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Khan v. Gramercy Advisors, LLC

Court of Appeals of Illinois, Fourth District

October 3, 2016

SHAHID R. KHAN; ANN C. KHAN; UVIADO, LLC; JONCTION, LLC; and LEMAN, LLC, Plaintiffs-Appellees,
v.
GRAMERCY ADVISORS, LLC; GRAMERCY ASSET MANAGEMENT, LLC; GRAMERCY FINANCIAL SERVICES, LLC; TALL SHIPS CAPITAL MANAGEMENT, LLC; and JAY A. JOHNSTON, Defendants-Appellants.

          Modified upon denial of rehearing October 3, 2016

         Appeal from Circuit Court of Champaign County No. 09L139 Honorable Jeffrey B. Ford, Judge Presiding.

          JUSTICE APPLETON delivered the judgment of the court, with opinion. Justice Turner concurred in the judgment and opinion. Justice Steigmann specially concurred, with opinion.

          OPINION

APPLETON JUSTICE

         ¶ 1 The plaintiffs are Shahid R. Khan (Khan); his spouse, Ann C. Khan; and some limited liability companies, in which, pursuant to the "2002 and 2003 Distressed Debt Strategies, " Khan bought majority interests. The strategies proved to be ineffectual tax shelters, as the Khans later came to realize. The limited liability companies generated losses, which the Khans claimed in their individual income tax returns so as to reduce their taxable income, but after auditing their returns, the Internal Revenue Service (IRS) disallowed the losses as artificial and lacking in economic substance. Consequently, the Khans incurred genuine financial loss in the form of interest, penalties, and the amounts they had paid for the creation and implementation of the tax shelters. Now plaintiffs seek damages from defendants for inducing them, by allegedly fraudulent misrepresentations, to buy the tax shelters and to use them for the 2002 and 2003 tax years. The defendants are Gramercy Advisors, LLC (Gramercy Advisors); Gramercy Asset Management, LLC (Gramercy Asset Management); Gramercy Financial Services, LLC (Gramercy Financial); Tall Ships Capital Management, LLC (Tall Ships); and Jay A. Johnston.

         ¶ 2 None of these defendants is domiciled in Illinois. Therefore, they filed a motion for dismissal in the trial court, arguing that exercising personal jurisdiction over them in Illinois would violate due process. Without an evidentiary hearing, the court denied their motion, finding, on the basis of the documentary submissions, that it would be consistent with due process to subject defendants to the specific jurisdiction of Illinois. We granted defendants leave to appeal. See Ill. S.Ct. R. 306(a)(3) (eff. July 1, 2014).

         ¶ 3 In our de novo review, we find that two of the defendants, Gramercy Advisors and Johnston, have made minimum contacts with Illinois and that exercising personal jurisdiction over them would be consistent with due process. But we find no minimum contacts with Illinois by the remaining defendants, Gramercy Asset Management, Gramercy Financial, and Tall Ships. Therefore, we affirm the trial court's judgment in part and reverse it in part: as to Gramercy Advisors and Johnston, we affirm the denial of the motion for dismissal, but as to Gramercy Asset Management, Gramercy Financial, and Tall Ships, we reverse the denial of the motion for dismissal.

         ¶ 4 I. BACKGROUND

         ¶ 5 A. The Places Where the Parties Reside or Are Domiciled

         ¶ 6 According to the complaint, the Khans are citizens of Illinois and reside in Champaign, Illinois, and the remaining three plaintiffs-UVIADO, LLC (UVIADO); JONCTION, LLC (JONCTION); and LEMAN, LLC (LEMAN)-are Delaware limited liability companies and have their principal place of business in Houston, Texas.

         ¶ 7 The defendants that are limited liability companies-Gramercy Advisors, Gramercy Asset Management, Gramercy Financial, and Tall Ships-are Delaware companies and have their principal place of business in Greenwich, Connecticut, according to the complaint.

         ¶ 8 "On information and belief, " the complaint alleges that the remaining defendant, Johnston, is a citizen of Connecticut and that he has his principal place of business in Greenwich. Johnston states, in his affidavit of April 21, 2015, that he is a comanaging member of Gramercy Advisors and that he resides in Puerto Rico.

