Canceled Debt Income Decision Should be Affirmed, DOJ Argues

ROBERT CONNELL,
Petitioner-Appellant
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent-Appellee

IN THE UNITED STATES COURT OF APPEALS
FOR THE THIRD CIRCUIT

ON APPEAL FROM THE DECISION OF
THE UNITED STATES TAX COURT

BRIEF FOR THE APPELLEE

RICHARD E. ZUCKERMAN
Principal Deputy Assistant Attorney General

BRUCE R. ELLISEN (202) 514-2929
NATHANIEL S. POLLOCK (202) 514-8139
Attorneys
Tax Division
Department of Justice
Post Office Box 502
Washington, D.C. 20044

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TABLE OF CONTENTS

Table of contents

Table of authorities

Introduction

Statement of subject matter and appellate jurisdiction

Statement of the issue

Statement of related cases and proceedings

Statement of the case

Summary of argument

Argument

The Tax Court correctly decided that Connell's retention of the balance Merrill claimed he owed on a $3,637,217 up-front forgivable loan, pursuant to the FINRA panel's ruling that he was entitled to retain it, is ordinary income for tax purposes

Conclusion

Certificate of bar membership

Certificate of compliance

TABLE OF AUTHORITIES

Cases:

Alexander v. I.R.S., 72 F.3d 938 (1st Cir. 1995)

Anderson v. Commissioner, 698 F.3d 160 (3d Cir. 2012)

Commissioner v. Murdoch, 318 F.2d 414 (3d Cir. 1963)

Dye v. United States, 121 F.3d 1399 (10th Cir. 1997)

Francisco v. United States, 267 F.3d 303 (3d Cir. 2001)

Freda v. Commissioner, 656 F.3d 570 (7th Cir. 2011)

Gail v. United States, 58 F.3d 580 (10th Cir. 1995)

Liss v. Liss, No. 03502 JUNE TERM 2002, 2005 WL 1579502 (Pa. Com. Pl. June 29, 2005), aff'd, 911 A.2d 193 (Pa. Super. Ct. 2006)

Estate of McKelvey v. Commissioner, 906 F.3d 26 (2d Cir. 2018)

Miller v. Butcher Distributors, 89 F.3d 265 (5th Cir. 1996)

Mitchell v. Moore, 729 A.2d 1200 (Pa. Super. Ct. 1999)

Pittsburgh Const. Co. v. Griffith, 2003 PA Super 374, 834 A.2d 572 (2003)

PTSI, Inc. v. Haley, 71 A.3d 304 (2013)

Raytheon Production Corp. v. Commissioner, 144 F.2d 110 (1st Cir. 1944)

Rodriguez v. City of Doral, 863 F.3d 1343 (11th Cir. 2017)

Romy v. Burke, No. 1236 MAY.TERM 2002, 2003 WL 21205975 (Pa. Com. Pl. May 2, 2003)

Stevens v. City of Forest Park, 635 F. App'x 690 (11th Cir. 2015)

Tribune Pub. Co. v. United States, 836 F.2d 1176 (9th Cir. 1988)

State Fish Coup. v. Commissioner, 48 T.C. 465 (1967)

Wilson Area Sch. Dist. v. Skepton, 586 Pa. 513, 895 A.2d 1250 (2006)

Statutes:

Internal Revenue Code (26 U.S.C.):

Miscellaneous:

Fed. R. App. P. 13(a)

Local Rule 28.3(d)

Restatement (2d) of Torts

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INTRODUCTION

This is a case in which the Tax Court applied the origin-of-the-claim doctrine to determine whether loan proceeds that Connell retained under an arbitration award are ordinary income or a capital gain. Under the origin-of-the-claim doctrine, courts must ask “in lieu of what were the damages awarded [or, here, the alleged debt extinguished]?” Connell wanted the proceeds to be taxed as a capital gain, which would have meant an income tax savings of more than $1 million. The Tax Court sustained the IRS's determination that the proceeds are taxable as ordinary income. The Tax Court found that Connell failed to prove that the arbitration award was predicated upon a determination that his former employer (Merrill) converted his book of business. Connell's failure to straightforwardly challenge that finding should be fatal to his appeal. In any event, the finding is amply supported by the record.

