Upper Deck v. American Intern. Specialty Lines

• Decision Date: 28 June 2007
• Docket Number: No. 05CV1945 IEG (RBB).,05CV1945 IEG (RBB).
• Citation: 495 F.Supp.2d 1092
• Parties: The UPPER DECK COMPANY, et. al., Plaintiffs, v. AMERICAN INTERNATIONAL SPECIALTY LINES INSURANCE COMPANY, Defendant.
• Court: U.S. District Court — Southern District of California

495 F.Supp.2d 1092

The UPPER DECK COMPANY, et. al., Plaintiffs, v. AMERICAN INTERNATIONAL SPECIALTY LINES INSURANCE COMPANY, Defendant.

No. 05CV1945 IEG (RBB).

United States District Court, S.D. California.

June 28, 2007.

Duke F. Wahlquist, Richard Keith Howell, Rutan & Tucker, LLP, Costa Mesa, CA, for Plaintiffs.

Peter A. Stroili, Robert E. Kushner, D'Amato and Lynch, New York City, R. Gaylord Smith, Ernest Slome, Lewis Brisbois Bisgaard and Smith, San Diego, CA, for Defendant.

ORDER [1] LIFTING STAY, [2] GRANTING DEFENDANT'S MOTION TO CONFIRM ARBITRATION AWARD and [3] DENYING PLAINTIFFS' MOTION TO VACATE ARBITRATION AWARD

[Doc. Nos. 17, 37]

GONZALEZ, Chief Judge.

Presently before the Court is Upper Deck's and Richard P. McWilliam's (collectively, "plaintiffs") motion to vacate an arbitration award in favor of American International Speciality Lines Insurance ("AISLIC"). (Doc. No. 17.) AISLIC has filed a cross-motion to confirm the same arbitration award, which declared that plaintiffs were entitled to no coverage under AISLIC's policy. (Doc. No. 37.) For the reasons stated below, the Court confirms the arbitration award in favor of AISLIC and denies plaintiffs' motion to vacate the award.

BACKGROUND

A. Factual History

The KPMG accounting firm developed the Subchapter S Charitable Contribution Strategy (SC2) in the early '00s to enable S corporations to reduce tax liability. (Pls. Memo. ISO Motion to Vacate, at 4.) In the typical SC2 transaction, the S corporation issues shares of nonvoting stock to its shareholders, who then donate the stock to a tax-exempt entity. (Pls. Exhibit F (I.R.S. Bulletin 2004-17), at 115.) The number of nonvoting shares is nine times the number of voting shares, such that the parties can claim the tax-exempt entity owns ninety percent of the S corporation's stock. (Id.) The S corporation then allocates ninety percent of its income to the tax-exempt party. (Id.)

Upper Deck, an S corporation, has one shareholder — the MPR Trust, of which McWilliam is the sole beneficiary. (Pls. Memo. ISO Motion to Vacate, at 5.) Upper Deck purchased SC2 from KPMG in March 2001. (Id. at 6.) On May 2, 2001, in conjunction with the sale of SC2 to Upper Deck, KPMG issued a series of opinion letters regarding the tax consequences of the SC2-implementing transactions. (See Pls. Exhibit B, at 32-53.) On March 29, 2001, Upper Deck issued 8.28 million shares of non-voting common stock to the MPR Trust, which, in turn, donated those shares to the Austin Firefighters Relief Fund ("charity").¹ (Pls. Memo. ISO Motion, at 6.) Fair Market Value, Inc. appraised those shares at a fair market value of $1,357,920 as of March 31, 2001. (Id.; Policy, Exhibit E.) The SC2 strategy contemplated that Upper Deck would allocate 90% of its income to the charity, which would pay no taxes on that income. (Pls. Exhibit F, at 115-16.) The MPR Trust would likewise not pay taxes on income allocated to the charity.

The MPR Trust and the charity also entered a Shareholders Agreement, which, inter alia, prescribed the conditions under which the charity could resell the shares to the MPR Trust or otherwise transfer them. (See Pls. Exhibit B, at 56-73.) The Shareholders Agreement included three specific provisions on resale. Under § 2.1, where the charity sought to transfer the shares to a "bona fide, good faith purchaser" Upper Deck had a right of first refusal to purchase the shares on the same terms.² (Pls. Exhibit B, at 57.) Under § 3.5, upon the occurrence of any specified "Disposition Event" (e.g., if the charity filed for bankruptcy), Upper Deck or its shareholder could repurchase the shares at fair market value. (Id. at 60.) Finally, under § 5.2, during a six-month window beginning April 1, 2003, the charity could resell all of its shares back to Upper Deck for fair market value. (Id. at 65.) Otherwise, § 1 prohibited the charity from otherwise disposing of the shares without the prior written consent of Upper Deck and the MPR Trust. (Id. at 56.)

AISLIC drafted a Fiscal Event Insurance Policy ("Policy") to cover tax liabilities associated with the SC2 strategy. (See Pls. Exhibit B, at 1-26.) On August 29, 2001, AISLIC issued the Policy to plaintiffs for a premium of $3.25 million. (Policy, at ii.) The Policy carried a coverage limit of $50 million. (Id.) The Policy incorporated the KPMG opinion letters; the Shareholders Agreement; Upper Deck's September 4, 2001 Representation Letter; the warrant agreement; and the share appraisal. (Award, at 3.)