         ¶ 9 B. The Fee-Sharing Agreement Between BDO Seidman, LLP, and Gramercy Advisors

         ¶ 10 Paul Shanbrom states as follows in his own affidavit, likewise dated April 21, 2015. From July 1987 to December 2008, he was a partner at BDO Seidman, LLP (BDO), where he was a member of the "Tax Solutions Group." (According to the complaint, BDO has its principal place of business in Chicago.) As a member of this group, Shanbrom "was specifically charged with the task of negotiating the terms of BDO's arrangement with Gramercy with regard to their joint efforts in offering tax-advantaged transactions to potential clients, including those at issue in the instant proceedings." The person at "Gramercy" he negotiated with was Johnston. (Shanbrom does not define the term "Gramercy" in his affidavit-but, again, Johnston was a comanaging member of Gramercy Advisors, and as we soon will discuss, Gramercy Advisors is the entity to which BDO paid fees pursuant to these negotiations between Shanbrom and Johnston.)

         ¶ 11 On January 10, 2001, Shanbrom and Johnston reached a "[n]ew deal, " under which BDO and Gramercy Advisors would split the fees "charged to clients in connection with the tax-advantaged transactions jointly promoted by BDO and Gramercy [, ] *** which included the tax-advantaged transaction involving distressed debt (engaged in by the Khans in the tax years 2002 and 2003)."

         ¶ 12 The term "[n]ew deal" is in a note handwritten by Shanbrom at the time of the negotiation and attached to his affidavit. According to this note, the "[o]ld deal" between BDO and Gramercy Advisors was 50/50 of net fees, but the "[n]ew deal" would be 66% for BDO and 34% for Gramercy Advisors, although, when it came to "[p]erformance, " the split would be 20% for BDO and 80% for Gramercy Advisors.

         ¶ 13 Shanbrom describes the contemplated joint efforts of BDO and Gramercy Advisors as follows:

"As part of this fee-splitting agreement between BDO and Gramercy, it was understood and agreed to that BDO had primary responsibility for, among other things, identifying potential clients and assisting in the marketing of the Transactions and that Gramercy had primary responsibility for, among other things, handling all aspects of the investments and transactional documents necessary to implement the [t]ransactions, in addition to assisting in marketing the [t]ransactions to clients identified by BDO. It was on this basis of BDO's and Gramercy's joint efforts that BDO and Gramercy orally agreed to the division of fees and profits as outlined in my January 10, 2001, notes."

         ¶ 14 The record contains the printout of an e-mail, dated January 22, 2001, from Robert Jones to Judy Geiselhart, both of BDO. The subject line is "Bonus for Paul Shanbrom, " and the text of the e-mail reads: "Please process a $100, 000 bonus for Paul Shanbrom in recognition of his achievement in re-negotiating the joint venture between Gramercy and Tax Solutions." (An affidavit of Todd Simmens, BDO's national managing partner of tax risk management, authenticates this e-mail as a business record of BDO.)

         ¶ 15 C. The Joint Efforts of BDO and Gramercy Advisors To Sell the 2002 Distressed Debt Strategy to Khan

         ¶ 16 1. The Alleged Meeting in Urbana, Illinois

         ¶ 17 In his affidavit, dated April 1, 2014, Khan states the following. Around June 2001, Shanbrom, a partner at BDO-a firm that Khan describes as his and his wife's "longtime accountants"-solicited the Khans to participate in a "new Foreign Currency Derivative Strategy" (which is the subject of Khan v. Gramercy Advisors, LLC, 2016 IL App (4th) 150436-U, and which, to be clear, we will not consider as a suit-based contact in the present case-this case is about the 2002 and 2003 Distressed Debt Strategies, not the 2001 Foreign Currency Derivative Strategy-although, merely for the sake of a coherent narrative, we occasionally will refer to the 2001 Foreign Currency Derivative Strategy). In order that Khan could learn more about the 2001 Foreign Currency Derivative Strategy, Shanbrom "referred [him] to [']Gramercy, ['] " which Khan defines in his affidavit as "Gramercy Advisors and its many affiliated entities." Shanbrom even arranged for a representative from "Gramercy" to meet with Khan at his executive office in Urbana, Illinois, in the summer of 2001 (Khan says in his affidavit). Khan cannot remember the name of the person Shanbrom brought along to this meeting in Urbana, but he remembers that Shanbrom introduced him as a "Gramercy operating partner."