STATEMENT OF SUBJECT MATTER AND APPELLATE JURISDICTION

The Tax Court had jurisdiction over this case, and this Court has jurisdiction over this appeal.

The IRS sent a notice of deficiency for the 2009 tax year to Connell, and it also sent a notice of deficiency to Connell for the 2010 and 2011 tax years. These notices of deficiency were each sent on April 6, 2016. Connell timely filed petitions in the Tax Court contesting the deficiencies, and the two petitions (contesting the two notices of deficiency) were later consolidated in the Tax Court. (JA6 n.1.) By the time of the Tax Court's decision, only the deficiency for 2011 remained in dispute. (JA8.) The Tax Court had jurisdiction under I.R.C. (26 U.S.C.) §§ 6213(a) and 7442.

The Tax Court entered a final decision in the case on April 18, 2019 (JA4.), and Connell timely appealed to this Court (JA2.). See Fed. R. App. P. 13(a). This Court has jurisdiction under I.R.C. § 7482(a).

STATEMENT OF THE ISSUE

Whether the Tax Court correctly decided that Connell's retention of the balance Merrill claimed he owed on a $3,637,217 up-front forgivable loan, pursuant to the FINRA panel's ruling that he was entitled to retain it, is ordinary income for tax purposes

STATEMENT OF RELATED CASES AND PROCEEDINGS

No other appeal in (or from) this case has been before this or any other appellate court. We are not aware of any case pending in this or any other court that will directly affect this Court's decision in this case.

STATEMENT OF THE CASE

A. Overview of the case and proceeding below

After a long and successful career as a financial adviser at another firm, Connell took a job at Merrill in 2009.¹ (JA9-11.) As part of Connell's compensation package, which also included commission pay and significant performance bonuses, Merrill paid him $3,637,217 up front. (JA12.) This up-front payment that Connell received when he signed the employment contract was structured as a loan and Connell signed a promissory note. (JA13.) Payments of $42,980.07 were due and payable by Connell to Merrill each month but were essentially forgiven because Merrill agreed to pay Connell $42,980.07 each month until the loan was paid off and, instead of actually paying these monthly amounts to Connell, it used them to make the loan payments. (Id.) The balance of the loan would, however, come due and be immediately payable if Connell's employment with Merrill was terminated for cause or if he resigned. (JA11-13, 637, 650.)

Connell's employment with Merrill was short-lived. Less than a year after he began his employment, he was, by his own account, forced to resign. (JA16-17.) Concurrent with the ending of Connell's employment, Merrill proceeded in a number of ways that were adverse to him. One step it took was to file an arbitration action against him with the Financial Industry Regulatory Authority (FINRA), which is a private corporation that plays a role in regulating the financial industry. (JA8, 17-21.) In the arbitration proceeding, Merrill principally sought repayment of the outstanding balance on the $3,637,217 up-front forgivable loan. (JA20-34.) Connell argued that he should not have to pay that balance, and he also sought millions in lost compensation, punitive damages, attorney's fees, and costs. (JA21.)

Concerning the balance of the up-front forgivable loan, Connell prevailed. The FINRA panel denied Merrill's claims and thus declined to order Connell to pay the balance of the loan. (JA33.) It also awarded him $476,500 in compensatory damages and $311,466 in attorney's fees and costs. (Id.)

