80 Million in punitive damages.

      As noted above, the determination of liability was affirmed by the Court of Appeals, but the punitive damages were reduced to approximately $20 Million yielding a 1:1 ratio between compensatory and punitive damages.

      In its decision, the initial substantive determination is that, under Kentucky law, tax and related interest liability will be recoverable, notwithstanding Grant Thornton’s argument that those payments put the Yungs in a position better than they would have been absent the Lev301 transaction. Specifically:

[W]e join those jurisdictions that deem the issue of whether the plaintiff  has actually been damaged by incurring tax and interest liability a question of fact.  Consequently, we refuse to adopt the blanket “matter of law” rule advocated by GT forbidding tax and IRS interest recovery in accounting fraud and negligence actions.  Under our traditional tort damage principles, if the taxpayer has been injured, recovery should be allowed if the taxpayer meets the burden of proving causation and damages.  Therefore, if the tax liability (i.e., taxes and interest paid to the IRS) is a direct result of an accounting’s fraudulent or negligent conduct, a plaintiff’s out-of-pocket damages are recoverable.  Ultimately, the issue depends on the circumstances of each case, and in this case, we conclude the trial court properly awarded taxes and interest as compensatory damages. 563 S.W.3d at 59-60.

      Turning to the topic of punitive damages, the Supreme Court began by holding that the Court Of Appeals does have the capacity to order remittitur of punitive damages. From their return to the question of whether the initial award of $80 Million of punitive damages was constitutionally excessive. Applying a de novo standard of review and KRS § 411.184, the Supreme Court found Grant Thornton’s conduct to have satisfied the reprehensible element of punitive damages, it observed:

Over the course of time, despite multiple IRS notices and regulations, professional articles, opinions of outside legal counsel, and internal confusion alerting GT that the Lev301 was likely an abusive tax shelter and IRS regulations likely would apply retroactively to the Yungs’ detriment, GT never once disclosed to the Yungs the problems with the Lev301 concept in general nor specifically, e.g., the use of a recourse bank loan and the need for a stated business purpose for the transaction.  When the Yungs discovered on their own that the IRS could possibly disallow the Lev301 tax benefits and communicated that concern to GT, GT misrepresented its confidence in the product. Although GT stopped selling Lev301 multiple times in response to IRS notices and new regulations, the Yungs were not told even once about the cessation of sales of an increasingly dubious product.  At one point, the Yungs’ Lev301 use was described as a successful sale to GT’s staff for promotional purposes and the staff was also told, despite it not being so, that the Lev301 was vetted and approved by outside counsel. Furthermore, although the Yungs were never informed of the problems associated with their particular transaction, the knowledge of those problems (e.g., recourse loan, business purpose) was reflected in numerous internal communications with GT and personnel sought to avoid like circumstances with other sales.  When GT was subject to an IRS examination because of the Lev301, GT did not inform the Yungs; instead these “trusting” clients learned of the scrutiny from a tax publication.

These various misrepresentations and nondisclosures were made to save the $900,000 deal and to cover GT’s negligent and fraudulent acts that accumulated over time.  This summary of GT’s grossly negligent and fraudulent behavior does not fully reflect GT’s reprehensible behavior in the marketing and sale of the Lev301 to the Yungs.  In our view, these individual and cumulative acts place GT’s behavior toward their clients at the high end of professional reprehensibility. Although the Yungs may not have been financially vulnerable, the reprehensibility of GT’s orchestrated, on-going deceit is not lessened or mitigated by the fact GT defrauded people of wealth, rather than the financially vulnerable. We noted above in the discussion of justifiable reliance that a plaintiff’s wealth and business experience cannot preclude a finding of reliance on that plaintiff’s trusted accounting and tax advisors nor should it preclude a punitive damage award where the advisors’ conduct is reprehensible. 563 S.W.3d at 67. (emphasis in original).

      Turning to the ratio, it was held that the 4.1 ratio here applied was acceptable “We do not view the $80 million punitive damage award to be disproportionate to the harm suffered by the Yungs.”

      Last, turning to an the question of whether there was a disparity between the compensatory and punitive damages, in what can at least in part the characterize as a conclusory determination, it was held that this element was satisfied.