Kelly Capital, LLC v. S & M Brands, Inc.

• Decision Date: 10 October 2012
• Docket Number: Civil Action No. 3:10cv728.
• Citation: 873 F.Supp.2d 659
• Court: U.S. District Court — Eastern District of Virginia
• Parties: KELLY CAPITAL, LLC and Kelly Escrow Fund V, LLC, Plaintiffs and Counterclaim Defendants, v. S & M BRANDS, INC., Defendant and Counterclaim Plaintiff, v. SEI Private Trust Company, as Trustee of the SEI Private Trust, Counterclaim Defendant.

873 F.Supp.2d 659

KELLY CAPITAL, LLC and Kelly Escrow Fund V, LLC, Plaintiffs and Counterclaim Defendants,

v.S & M BRANDS, INC., Defendant and Counterclaim Plaintiff,

v.SEI Private Trust Company, as Trustee of the SEI Private Trust, Counterclaim Defendant.

Civil Action No. 3:10cv728.

United States District Court,

E.D. Virginia,

Richmond Division.

June 1, 2012.

Opinion Amended In Part Aug. 14, 2012.

As Corrected Oct. 10, 2012.

David Barmak, Matthew Adam Richer Cohen, Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C., Washington, DC, Bridget Moorhead, Mintz Levin Cohn Ferris Glovsky and Popeo PC, San Diego, CA, for Plaintiffs and Counterclaim Defendants.

Alan Durrum Wingfield, Bryan Michael Haynes, Timothy James St. George, Troutman Sanders LLP, Richmond, VA, for Defendant and Counterclaim Plaintiff.

MEMORANDUM OPINION

ROBERT E. PAYNE, Senior District Judge.

This matter is before the Court after a bench trial on the First Amended Complaint (“FAC”) (Docket No. 49) filed by Kelly Capital, LLC (“Kelly Capital”) and Kelly Escrow Fund V, LLC (“Kelly Escrow”) ¹ against S & M Brands, Inc. (“S & M Brands”); the Amended Counterclaim (“ACC”) filed by S & M against Kelly Capital, Kelly Escrow, and SEI Private Trust Company as Trustee of the SEI Private Trust (“SEI”) (Docket No. 53); and the Amended Answer and Counterclaim filed by SEI against S & M (Docket No. 58).

In Count One of the FAC, Kelly seeks a declaratory judgment respecting the obligation to pay certain taxes under a contract with S & M and a declaration that Kelly has not breached that contract and is entitled to exercise certain option rights under it. In Count Two of the FAC, Kelly seeks specific performance of the contract.

In Count I of the ACC, S & M seeks a declaratory judgment respecting Kelly's and SEI's obligations to pay those same taxes under the same contract that is at issue in the FAC. In Count II of the ACC, S & M seeks a declaration that Kelly and SEI have committed an anticipatory breach of that contract by stating that they will not pay the taxes and that, because of this breach, S & M is released from certain obligations under the contract respecting the option rights.

In Count I of the Amended Counterclaim (Docket No. 53), SEI seeks the same declaration that Kelly Capital seeks in Count One of the FAC. SEI does not present a claim equivalent to Count Two of Kelly's FAC.

For the reasons that follow, judgment will be entered for S & M and against Kelly on the FAC; judgment will be entered against Kelly and SEI on the ACC; and judgment will be entered in favor of S & M and against SEI on SEI's Amended Counterclaim.²

FINDINGS OF FACT

The contract at the core of the FAC, S & M's ACC, and SEI's Amended Counterclaim is an Escrow Release Transfer Agreement (“ERTA”) which was executed on April 2, 2010 between S & M and Kelly Capital. The ERTA incorporates by reference an Escrow Agreement executed the same day. Also, at issue is a related indemnity agreement executed by Malcolm (“Mac”) Bailey, founder and Chief Executive Officer of S & M.

The April 2 ERTA gave Kelly Capital rights to make an initial purchase of “escrow releases” and an option to purchase “escrow releases” in the future. ³ FPTO ¶ 45. On April 16, Kelly Capital assigned its rights to purchase the initial escrow releases to SEI. Id. ¶ 47. S & M and SEI executed an ERTA identical to the April 2 ERTA, except that SEI did not obtain an option to purchase future escrow releases. On July 15, Kelly Capital's option having expired, the parties agreed to a reinstatement of, and a second amendment to, the April 2 ERTA. Id. ¶ 48. In the Second Amended ERTA, Kelly Capital assigned its rights to Kelly Escrow, and S & M agreed to give Kelly Escrow additional options for future purchases of escrow releases. Id. ¶¶ 48–49. This opinion will refer to the first ERTA because all of the ERTAs reflect the terms of that ERTA, the only differences between them being that SEI did not have any options for future purchases, and the change in the date by which Kelly Escrow was permitted to exercise its options.