Connell argued to the Tax Court that the FINRA panel's determination that he was entitled to retain the proceeds of the up-front forgivable loan was predicted upon a determination that those funds “represented fair compensation for Merrill Lynch's having taken his book of business,” and therefore that those retained proceeds should be taxed as a capital gain. (JA38-39.) This was so, Connell argued, because this “taking” or conversion argument was the only argument he made in support of his claim for retention of the loan proceeds. (Id.) The Tax Court disagreed. It found that Connell had actually made other arguments to the FINRA panel in support of his claim for retention of the loan proceeds, including a breach-of-contract argument. The Tax Court thus found that Connell did not succeed in proving that the FINRA panel's ruling that he was entitled to retain the proceeds of the up-front forgivable loan was an award in lieu of payment for a capital asset. It accordingly sustained the IRS's determination “that the amount of the extinguishment is taxable as ordinary income.” (JA39.)

B. The relevant facts

1. Connell's successful career

Connell has worked as a financial advisor since 1974. He started his career at a firm called Bache (now Prudential Bache). (JA9.) In 1980, he joined Smith Barney, and he worked there for the next 29 years. (Id.) He used that time to become a top performer. In 2009, immediately prior to his departure from Smith Barney, Connell had about 200 clients and a team of brokers and assistants who were employed by Smith Barney but worked under him. (Id.) His team managed more than $350 million in assets, and most of that ($291,556,000) was under Connell's direct management. (JA9-10.) In the twelve months prior to his departure, Connell's team generated $3,150,000 in fees paid to Smith Barney, with the majority of that ($2,609,835) generated by Connell's own clients. (JA10.) Those performance numbers made Connell the top financial advisor in his office and region, and put him among the best 20 Smith Barney financial advisors in the nation. (Id.)

2. Connell takes a job with Merrill

In early 2009, Connell learned that Smith Barney would be acquired by another firm, and he decided to explore other employment opportunities. (JA9.) Merrill offered him their highest level compensation package, and in June 2009, Connell signed an employment agreement. (JA10-11.) That compensation package included several elements, such as: higher salaries for each of Connell's team members if they agree to come with him to Merrill (JA15); payment in accordance with “the Merrill Lynch Financial Advisor Incentive Compensation Program” (JA637); and a series of lucrative “Asset Hurdle/Production Credit” bonuses that were based on meeting targets numbers for “assets of customers in accounts serviced by Connell” and his team (JA637-40).

A significant piece of Connell's compensation from Merrill Lynch was a transition compensation payment to Connell of $3,637,217. (JA12.) The payment was structured as a loan (referred to in the financial services industry and by the Tax Court as an “up-front forgivable loan”), and Connell signed a promissory note agreeing to make monthly payments of $42,980.07 over an 8-year period. (JA13.) Connell's employment agreement with Merrill also provided that he would receive monthly transition compensation of $42,980.07, in addition to other incentive compensation and bonuses, for the same 8-year period. (JA12, 637-38.) And, for Connell's convenience, the loan payment was to be deducted from his monthly compensation. (JA13, 649.) So Connell's loan payments and transition compensation payments exactly matched and offset. This arrangement allowed Connell “to receive the full amount of his transition compensation upfront, while recognizing income only as each monthly payment came due.” (JA13.) Merrill included its monthly transition compensation payments of $42,980.07 on Connell's Forms W-2, and Connell reported those amounts as wages on his income tax returns for 2009 and 2010. (JA1681.)

The promissory note provided that the outstanding principal and accrued but unpaid interest would become due and immediately payable if Connell's “employment with Merrill Lynch is terminated for any reason.” (JA13, 650.) The employment agreement provided, however, that if Connell's employment was terminated by Merrill Lynch other than for cause, or by reason of death or disability, Connell or his estate would be paid “a lump sum payment equal to the remaining transition compensation.” (JA11, 637.) In other words, although the balance of the loan would become due and payable upon Connell's termination other than for cause, he would also be entitled to a lump-sum payment that would be equivalent (at least substantially) to what he owed on the loan. Under the employment agreement, Connell would not be entitled to the lump-sum payment of the balance of the transition compensation if he was terminated for cause, or if he resigned. (Id.)