In 2002, Congress and the IRS began investigating the SC2 strategy. (Pls. Memo. ISO Motion, at 8-9.) The IRS issued summonses to KPMG to obtain a list of SC2 participants, and implemented a voluntary disclosure initiative. (Wahlquist Decla. ¶ 7.) The California Franchise Tax Board (FTB) implemented a similar initiative. (Pls. Exhibit H.)

At the end of 2002, Upper Deck approached the charity about repurchasing the non-voting shares. Pursuant to a share purchase agreement dated December 10, 2002, Upper Deck repurchased the shares for $2 million. (Pls. Exhibit C, at 89 (Share Purchase Agreement § 1. 1).) As appraised by Empire Valuation Consultants, the fair market value of the shares at the time of repurchase was $11.3 million (more than five times the actual repurchase price). (Trans., at 325:19-22.)

In Notice 2004-30 issued in April 2004, the IRS indicated it would challenge the tax benefits obtained from the SC2 strategy and possibly terminate a participating corporation's subchapter S status. (Pls. Exhibit F, at 115.) The IRS followed up with a Coordinated Issue Paper on November 8, 2004, explaining that it would disregard the transfer of stock to a tax-exempt party and disallow charitable deductions by the donating shareholder(s) for federal tax purposes. (Pls. Exhibit G, at 118.) A similar measure by the California Franchise Tax Board (FTB) required SC2 participants to amend their returns to allocate all S-corporation income back to the original shareholders. (Pls. Exhibit H, at 135.)

Participating in the voluntary disclosure initiatives, Upper Deck settled with the IRS for $80 million in back taxes and interest, and with the FTB for $17 million in back taxes and interest. (Pls. Memo. ISO Motion to Vacate, at 10.) After the settlement, Upper Deck turned to AISLIC for coverage of the back taxes and interest. In a letter dated July 9, 2004, AISLIC's counsel concluded the Policy may not cover the loss because the Shareholders Agreement required Upper Deck to repurchase the shares at fair market value (as determined by an independent appraisal), and there was no evidence to show that the fair market value of the repurchased shares in December 2002 was $2 million. (Pls. Exhibit D, at 102-08.) AISLIC requested further information on the details of the repurchase transaction. (Id. at 107-08.) AISLIC finally denied coverage in a letter dated July 29, 2005. (Id. at 96-101.)

B. Procedural History

On October 13, 2005, plaintiffs filed their complaint seeking a declaratory judgment that AISLIC must cover plaintiffs'"Insured Tax Loss" under the Policy terms. (Compl. ¶¶ 38-49.) Plaintiffs further alleged causes of action for breach of contract and tortious breach of the covenant of good faith and fair dealing. (Id. at 18.)

On February 1, 2006, this Court granted AISLIC's motion to compel arbitration and stayed the case, pending the outcome of arbitration. (Doc. No. 13, at 11.) The AAA panel held a hearing for seven days in October and November 2006. (Def. Opp. to Motion to Vacate, at 14-15.) The panel's January 6, 2007 award declared plaintiffs were not covered under AISLIC's Policy and were entitled to no insurance proceeds. (Award, at 4.) The panel denied AISLIC's counterclaims. (Id. at 4-5.)

On March 15, 2007, the Court issued notice of a hearing for dismissal for want of prosecution pursuant to Local Rule 41.1. (Doc. No. 15.) Plaintiffs moved to vacate the arbitration award on April 9, 2007.³ (Doc. No. 17.) AISLIC filed a cross-motion to confirm the award on April 23, 2007. (Doc. No. 37.) AISLIC filed its opposition on May 10, 2007. (Doc. No. 42.) Plaintiffs filed their opposition on May 15, 2007. (Doc. No. 43.) Both parties filed replies on May 21, 2007. (Doc. Nos. 44-45.) After hearing oral argument on May 29, 2007, the Court took the matter under submission.

DISCUSSION

A. Legal Standard

Within a year after an arbitration award is made, if any party to the arbitration applies for an Order confirming the arbitration award, the Court which compelled arbitration must confirm the award "unless the award is vacated, modified or corrected[.]" 9 U.S.C. § 9 (2005). Any party to the arbitration can likewise apply to vacate the award, inter alia, "[w]here the arbitrators exceeded their powers[.]" Id. § 10(a)(4). Arbitrators exceed their powers where, e.g., the award is "`completely irrational' or `constitutes manifest disregard of the law.'" Poweragent, Inc. v. Elec. Data Sys. Corp., 358 F.3d 1187, 1193 (9th Cir.2004) (quoting Coutee v. Barington Capital Group, 336 F.3d 1128, 1132-33 (9th Cir.2003)). When arbitrators are called to interpret a contract, their award must "`draw[] its essence from the [parties'] agreement.'" Coast Trading Co., Inc. v. Pax. Molasses Co., 681 F.2d 1195, 1197 (9th Cir.1982) (quoting United Steelworkers of Am. v. Enter. Wheel & Car Corp., 363 U.S. 593, 597, 80 S.Ct. 1358, 4 L.Ed.2d 1424 (1960)).

However, review of an arbitration panel's contract interpretation is highly deferential because "an award must be confirmed if the arbitrators even arguably construed or applied the contract and acted within the scope of their authority." Barnes v. Logan, 122 F.3d 820, 822 (9th Cir.1997); Goodman v. CIBC Oppenheimer & Co., 131 F.Supp.2d 1180, 1183 (C.D.Cal.2001). An award that "draws its essence" from the parties' agreement is a "plausible interpretation" of that agreement. Sheet Metal Workers' Int'l Ass'n Local Union No. 359 v. Madison Indus., Inc., 84...