DeMartino v. C.I.R.

• Decision Date: 23 November 1988
• Docket Number: No. 106,D,106
• Citation: 862 F.2d 400
• Parties: -327, 88-2 USTC P 9608 Robert DeMARTINO, Appellant-Cross-Appellee, v. COMMISSIONER OF INTERNAL REVENUE, Appellee-Cross-Appellant. ocket 88-4048.
• Court: U.S. Court of Appeals — Second Circuit

Page 400

862 F.2d 400

63 A.F.T.R.2d 89-327, 88-2 USTC P 9608

Robert DeMARTINO, Appellant-Cross-Appellee, v. COMMISSIONER OF INTERNAL REVENUE, Appellee-Cross-Appellant.

No. 106, Docket 88-4048.

United States Court of Appeals Second Circuit.

Argued Sept. 28, 1988.

Decided Nov. 23, 1988.

James C. Sherwood, New York City (Kostelanetz Ritholz Tigue & Fink, Jules Ritholz, David M. Kohane, New York City, of counsel), for appellant-cross-appellee.

Francis M. Allegra, Washington, D.C. (William S. Rose, Jr., Asst. Atty. Gen., Gary R. Allen, Chief, Appellate Section, Richard Farber, Kenneth L. Greene, Tax Div., Dept. of Justice, Washington, D.C., of counsel), for appellee-cross-appellant.

Before OAKES, MINER and ALTIMARI, Circuit Judges.

OAKES, Circuit Judge:

At least since Gregory v. Helvering, 293 U.S. 465, 55 S.Ct. 266, 79 L.Ed. 596 (1935), the Internal Revenue Service and the courts have looked askance at transactions that are "sham" or lack a business purpose. See 6 J. Mertens, Law of Federal Income Taxation Sec. 26.10 (1985). The taxpayer in this case, Robert DeMartino, would have us view otherwise the crude oil futures trading losses that he claimed in his 1975 tax year. The Tax Court, Jules G. Korner, III, Judge, held that the losses were not recognizable because the trades--"straddles"--were prearranged shams that took place in a thin market with unvarying straddle differentials and were not executed at free market prices. DeMartino v. Commissioner, 51 T.C.M. (CCH) 1278 (1986) (memorandum findings of fact and opinion). ¹ It held that the taxpayer was not liable for additional interest under section 6621 ² because a sham trade did not meet the definition of "straddle" used by that section. ³ DeMartino was liable, however, for a 5% addition to the tax for negligence under section 6653(a). ⁴ Before the decision became final (Tax Court Rule 155 allows the parties to submit computations consistent with the court's decision), Congress passed section 1535(a) of the Tax Reform Act of 1986 and legislatively overruled the part of the decision that pertained to section 6621. Judge Korner then upheld the retroactive application of section 1535 of the 1986 Act in a supplemental opinion. DeMartino v. Commissioner, 88 T.C. 583 (1987). We affirm the Tax Court's ultimate holdings.

FACTS

In 1970 taxpayer Robert DeMartino, a long-time commodities trader, and Robert E. McDonnell formed Commodity International ("CI"), a partnership dealing in a broad range of commodities on all of the New York and Chicago exchanges and on certain London exchanges. CI was a member of the National Futures Association, was registered with the Commodity Futures Trading Commission ("CFTC"), and was a clearing member of the Commodity Clearing Corporation, which clears all trades on the New York Cotton Exchange ("NYCE"). The trades involved here were executed on behalf of CI at the NYCE between September 17, 1975, and January 21, 1976.

Commodity futures contracts are executory contracts representing commitments to deliver or receive a specified quantity and grade of a commodity during a specified month in the future at a price designated by the trading participants. One who commits to deliver pursuant to a futures contract is a "seller" and has a "short position" in the futures market, while one who commits to receive is a "buyer" and has a "long position" in the futures market. Trading of commodity futures contracts takes place in so-called trading pits or trading rings on the floor of the NYCE. The trades must take place by "open outcry," which involves vocal expressions and ritualized hand signals indicating the position, quantity, and price at which the floor broker or trader is willing to trade; this practice was vividly described in Frank Norris's The Pit, a 1903 novel about Chicago's grain market. Contracts do not remain bilateral between buyers and sellers. Once cleared, they exist only between the buyer or seller and the clearing house for the exchange, so that the clearing house stands as buyer to every seller and as seller to every buyer. Only a small percentage of futures contracts are satisfied by delivery. The bulk of them are terminated prior to delivery by offsets, that is, by the execution of an equal and opposite transaction.