3. The termination of Connell's employment with Merrill

Less than a year into his new employment, Merrill began an investigation into whether Connell violated both the Protocol for Broker Recruiting (“the Protocol”) and his employment agreement when he moved from Smith Barney to Merrill. (JA13-14, 16.) The Protocol is an agreement between most financial services firms governing the type of client information financial advisors may bring from one firm to another. (JA14.) The outside legal counsel that Merrill engaged to conduct this investigation concluded that Connell's violations warranted a letter of reprimand, but Merrill instead told Connell he “was going to be resigning.” (JA17.) And, after contacting his lawyer, Connell resigned. (Id.)

After Connell's employment with Merrill ended on July 27, 2010, Merrill filed suit against him. (JA16, 18.) In the context of that suit, Connell agreed to an injunction concerning his solicitation of clients and seeking return of Merrill property. (Id.) Merrill then initiated an arbitration proceeding before FINRA. (Id.)

Merrill also filed, on August 18, 2010, a form with FINRA called a Form U5 that is required to be filed when a financial advisor leaves a financial services firm. (JA17, 19-20.) This form provides details regarding the termination of an individual's employment. (JA17.) The form Merrill filed stated that Connell had been “Permitted to Resign” and, in explanation, provided the reason as “[c]onduct resulting in loss of management's confidence, including conduct relating to the handling of customer information and lack of cooperation in the firm's review of the matter.” (JA20.)

After Merrill filed the Form U5, Connell began taking steps to create his own firm. He created Apex Financial Advisors in September 2010, while the arbitration proceeding before the FINRA panel was ongoing. (JA1707.) Connell began Apex with just one employee, and the firm lost money for the first two years of its existence. (JA1708-15) Apex eventually hired six employees and became profitable. (JA1708-16.) Apex's typical client has assets of $500,000 “up to a number of millions.” (JA1708.) Connell was eventually able to bring ten percent of his former clients to Apex. (JA1709.) Connell attributed his difficulty in convincing clients to move over to Apex in part to the fact that it is important when changing firms to reach out to clients right away to let them know about the move and the reason for it. (JA1717.) He also indicated that it was difficult to recruit his former clients because his team was still at Merrill. (JA1717.) And he explained that “[i]t's a pain for clients to move.” (Id.) He noted that his clients had “just moved to Merrill Lynch, and so we're asking them to move months later and then change accounts and change custodians and change checkbooks and change everything else.” (JA1718.) He concluded that “I'm not sure anybody would want to do it [i.e., want to change brokerage firms],” and that “given all the circumstances, I'm not sure I'd move.” (Id.)

4. The FINRA arbitration proceeding

In the FINRA arbitration, Merrill sought to recover the balance of the transition compensation that was structured as a loan, as well as additional damages for breach of contract, certain injunctive relief, fees, and costs. (JA20.) Connell sought to retain the transition compensation, and also sought millions in compensatory damages, punitive damages, as well as other relief. (JA21.)

a. In his “Answer, Affirmative Defenses, And Counterclaim,” Connell outlined his grievance against Merrill: that after offering him a generous compensation package to lure him and his book of business, Merrill “essentially forc[ed] his voluntary resignation,” filed an intentionally false Form U5 Notice of Termination to render him “virtually unemployable,” and then “sought the very compensation paid to Mr. Connell in return for his decision to transfer his book of business to Merrill Lynch.” (JA750.) Connell explained that the forgivable loan was “only a small portion of the compensation promised to [him] if he were to leave Smith Barney” and join Merrill. (JA752.) The pleading asserted that “[b]y ensuring that Mr. Connell will not be able to secure comparable employment in the financial services industry, Merrill Lynch's actions have caused Mr. Connell to suffer damages in excess of $20 million, including compensation promised by Merrill Lynch to lure Mr. Connell to transition there as well as lost revenue earnings.” (JA751.)