         ¶ 18 Khan continues in his affidavit:

"This meeting lasted between 45 minutes and one hour. During the meeting the Gramercy partner described Gramercy's investment capabilities generally and in particular with regard to distressed debt investments, and solicited my investment with Gramercy. Shanbrom and the Gramercy operating partner further represented that BDO and Gramercy had worked together on these types of investments before, had other investors lined up to participate, that the product was bullet-proof, and that prominent law firm opinions backed up the product."

         ¶ 19 Defendants, on the other hand, dispute that they or any agent of theirs visited Khan in Urbana. In the summer of 2001, the "Gramercy"-affiliated companies had a total of only eight officers and employees-Johnston, Robert Young, Robert Lanava, Rodd Kauffman, Robert S. Koenigsberger, Marc Hélie, Robert Rauch, and Renato Mazzuchelli-and they all have signed affidavits stating they never personally met with Khan in Illinois and that, as far as they know, none of their colleagues did, either.

         ¶ 20 2. Telephone Calls From "Gramercy" to Khan, in Illinois

         ¶ 21 After this meeting in Urbana (Khan further says in his affidavit), the "Gramercy operating partner" followed up with two or three telephone calls to Khan, in Illinois, "to inform [him] that Gramercy only had one Brazilian distressed debt investment to offer at the time, ask whether [he] was interested in the entire investment, request that [he] invest additional cash (several millions) to lend further legitimacy to the investment and enhance the return on the investment, and further assure [him] that a prominent law firm opinion on the transaction would issue." (According to the complaint, a law firm, DeCastro, West, Chodorow, Glickfield & Nass, Inc. (DeCastro), ultimately did issue opinions to Khan validating the legality of the 2002 and 2003 Distressed Debt Strategies, but instead of being an "independent" law firm, DeCastro was in a conspiracy with BDO.)

         ¶ 22 3. The Conference Call in August 2001

         ¶ 23 In August 2001, Shanbrom arranged for a conference call between Khan, himself, and Johnston "to further discuss the 2001 Foreign Currency Derivative Strategy." Khan recounts this conference call as follows:

"12. *** Shanbrom initiated the call, Johnston joined in, and I participated in the call from my office in Illinois. During the call, I introduced myself to Johnston and told him about my Illinois-based businesses and residency. *** Johnston *** touted what he described as Gramercy's special expertise with distressed debt investments and its long history of achieving high rates of return. Johnston promised me that Gramercy could achieve results for my wife and me (and the other Plaintiffs) that few, if any, other investment firms could provide. *** ***
14. Again, before Plaintiffs ever entered into any agreements with Gramercy, during the call referenced in paragraph 12, BDO's Shanbrom and Gramercy's Johnston advised me that the 2001 Foreign Currency Derivative Strategy could yield a substantial profit and at the same time, regardless of whether we made or lost money on the investments, legally reduce Plaintiffs' capital gains and income tax burden. Both men also told me that Plaintiffs should invest additional sums of money with Gramercy, aside from the investments directly involved in the strategies, because these other investments would diversify Plaintiffs' portfolio, provide [plaintiffs] with a chance to achieve even higher rates of return, and provide even more economic substance for the 2001 Foreign Currency Derivative Strategy. They later repeated these statements with respect to the Distressed Debt Strategies (sometimes collectively referred to as the 'Strategies'). In addition to the money related to the Strategies, Shanbrom further recommended that Plaintiffs invest additional funds with Gramercy. Johnston and Shanbrom told me that any further investment would be part of the Strategies.
15.My wife and I lacked any prior knowledge in the area of these types of sophisticated investments and tax reduction strategies."

         ¶ 24 In his affidavit of November 13, 2014, Johnston denies that, in the telephone conversation of August 2001, he "made statements to Khan regarding the legality and tax implications of Khan and BDO's tax strategies." But he does not deny that the telephone conversation took place, nor does he otherwise contradict Khan's account of the telephone conversation, including Khan's recollection that Johnston told him the 2001 Foreign Currency Derivative Strategy and the distressed debt strategies "could yield a substantial profit."

         ¶ 25 D. The Implementation of the 2002 Distressed Debt Strategy

         ¶ 26 1. The Investment Management Agreement of 2001

         ¶ 27 In November 2001, Gramercy Advisors sent a proposed "Investment Management Agreement" to Khan in Illinois. After reviewing the agreement and signing it in Illinois, Khan sent it back to Gramercy Advisors in Connecticut.

