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Ouch – Kentucky Supreme Court Reinstates Punitive Damages Award Against Accounting Firm

The case is Yung v. Grant Thornton, 2016-SC-00571 and 2017-SC-00151. The plaintiffs sued Grant Thornton for fraud for placing them in a tax shelter. The IRS disallowed the tax shelter and the Yungs were required to pay $20 million in back taxes and penalties. The Yungs sued Grant Thornton for fraud and, in the trial court, obtained a judgment of $20 million in compensatory damages (for the back taxes they had to pay) and, more controversially, $80 million in punitive damages.

Punitive damages awards were once quite common. They have become far less common in recent years after the Supreme Court decided a series of cases requiring that the punitive damage award be proportional to the compensatory damages award.

The Appellate Court reversed the punitive damages award and the Yungs appealed to the Kentucky Supreme Court. In a thoughtful and detailed opinion, The Kentucky Supreme Court reinstated the punitive damage award!

The crux of the liability case was that Grant Thornton issued false and misleading opinions to the Yungs concerning the validity of the tax shelter. The opinion details the problems with the notices, but, most importantly for our purposes, the IRS issued a notice in 2000 disallowing similar tax shelters. Despite the notice Grant Thornton reassured the Yungs that the tax shelter was valid.

The Kentucky Supreme Court found that the punitive damage award was proper under both Kentucky law and recent U.S. Supreme Court cases. It wrote:

Pursuant to KRS 411.184(2), punitive damages are available if a plaintiff proves by clear and convincing evidence that a defendant acted with fraud, oppression, or malice. Punitive damages are also available if gross negligence is shown. See Williams v. Wilson, 972 S.W.2d 260, 262-65 (Ky. 1998). Statutory guidelines for assessing the culpability of the defendant and the amount needed to deter or to make such behavior unprofitable are:

(a) The likelihood at the relevant time that serious harm would arise from the defendant’s misconduct;

(b) The degree of the defendant’s awareness of that likelihood;

(c) The profitability of the misconduct to the defendant;

(d) The duration of the misconduct and any concealment of it by the defendant; and

(e) Any actions by the defendant to remedy the misconduct once it became known to the defendant.KRS 411.186(2); Sand Hill Energy, Inc. v. Smith, 142 S.W.3d at 167.

The Due Process Clause prohibits imposing “grossly excessive” punishment on a defendant. State Farm, 538 U.S. at 416. Excessive punitive damage awards offend the Constitution because “[e]lementary notions of fairness enshrined in our constitutional jurisprudence dictate that a person receive fair notice not only of the conduct that will subject him to punishment, but also of the severity of the penalty that a State may impose.” Id. (quoting BMW, 517 U.S. at 574). “To the extent an award is grossly excessive, it furthers no legitimate purpose and constitutes an arbitrary deprivation of property.” Id. (citing Pac. Mut. Life Ins. Co. v. Haslip, 499 U.S. 1, 54, (O’Connor, J., dissenting)). When exemplary damages are warranted, they should reflect — but not be grossly out of proportion with — the enormity of the offense. BMW, 517 U.S. at 575-76 (citations omitted). The touchstone for determining whether a punitive damage award is constitutional is whether the award is reasonable based upon the facts of the case. TXO, 509 U.S. at 458. Due process requires appellate courts to perform a de novo review of the constitutionality of punitive damage awards. See Sand Hill, 83 S.W.3d at 493(citing Cooper Indus., 532 U.S. at 424); St. Joseph Healthcare, Inc. v. Thomas,487 S.W.3d 864, 878 (Ky. 2016).

According to the Court, the Grant Thorton’s behavior was “reprehensible.”

Over the course of time, despite multiple I.R.S. 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 I.R.S. 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 I.R.S. 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 I.R.S. 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 within GT and personnel sought to avoid like circumstances with other sales. When GT was subject to an I.R.S. 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.

The court also concluded that the award was not excessive given the amount of the compensatory damages award.

The conclusion:

In consideration of the five factors in KRS 411.186(2), the trial court found that the facts of this case support an $80 million punitive damage assessment and that an award of that magnitude passed constitutional muster under federal due process guidelines. Performing a de novo review of the punitive damage award, we also conclude that the $80 million award is not grossly excessive and is constitutionally acceptable. Consequently, we reverse the Court of Appeals’ remittitur and reinstate the trial court’s $80 million punitive damage award. Otherwise, we affirm the Court of Appeals’ decision.

My thoughts: in an ever more conservative legal world the decision is refreshing. The court held the accounting firm liable for wrongful conduct and awarded punitive damages because Grant Thornton continued to advise participation in the tax shelter long after the IRS had warned that similar tax shelters were invalid.

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