In response to Merrill's contract claim for repayment of the balance due under the promissory note, Connell declined to concede that any money was owed under the contract, referring to “the amounts allegedly outstanding.” (JA778.) He argued that, so long as he was prevented from competing with Merrill for his former clients by virtue of the Form U5 Merrill filed that effectively prevented him from finding employment with another firm, it would be “manifestly unjust” to allow Merrill to collect the balance of the loan. (JA777-78.) He also contended that Merrill's demand for repayment of “upfront transition compensation” constituted a breach of the employment agreement. (JA790-92.)

In addition, Connell advanced three other claims in support of his position that he was entitled to retain the balance of the forgivable loan. First, he contended that Merrill's demand for repayment of the forgivable loan breached the implied covenant of good faith and fair dealing that, under Pennsylvania law, is inherent in every contract. (JA793-95.) Second, he asserted that he should retain the up-front transition compensation, and be awarded additional backend compensation, under a common law fraud theory because Merrill “represented that it would provide this compensation to [him] only to induce [him] to transfer his book of business to Merrill Lynch, all the while knowing that, after [he] transferred his client base to Merrill Lynch, it would end the employment relationship and attempt to avoid its obligations to compensate [him] as it had promised.” (JA796.) Third, he advanced an unjust-enrichment claim. He asserted that “to entice him to transfer his book of business to Merrill Lynch, Merrill Lynch agreed to compensate [him] with a series of bonuses, the initial of which was in the amount of $3,637,217 [i.e., the forgivable loan].” (JA800.) He contended that if Merrill was permitted to extract from him “the allegedly outstanding balance,” then it “will have been permitted to reap the substantial benefit of servicing [his] clients, without having paid any compensation to [him] for [his] entire book of business.” (JA801.)

b. On October 7, 2010, Connell filed an “Emergency Motion” asking the FINRA panel to direct Merrill to amend his Form U5, release a full Protocol-compliant client list, and return certain property to him. (JA290-309, 575.) Concerning the Form U5, Connell contended that, contrary to what Merrill wrote, he had always “maintained any client information in his possession in a safe and secure manner.” (JA303.) He argued that the Form U5 Merrill filed was thus “knowingly false” and asked that Merrill “be directed to file an amended Form U5 providing that [his] resignation was voluntary.” (Id.) Concerning the client list, Connell conceded that Merrill had previously “made attempts to fulfill its obligations to provide [him] with a Protocol-compliant list of his clients,” i.e., a list containing client names, addresses, email addresses, phone numbers, and account types, but asserted that the attempts were “half-hearted and incomplete.” (JA305.) More specifically, he conceded that, in the 72 days between the termination of his employment on July 27, 2010 and October 7, 2010, when he filed his emergency motion, Merrill had provided him with three client lists. (JA305.) He explained, however, that the first list included “almost no” phone numbers or email addresses, the second list included “more, but not all,” phone numbers and less than a quarter of the email addresses, and the third list included “most” phone numbers but still only half the email addresses. (Id.)² Merrill asserted that the first and second lists Connell mentioned were produced to Connell on August 24, 2010, and that the third list was produced to Connell on September 7, 2010. (JA348.) Connell asked the FINRA panel to compel Merrill to provide him “a Protocol-compliant list containing the names, addresses, telephone numbers, email addresses, and account types of all [his] clients. (JA305.)

On November 22, the FINRA panel ordered Merrill to produce to Connell a fully-Protocol-compliant client list within 30 days. (JA575.) Also, sometime after the October 7, 2010 emergency motion, Connell withdrew his request for amendment of the Form U5. (Id.)