         ¶ 28 In the agreement, which contained a New York choice-of-law clause but not a forum-selection clause, Khan designated Gramercy Advisors as his "attorney-in-fact, " authorizing Gramercy Advisors to do various things on his behalf, i.e., entering into investments; selecting, maintaining, and closing accounts with brokers; opening, maintaining, and closing bank accounts in the course of effecting trading and investment transactions; and executing all documents and taking all other actions that Gramercy Advisors considered to be necessary or appropriate to carry out its duties. The agreement further stated that all correspondence was to be mailed to Khan at his Illinois address and that his initial capital allocation to Gramercy Advisors was to be $2.5 million.

         ¶ 29 Under the heading "Limitation of Liability, Exculpation[, ] and Indemnification, " the investment management agreement provided as follows:

"(c) The Investment Manager [(defined as Gramercy Advisors)] is not required to inquire into or take into account the effect of any tax laws or the tax position of the Client [(defined as Khan)] in connection with managing the Account. To the fullest extent permitted by law, neither the Investment Manager, its members[, ][n]or any of their respective affiliates and their respective partners, members, officers, directors, employees, shareholders [, ] and agents shall be liable in any manner to the Client with respect to the effect of any U.S. federal, state, local[, ] or any other taxes of any nature whatsoever on the Account or the Client in connection with managing the Account or in connection with this Agreement or otherwise. The Client agrees that it has consulted its own tax advisor regarding the possible tax consequences of establishing the Account or entering into any investment made under or in connection with this Agreement."

(In their brief, defendants quote section 7(c) as further saying: " '[Khan] represents and agrees that it has consulted its own tax advisor, and that neither [Gramercy Advisors] nor any of its affiliates has made any oral or written statement to [Khan], regarding the possible tax consequences of establishing the Account or entering into any investment made under or in connection with this Agreement. [Khan] further represents and agrees that it has not relied on [Gramercy Advisors] or any of its affiliates in connection with any tax advice.' " (Emphasis omitted.) Actually, that language is not in section 7(c) of the 2001 investment management agreement, although, as we later will discuss, it is in section 7(c) of a subsequent investment management agreement, the one Khan entered into in 2003, and in that agreement, "Investment Manager" was defined as Gramercy Asset Management.

         ¶ 30 On November 5, 2001, the same day he signed the 2001 investment management agreement, Khan signed a letter addressed to Gramercy Advisors, in which he repeatedly referred to himself as "it" (suggesting, perhaps, that this was a form letter). The second paragraph of this letter, which defendants call a "side letter, " reads as follows:

"The undersigned further acknowledges that: (a) it has consulted with its own financial, tax[, ] and legal advisors with respect to the Transactions and, in particular, the effect of the tax laws and regulations and the impact of any notices or announcements issued by the IRS, (b) it has not relied on the Investment Manager for any financial, tax[, ] or legal advice with respect to the Transactions, and (c) it shall not have any claim against the Investment Manager in the event that any tax liability, problem[, ] or issue should arise in connection with the Transactions other than as a direct result of any negligence of the Investment Manager in effecting the investments pursuant to the Agreement."

         ¶ 31 2. Step-by-Step Telephonic Instructions From Johnston and Others to Khan, in Illinois, on How To Carry Out the 2002 Distressed Debt Strategy

         ¶ 32 Khan recounts in his affidavit that Johnston and other "Gramercy representatives" repeatedly telephoned him, in Illinois, to explain to him how to accomplish the various steps of the 2002 Distressed Debt Strategy. He says:

"Gramercy's representatives also participated in many telephone conversations with me (directly and through Plaintiffs' representative) regarding the implementation of the 2002 Distressed Debt Strategy. During these telephone conversations, Gramercy's representatives, including Johnston, advised me as to the status of the 2002 Distressed Debt Strategy and Plaintiffs' investments in distressed debt and instructed Plaintiffs with respect to carrying out each of the steps of the Distressed Debt Strategies, including when to dispose of the debt. I was present in Illinois during these calls."

         ¶ 33 3. The Steps of the 2002 Distressed Debt Strategy

         ¶ 34 In their complaint, plaintiffs provide the following nutshell description of a distressed debt strategy:

"The tax component [of the strategy] involves the contribution of distressed debts (generally assets trading substantially below their face value) from a foreign contributor to a U.S. partnership. That partnership subsequently contributes the distressed debts to lower-tier partnerships. The foreign partner then sells its interest in the lower-tier partnership to a U.S. taxpayer[, ] who contributes other assets to the partnership. The tax benefit is realized when the partnership sells or exchanges the contributed distressed assets for cash or other assets."