A brief look at the background of S & M's business and the circumstances giving rise to the ERTA will help in understanding the contract dispute here at issue. The facts recited are either stipulated, not in dispute, or, if in dispute, are found, as recited, because they are proved by a preponderance of the evidence.

A. Background; Escrow Accounts; Escrow Releases

S & M has been a tobacco manufacturer and distributor of cigarettes and other tobaccoproducts since 1994. FPTO ¶ 5 (Docket No. 123). It is a privately owned, family run corporation, with its principal place of business in Keysville, Virginia, but it sells tobacco products throughout the Eastern United States. Id.

In the 1990's, several states initiated class actions against tobacco manufacturers seeking compensation for expenses incurred, or to. be incurred, in treating diseases associated with smoking tobacco. Those actions were settled pursuant to a 1998 Master Settlement Agreement (“MSA”). However, not all tobacco companies were parties to the class actions or the MSA; and, to bring the non-signing manufacturers into the fold and achieve the same result as the MSA, states passed legislation.

As a result of the MSA or the state legislation, tobacco manufacturers in Virginia and 45 other states are required either to have signed the MSA or to contribute annually to an escrow account certain sums for each carton of cigarettes sold. See, e.g.,Virginia Code § 3.2–4201. The deposited funds must remain in escrow for 25 years. While in escrow, those funds may be used only to pay judgments on, or settlements of, tobacco-related claims. Id. At the end of 25 years, the depositing company is entitled to the deposited funds then remaining in the escrow account, i.e., the portion of the principal that has not been used to pay judgments on, or settlements of, tobacco-related claims. The deposited funds may be invested, under tightly regulated circumstances, in very restricted investment vehicles that produce interest income. In essence, the deposited funds earn interest and the depositing company is entitled to that interest, as it is earned.

S & M did not sign the MSA, and thus, as required by state laws, it has established escrow accounts in each state in which it sells cigarettes. The escrow accounts are governed by an Escrow Agreement between S & M and a national banking association (the “Escrow Agent”). FPTO ¶ 17. S & M has a separate escrow account for each year in which it has sold cigarettes and thereafter funded the escrow accounts. Id.

The tobacco companies that establish, and fund, these escrow accounts cannot sell, transfer, distribute, or use the principal funds deposited in the accounts until expiration of the 25–year period. Id. However, they can sell or distribute what are called “escrow releases.” An escrow release, inter alia, vests in the purchasing entity: (1) the right to the interest income earned from the funds that have been deposited into the escrow accounts; and (2) the right to receive any funds, principal or interest, that remain in the escrow account at the end of the 25–year period. Id.

B. Qualified Settlement Funds

Tobacco companies that were signatories to the MSA were able to take tax deductions for their contributions to. the escrow accounts because those accounts were designated as Qualified Settlement Funds (“QSF”). However, non-signatories to the MSA were not accorded that benefit. Thus, from 2000–2007, ⁴ S & M was not able to take deductions for its deposits to the escrow accounts. The inability to take tax deductions reduced S & M's profits and also put S & M at a competitive disadvantage with manufacturers which were parties to the MSA even though S & M's products generally sold at lower prices than so-called brand name cigarettes.

In January 2007, however, S & M obtained a private letter ruling from the Internal Revenue Service (IRS) stating that its escrow accounts could be treated as QSFs for tax purposes under Treas. Reg. § 1.468B. Id. ¶ 22. Thereafter, deposits made to the QSFs were tax-deductible by S & M.

A QSF is a creature of regulation. It is defined as a fund that is: (1) established to resolve claims arising, inter alia, from a tort or violation of law; (2) established pursuant to a court order or approved by a state or federal governmental entity; and (3) segregated from the other assets of the “transferor.” Id. ¶ 23. It is a “United States person and is subject to tax on its modified gross income for any taxable year at a rate equal to the maximum rate in effect for that taxable year.” Id. ¶ 26 (quoting Treas. Reg. 1.468B–2(a)).

The “income” earned by the escrow accounts is the interest earned on the funds deposited in those accounts. And, the interest is the only source of funding that a QSF can permissibly use to pay its taxes because it produces no other income, and, of course, the principal in the QSF cannot be used for any purpose other than to pay judgments on, or settlements of, tobacco-related claims.

The parties agree that, the interest earned on the deposited principal funds in a QSF is subject to a double layer of taxation. Specifically, the owner of the right to the interest income must pay income tax when that interest is received. And, the QSF also must pay income tax on that interest under Treasury Regulation § 1.468B–1 (the so-called “QSF-level tax”).

C. Sale of the Escrow Releases

In 2007, S & M began actively trying to sell its “escrow releases.” To that end, it engaged in negotiations with a company known. as “Fortress” and arrived at a tentative arrangement to sell escrow releases for 34 cents per dollar of principal transferred.⁵ Brian Gallogly and Andrew Sroka, lawyers in the Brown Rudnick firm, represented Fortress during the negotiations with S & M.⁶ Fortress and S & M executed an ERTA, but the transaction did not close because Fortress belatedly realized the import...