c. In its pre-hearing brief to the FINRA panel, filed in March 2011, Merrill laid out its contentions in greater detail. After providing a bullet-point summary of Connell's alleged misconduct (JA439-40), Merrill described the termination of Connell's employment. It explained that, after being told that the outcome of the investigations “was severe,” and after Connell talked to his lawyer, Connell “asked about his options” and was told “that there really were no options.” (JA440.) Connell then said that “in light of the fact that he was not being given any options, he would be resigning his employment.” (Id.) Merrill argued that the balance due under the promissory note was due and owing under the note's terms. (JA449-50, 54.) It argued that, because Connell resigned, it was not obligated to pay Connell a lump sum equivalent to the remainder of his transition compensation that would be due to him if his employment was terminated other than for cause. (JA454.) It also argued that it had cause to terminate Connell's employment, contending that Connell's violations of company policies and dishonestly qualified as cause under the employment agreement. (JA454-55.) Merrill failed to offer any substantive response to Connell's implied-covenant-of-good-faith-and-fair-dealing claim. (JA455-56.) In response to Connell's fraud claim, Merrill simply contended that there was no evidence it “lured Connell over to Merrill Lynch under false [pretenses].” (JA456.) And, in response to Connell's unjust-enrichment claim, Merrill contended that Connell had been free to solicit his old clients because it provided him with their contact information, and that the evidence showed that “prior to Merrill Lynch's production of the list, [Connell] had already contacted all of the customers to solicit their accounts.” (JA460.) Merrill also asserted that the Form U5 was privileged and could not subject the author to liability. (JA458.)

d. In his prehearing brief, Connell likewise expanded upon his earlier claims and contentions. Much of the brief focused on refuting Merrill's charges of violating the Protocol, dishonesty, etc. (JA475-504.) In his recitation of the facts, Connell explained that, on July 27, 2010, the day his employment with Merrill ended, he came to the conclusion “that if he did not resign he would be terminated.” (JA495.) And he noted that his instinct proved correct because “emails between Merrill Lynch's management indicate that Merrill Lynch had every intention of terminating his employment.” (Id.) He also stated that he did not draft his resignation letter; rather, a Merrill employee drafted it. (JA495-96.)

Concerning his contract claim for retention of the transition compensation, Connell asserted that it was a violation of the contract for Merrill to seek the return of compensation paid “to induce him to transfer his entire client base to Merrill Lynch” after that transfer had already taken place. (JA509.) Expanding on his implied-covenant-of-good-faith-and-fair-dealing claim, Connell contended that it was an actionable breach of the good faith required under Pennsylvania contract law for Merrill to have lured him and his client base only to “force [his] resignation one short year later (after his entire book of business had transferred to Merrill Lynch) and then seek to force [him] to repay that transition compensation,” i.e., the up-front forgivable loan. (JA511.) Similarly expanding on his fraud claim, Connell asserted that Merrill fraudulently induced him to enter into an employment agreement it had no intention of honoring. (JA513.) And further, that Merrill executed its plan by “determin[ing] to find a motive to force [his] resignation” and then initiating a hostile investigation once the majority of Connell's clients had transferred. (JA514.) Finally, according to Connell, Merrill sought to complete its premeditated scheme by demanding that he “repay the amounts allegedly outstanding from his transition compensation.” (Id.)

Connell also reprised his unjust-enrichment claim, explaining that, by forcing his resignation and then filing a false and defamatory Form U5, Merrill secured its ability to continue to service his clients “almost entirely free from competition.” (JA517.) He argued that, if Merrill was also permitted to collect the “allegedly outstanding balance” on the forgivable loan, it would have secured its “almost entirely” competition-free access to his former clients without having paid him any compensation. (Id.)

Connell separately itemized seven types of damages he suffered on account of Merrill's actions — i.e., luring him into an employment relationship, forcing his resignation after he moved his clients over, and then filing a false Form U5 to prevent his employment elsewhere: (1) the balance of the transition compensation that Merrill was demanding he return (approximately $3.25 million); (2) first-year backend compensation lost due to his forced resignation (approximately $950,000); (3) second through fifth year backend compensation lost due to his forced resignation (approximately $4.8 million); (4) lost commission compensation (approximately $27 million); (5) “[i]ncome lost from the sale of [his] book of business to Merrill Lynch or to a financial advisor with Merrill Lynch upon [his] retirement”; (6) interest; and (7) attorney's fees. (JA523.)