See also IRS, "Coordinated Issue Paper-Distressed Asset/Debt Tax Shelters, " LMSB-04-0407-031 (eff. April 18, 2007), available at www.lb7.uscourts.gov/documents/12-33671.pdf (last visited June 27, 2016).

         ¶ 35 When the foreign party contributes an asset to a domestic partnership, such as a distressed debt, the foreign party receives, in return, an interest in the partnership and becomes a partner (or, in the case of a limited liability company, a member). See Superior Trading, LLC v. Commissioner, 728 F.3d 676, 679 (7th Cir. 2013). In the hands of the partnership, the basis of the asset is the foreign partner's original basis, which is, roughly speaking, what the foreign partner originally paid for the asset. See id.; Black's Law Dictionary 145 (7th ed. 1999) (defining "basis" as "[t]he value assigned to a taxpayer's investment in property and used primarily for computing gain or loss from a transfer of the property").

         ¶ 36 Over time, assets can fluctuate in value. The value of the asset that the foreign partner contributed to the partnership might have changed since the date when the foreign partner originally acquired the asset. For example, a receivable that is "distressed"-a debt that the borrower, because of his worsening financial condition, appears increasingly unlikely to repay- will have declined in fair market value since the date when the foreign partner acquired it, because a receivable, a debt, has value only to the extent it is likely to be paid. This decline in value is a loss to the foreign partner.

         ¶ 37 Recognition, for tax purposes, of loss attributed to any change in the asset's value that occurred before the foreign partner contributed the asset to the partnership is deferred until the partnership sells the asset. See id. (citing 26 U.S.C. § 721(a) (2012)). If the asset is worth less than what the foreign partner paid for it, the loss in value, called "built-in loss, " will be recognized only if and when the partnership sells the asset. See id. (citing 26 U.S.C. § 704(c)(1)(A) (2012)). If the foreign partner sells its partnership interest to a United States taxpayer before the partnership sells the contributed asset, the United States taxpayer steps into the foreign partner's shoes and will recognize the built-in loss only if and when the partnership sells the asset. See id. (citing 26 C.F.R. § 1.704-3(a)(7) (2012)).

         ¶ 38 The United States partner, however, will be able to claim a built-in loss only up the amount of his own basis in the partnership. See id. (citing 26 U.S.C. §§ 704(d), 705(a)(2)(A) (2012)). Unless the United States partner has made a contribution to the partnership, his basis in the partnership will equal only the amount he paid the foreign partner for its partnership interest, and his recognition of built-in loss will be limited accordingly. See id. (citing 26 C.F.R. § 1.7411 (2012)). For illustration, let us say that the built-in loss associated with the asset (the distressed debt the foreign partner had contributed to the partnership) is $1 million but that the United States taxpayer paid the foreign partner only $300, 000 for its partnership interest. When the partnership later sells that asset for next to nothing, the United States taxpayer's loss will be limited to $300, 000-unless, before the partnership sells the asset, the United States taxpayer contributes, say, an additional $700, 000 to the partnership, thereby increasing his basis in the partnership to a level at which he will be able to recognize the full loss of $1 million ($300, 000 $700, 000). See id.

         ¶ 39 By his capital contribution to the partnership, the United States taxpayer increases his basis in the partnership, enabling him to later on claim the full amount of the built-in loss when the partnership sells the asset. A distressed debt strategy is all about exploiting built-in loss in this manner. And typically, the built-in loss will be vastly greater than any actual economic loss the taxpayer himself incurred. That is the aim.

         ¶ 40 Specifically, how did the 2002 Distressed Debt Strategy exploit built-in loss? The first step was to find foreign companies that owned receivables that had declined precipitously in value since the foreign companies acquired them. As it happened, some Brazilian companies owned "emerging market receivables, " or notes, that were worth substantially less than their face value.

         ¶ 41 The next step was to form domestic partnerships to which the Brazilian companies could contribute these distressed receivables. Gramercy Advisors was the managing member of three United States limited liability companies that were suitable for that purpose: PBANAN, LLC; JAKEND, LLC; and CFURDR, LLC. We will call these three limited liability companies "the lower-tier partnerships." (For purposes of taxation, limited liability companies are treated the same as partnerships. 26 C.F.R. § 301.7701-2(c)(1) (2015).) On February 11, 2002, the Brazilian companies contributed their distressed receivables to the lower-tier partnerships in return for membership interests in those partnerships.