A straddle, or spread, position is established by simultaneously holding a long position in one delivery month and a short position in another delivery month with respect to the same commodity. For example, if one buys a contract in March 1990 crude oil and sells a contract in June 1990 crude oil, he establishes a straddle long March 1990 crude and short June 1990 crude. The two months are called the legs of the straddle. Profit or loss is based not on absolute price movements in the legs, but rather on the increase or decrease in the price differential between the long and the short contracts. Thus, if the short leg loses more value than the long leg gains, the differential changes and the value of the entire straddle position diminishes. By comparison, profit or loss on the trading of an "outright position"--solely short or long--is determined by the difference in price between the opening trade and the offsetting trade.

Open commodity futures positions are "marked to market" by the clearing house at the close of each trading day. This is done by comparing the actual prices paid for the futures contracts to settlement prices that the exchange fixes daily, and the market price is generally somewhere in the range of prices traded near the close of trading. Trading in commodity futures contracts has been regulated since April 1975 by the CFTC under the Commodity Futures Trading Commission Act of 1974, Pub.L. No. 93-463, 88 Stat. 1389, codified as per note following 7 U.S.C. Sec. 2 (1982).

Trading of crude oil futures contracts at the NYCE began on September 10, 1974, and ended on July 2, 1976. A standard NYCE crude oil futures contract specified 5,000 barrels of crude oil for delivery at Rotterdam, Holland, and four delivery months were utilized--March, June, September and December. During the first month this market existed, only five contracts were traded. During the entire operation of the NYCE crude oil market only about 55,000 trades were executed, of which approximately 37,000 were straddle trades. There was virtually no trading in the nearby months in the crude oil market, unlike other commodity markets.

The rules covering trading in crude oil futures contracts at the NYCE provided that, with few exceptions, "[n]o transaction that is not made competitively by open outcry in the trading ring of the Exchange shall be permitted, reported or recorded in the records of transactions," Crude Oil By-Laws and Rules of the Petroleum Associates of the New York Cotton Exchange, Inc., Delivery Rule C14(5), and that "[m]isleading or ambiguous bids, offers or acceptances, as well as those of a frivolous nature, are strictly prohibited," id. Rule C14(6). The rules further provided for straddle trades:

These orders are to be executed competitively by public outcry in the ring with at least one side of the straddle at the market price prevailing at the time of the trade. In inactive futures in which there are no prevailing market prices because there have been no trades, bids or offers in either future, the price must bear a reasonable relationship to the prevailing market prices of active futures.

Id. Rule C14(15). When a single broker had orders representing both sides of the same trade, the rules permitted him to place such orders only if they were "first offered openly and competitively by open outcry in the trading ring"; if "[n]either the future commission merchant receiving nor the member executing such orders [had] any interest therein, directly or indirectly, except as a fiduciary"; and if the broker met certain observation, reporting and recording requirements. Id. Rule C27.

CI engaged in two series of crude oil futures straddle trades in 1975 and 1976, the first a June 1977-December 1977 straddle and the second a December 1977-March 1978 straddle. The Tax Court found that all of the trades involved were pre-arranged outside of the trading ring in contravention of CFTC regulations. Joseph R. Hamilton, the broker who executed all of CI's trades, had so testifed. There was testimony to the contrary from one Norman Turkish, but the Tax Court found Turkish's testimony unreliable, especially in light of his conviction of tax evasion and conspiracy to defraud the United States, which resulted from his involvement in a conspiracy to fix commodity futures transactions in a similar tax deferment straddle scheme in the NYCE crude oil market. See United States v. Turkish, 623 F.2d 769 (2d Cir.1980), cert. denied, 449 U.S. 1077, 101 S.Ct. 856, 66 L.Ed.2d 800 (1981).

The Tax Court also found that the trades were not executed at free market prices because Hamilton, who was a broker for 98% of the trades executed in the NYCE crude oil market, testified that on several occasions he controlled the market and artificially moved prices downward. Some 67% of all the trades on the NYCE in the crude oil market were straddles. Almost all of the remaining trades were wash sales, purchases and sales of the same contract at the same time for the same price that resulted in no profit or loss to the trader. The wash sales apparently were made to inflate artificially the volume of contracts in order to make the market more attractive to investors. While the taxpayer argues that no one could have prevented outsiders from entering the market to capitalize on unrealistic prices, there was testimony from Hamilton that he moved market prices gradually in a successful effort to discourage outside investors from entering the market.

Third, the Tax Court found that the differentials in CI's crude oil straddles stayed virtually the same throughout the entire life of the straddles. Both CI straddle differentials varied on only...