Appeal from a judgment of the United States District Court for the Southern District of New York (Leonard B. Sand, Judge) rejecting plaintiff's federal and state securities claims on the ground that plaintiff failed to prove his reliance on defendants' material omissions with regard to a tax shelter investment. Because we hold that the defendant bore the burden of persuasion of nonreliance, we reverse and remand.
Feinberg, Chief Judge, Kearse and Winter, Circuit Judges.
The principal issue before us, one of first impression, is which party bears the burden of persuasion on the issue of a plaintiff's reliance or nonreliance on a defendant's material omissions under Section 10(b) of the Securities and Exchange Act of 1934, 15 U.S.C. § 78j(b) (1982), and Rule 10b-5 promulgated thereunder, 17 C.F.R. § 240.10b-5 (1986). We conclude that, once the plaintiff establishes the materiality of the omission by a preponderance of the evidence, the burden shifts to the defendant to establish also by a preponderance of the evidence that the plaintiff did not rely on the omission in making the investment decision. We therefore reverse and remand.
Eugene DuPont III commenced this action on July 11, 1985 in the Southern District of New York against his former lawyer, Edward J. Brady, and the law firm of Brady & Tarpey ("B&T"). DuPont claimed that the defendants had defrauded him with respect to his investment in the Kenona Coal Program limited partnership ("Kenona"), in violation of the federal securities laws, New York's Martin Act, N.Y. Gen. Bus. Law § 352-c (McKinney 1984), and the common law of fraud and attorney malpractice. A bench trial was held before Judge Sand in September 1986. The district court's opinion is reported at 646 F. Supp. 1067 (S.D.N.Y. 1986).
The evidence established that Brady was DuPont's personal lawyer from 1956 to 1980 and frequently advised DuPont on tax matters. Brady also assisted DuPont with a number of investments, several of which served as tax shelters.*fn1 One such tax shelter investment originated at a meeting in late 1979, when DuPont was informed by his financial advisers at the Southern National Bank of Houston that his potential tax exposure exceeded his available funds. In response, Brady, who was also present at the meeting, advised DuPont to invest in a tax shelter that would allow him to avoid tax on at least $300,000 of income.
Brady then instructed Daniel Gaven, an associate at B&T, to assist in finding a suitable tax shelter for DuPont. Brady and Gaven identified two such ventures, one of which was Kenona, a coal mining shelter. The promoters of both tax shelters had promised to pay a commission to B&T if any client of the firm invested in their program. Brady and Gaven ultimately determined that the Kenona program was better suited to DuPont's financial needs.
Investors who purchased limited partnership interest in Kenona were promised tax deductions of as much as four times the amount of their cash contributions. These tax benefits were to be provided by two features of the Kenona program. First, limited partners were to furnish recourse notes to an "insurance reserve fund" designed to protect the general partner against massive accident claims. These notes would be included in each limited partner's basis in Kenona even though they would become payable only in the remote event that claims exceeded the highest coal mining accident judgment ever reported. Second, the limited partners were to deduct a full year of "minimum royalty payments" in 1979, the first year of the program, even though coal mining operations were not to begin until November of that year. The minimum royalty payments were to be financed primarily out of nonrecourse loans on which the limited partnership would have to make payment only if the mine actually produced coal. The private placement memorandum on Kenona included a favorable tax opinion prepared by the law firm of Mirrer, Lerner & Ryan.
Gaven had previously reviewed the private placement memoranda on similar coal programs offered by the same promoter and the relevant legal authorities on the tax benefits of such programs. He had spoken both with an agent of the promoter and with the author of the tax opinion letter. He concluded that, although the Internal Revenue Service ("IRS") was likely to deny deductions for tax shelters like Kenona, the Tax Court ultimately would allow the deductions. Brady reached the same conclusion after consulting with Gaven and examining the tax opinion letter.*fn2
Gaven forwarded the Kenona private placement memorandum and subscription documents to DuPont on or about November 8, 1979. DuPont promptly purchased three units in the Kenona limited partnership for $75,000 with a check dated November 13, 1979. He also contributed a $225,000 promissory note, dated November 12, 1979, to fund the insurance reserve.
DuPont executed the subscription documents without reading the tax opinion or any other portion of the private placement memorandum. He therefore did not see a sentence in the memorandum stating that a fifteen percent commission would be paid to "Professional Advisors of Investors and to Persons Introducing Investors to the Partnership." Neither Brady nor anyone else at B&T otherwise notified DuPont that the firm would receive a commission if he invested in Kenona. Furthermore, DuPont was not informed of Brady's and Gaven's opinion that Kenona's tax benefits would be disallowed by the IRS although ultimately allowed by the Tax Court.
DuPont claimed a $300,000 deduction for his Kenona investment on his federal income tax return for 1979. The IRS disallowed the deduction in 1985. DuPont settled the matter in 1986 by agreeing to pay a tax deficiency of $140,513 plus interest. Because mining never began, the investment was worthless.
DuPont contends in this action that the defendants violated the federal securities laws, the Martin Act, and New York common law by failing to inform him of the commission that B&T would earn as a result of his investment in Kenona and of Brady's belief ...