         ¶ 42 Gramercy Advisors then helped Khan establish a contractual relationship with a broker, Refco Capital Markets, Ltd. (Refco), so that Khan could buy options. On September 13, 2002, Gramercy Advisors, as Khan's attorney-in-fact under the investment management agreement of 2001, signed, on his behalf, an International Swap Dealers Association, Inc. (ISDA), master agreement with Refco. The plan was for Khan to buy options through Refco and then contribute these options to a second-tier partnership. He thereby would build up his basis in the second-tier partnership so that, ultimately, he could claim the full amount of the built-in loss after the lower-tier partnerships contributed the distressed receivables to the second-tier partnership and the second-tier partnership sold them.

         ¶ 43 On September 16, 2002, Tall Ships (an affiliate of Gramercy Advisors) and the lower-tier partnerships entered into an operating agreement, creating the second-tier partnership UVIADO. The lower-tier partnerships then contributed the Brazilian distressed receivables to UVIADO in return for membership interests in UVIADO.

         ¶ 44 On September 26, 2002, "pursuant to Gramercy's instructions and authority as [his] attorney-in-fact, " Khan entered into option transactions with Refco, buying and selling options in Japanese yen (we quote from Khan's affidavit). He paid Refco a premium of $500, 000, representing the difference between the $70 million in options he bought and the $69.5 million in options he sold. We say that Khan paid the premium, but, more precisely, Gramercy Advisors, as his attorney-in-fact, paid this amount to Refco out of his account.

         ¶ 45 On October 17, 2002, Khan entered into an ISDA master agreement with Gramercy Financial. Johnston signed the agreement on Khan's behalf, by virtue of Gramercy Advisors's authority as Khan's attorney-in-fact. That same day, pursuant to this ISDA master agreement, Gramercy Financial sold Khan "certain United Mexican States 2026 Put Options" (to quote the complaint). Lanava signed for the seller, Gramercy Financial; Koenigsberger ("Founder, Partner[, ] and Chief Investment Officer at Gramercy, " according to his affidavit) signed for Khan as the buyer, acting on behalf of Gramercy Advisors as Khan's attorney-in-fact.

         ¶ 46 On November 18, 2002, through three interest transfer agreements, which "Gramercy" sent to Khan in Illinois and which he signed in Illinois, he bought membership interests in UVIADO from the first-tier partnerships (we quote from his affidavit). He thereby stepped into the shoes of the first-tier partnerships-and ultimately into the shoes of the foreign partners-for purposes of built-in loss.

         ¶ 47 That same day, Tall Ships entered into a contribution agreement between Khan and UVIADO, whereby Khan contributed the Refco options to UVIADO, together with cash and other assets. These contributions increased his basis in UVIADO to the point at which he owned roughly 97% of UVIADO, with Tall Ships and the first-tier partnerships owning the remaining 3%. He also entered into an assignment agreement with UVIADO, by which he assigned to UVIADO all his interest in the options he had bought from Gramercy Financial, further increasing his basis in UVIADO. Johnston signed the assignment agreement pursuant to Gramercy Advisors's authority as Khan's attorney-in-fact.

         ¶ 48 On December 26, 2002, UVIADO exchanged the Brazilian distressed receivables with an unrelated third party, triggering a built-in tax loss.

         ¶ 49 The next step was to distribute this loss among the members of UVIADO. That was done through the preparation of income tax forms. Gramercy Advisors hired Financial Strategy Group, a Tennessee accounting firm, to prepare the 2002 UVIADO income tax return and the corresponding Schedules K-1 for UVIADO's members, including the Khans.

         ¶ 50 Although Gramercy Advisors was the entity that hired Financial Strategy Group, Tall Ships technically was UVIADO's "tax matters partner, " according to UVIADO's 2002 tax return. Under section 1.39 of UVIADO's "Amended and Restated Operating Agreement, " dated November 18, 2002, Tall Ships was the " 'Sole Manager' " of UVIADO, and the sole manager had the exclusive right to make tax determinations. Section 3.8 empowered and obligated Tall Ships, as the sole manager, to make determinations as to the allocations of tax losses among members of UVIADO, and the members agreed not to gainsay those determinations. Section 3.8 provided: "All matters concerning the valuation of Securities and other assets of the Company, the allocation of Net Profit, Net Loss[, ] and items of taxable income, gains, losses[, ] and deductions among the Members, including taxes thereon, and accounting procedures not expressly provided for by the terms of this Agreement shall be determined in good faith by the Sole Manager, which determination shall be final and conclusive as to all Members."

         ¶ 51 Financial Strategy Group prepared the 2002 UVIADO income tax return "on behalf of Gramercy Advisors, LLC, " "using summary data sheets provided by [Gramercy Advisors] and reviewed by BDO Seidman as the source documents for the information to be reported in the returns." (We are quoting from exhibit No. 5 of Michael A. Shaul's deposition. He is a member of Financial Strategy Group, and exhibit No. 5 is an "engagement letter, " dated March 18, 2003, and addressed from him to "J. Robert Young" of "Gramercy Advisors" in Greenwich, Connecticut.) After completing the 2002 UVIADO income tax return and associated Schedules K-1, Financial Strategy Group sent them to Gramercy Advisors.

         ¶ 52 Gramercy Advisors in turn mailed a 2002 UVIADO Schedule K-1 to the Khans, in Illinois. According to Shaul's deposition, this Schedule K-1 stated that Khan owned almost 97% of UVIADO, and it "show[ed] a substantial loss of 69.8 million dollars." This was the loss, the Khans' loss, purportedly generated by the 2002 Distressed Debt Strategy.

         ¶ 53 As Khan says in his affidavit: "In April 2003, Plaintiffs received a copy of UVIADO's 2002 [Schedule] K-1 from Gramercy at my home address in Champaign, Illinois. *** UVIADO's 2002 tax return and corresponding K-1 comprised the mechanism which directed Plaintiffs to claim millions of dollars in losses on our tax returns, including my and my wife's returns. As had been explained to me by Gramercy and BDO, without the [Schedule] K-1 which Gramercy actually mailed to Plaintiffs in Illinois, Plaintiffs would have lacked the independent tax return support to realize the purported benefits of the 2002 Distressed Debt Strategy."

         ¶ 54 E. The IRS Audit

         ¶ 55 In 2005, the IRS audited the Khans' income tax returns for 2002 and 2003. Afterward, the IRS decided that the distressed debt strategies were abusive tax shelters and that the losses they purported to generate, being contrived and lacking economic substance, were invalid and did not have the effect of reducing the Khans' taxable income. Consequently, the IRS assessed millions of dollars of back taxes, interest, and penalties against the Khans, all of which they paid from Illinois.

         ¶ 56 F. BDO and Gramercy Advisors Split Khan's Fee for the 2002 Distressed Debt Strategy

         ¶ 57 On October 10, 2002, Johnston sent an invoice to Robert Jones in BDO's Chicago office, requesting "per [their] agreement" $400, 000 as Gramercy Advisors's share of Khan's fee for the 2002 Distressed Debt Strategy. The letterhead of the invoice consists of the icon of a pillared and arched doorway and, underneath that icon, the company name, "Gramercy Advisors." On October 16, 2002, Jones approved payment to Gramercy Advisors in that amount.

         ¶ 58 G. BDO and "Gramercy's" Joint Efforts To Sell the 2003 Distressed Debt Strategy to Khan

         ¶ 59 There was more than one distressed debt strategy. There was the 2002 Distressed Debt Strategy, which we have just finished describing, and then there was the purportedly new and improved version, the 2003 Distressed Debt Strategy. Khan says in his affidavit: "In the spring of 2003, Shanbrom and BDO advised me that BDO and Gramercy had redesigned the 2002 Distressed Debt Strategy to give its clients, like my wife and me, a much greater chance of making even more money from the distressed debt investments. By this time, Plaintiffs had been Gramercy clients for many years, and Gramercy engaged in continued efforts to solicit more business from us. Gramercy had been communicating, corresponding, and dealing with us in Illinois on a regular basis. BDO and Gramercy further advised me-in communications with me when I was in Illinois-that the 2003 Distressed Debt Strategy was legal and provided the same tax benefits found in the 2002 Distressed Debt Strategy. So, based on the advice of BDO, Gramercy (being my attorney-in-fact) and others, Plaintiffs decided to participate in the 2003 Distressed Debt Strategy." (Again, the IRS audit was not until 2005.)

         ¶ 60 H. The Implementation of the 2003 Distressed Debt Strategy

         ¶ 611. The Investment ...


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