e. In his response to Merrill's pre-hearing brief, Connell again focused much of his attention on refuting elements of Merrill's description of his alleged misconduct. (JA527-42.) In response to Merrill's claim that he breached the employment agreement by violating the confidentiality provision of the agreement, Connell strenuously objected, arguing that he never disclosed confidential information to third parties and that the agreement did not prevent removal of confidential information from Merrill's computers merely to conduct business on behalf of Merrill. (JA544-45.) He also argued that Merrill's breach-of-contract claim should be dismissed because, if Merrill had determined that he violated the confidentiality policy “and that Merrill Lynch therefore had cause to terminate his employment” Merrill was contractually required to give him a chance to cure the violation, and he contended that Merrill's failure to do so “violated the explicit terms of the Agreement.” (JA545-46.) He pointed out that any violations of the confidentiality policy must have been curable “because they were cured with respect to [the other members of his] former team,” who not only remained employed but also received significant increases in compensation. (JA500-01, 546-47.)

In response to Merrill's argument that he would be unjustly enriched if he was permitted to retain the balance of the forgivable loan, Connell pointed out that “under Pennsylvania law, a claim for unjust enrichment is inapplicable when a written or express contract exists.” (JA556.) In the alternative, he argued that it was in fact Merrill who would be unjustly enriched “if permitted to collect the amount allegedly due under [his] up-front loan.” (Id.)

In support of his breach-of-contract claim, Connell explained that Merrill, in its pre-hearing brief, had argued “that it had cause to terminate [his] employment, and, because it had cause to terminate [his] employment, it was not obligated to compensate [him] according to the terms of its Agreement with him.” (JA558.) Connell sought to rebut this argument. He disputed that Merrill had any cause to terminate his employment. (JA559.) He also pointed out that the Agreement required Merrill to give him notice and an opportunity to cure the alleged violation. (Id.) And he argued that “[b]ecause Merrill Lynch did not provide [him] with notice of his alleged violation and an opportunity to cure the violation, Merrill Lynch, even if it had cause to terminate his employment, violated the Agreement.” (Id.) He also again pointed out that his former team engaged in the same conduct that was the basis for his alleged violation of company policy, but remained employed at increased compensation levels. (JA559-60.) He contended that “because Merrill Lynch failed to provide notice and an opportunity to cure the offenses that it alleges [he] committed, offenses that were clearly curable as to every other member of [his] team, Merrill Lynch breached its Agreement with Mr. Connell.” (JA560.)

Finally, Connell expanded upon his fraud claim. He stressed evidence that Merrill recognized that it was offering him “an incredibly rich deal” that he would not be able to obtain elsewhere. (JA562-63.) He contended that this evidence gives rise to a reasonable inference that Merrill sought to terminate his employment after he succeeded in transferring the overwhelming majority of his clients in order to “avoid having to pay him” according to the deal's generous terms. (Id.) And he alleged that Merrill in fact initiated a hostile investigation in order to precipitate his “forced resignation” and avoid compensating him “according to the terms of his Agreement.” (JA563.)

Connell's response brief did not discuss his unjust-enrichment claim except to say, in response to Merrill's unjust-enrichment claim, that it was really Merrill who would be unjustly enriched if it were to receive the balance of the forgivable loan. (JA556.)

The record in this case does not include any direct evidence of what took place at the FINRA hearing, which, apparently, was not transcribed. (JA1770.)³

f. After setting out the claims and relief requested, and noting its prior rulings, including its ruling requiring that Merrill provide Connell with a Protocol-compliant client list, the FINRA panel issued its award. (JA571-77.) The panel denied Merrill's claims in their entirety. (JA576.) It awarded Connell $476,500 in compensatory damages, $288,734 in attorney's fees, and $22,408.67 in costs. (Id.) It also modified its prior permanent injunction to require Merrill to return certain items to Connell and to eliminate the restrictions on Connell's personal accounts authorized under the prior order — specifying that Connell “is entitled to retain the $3,285,228.26,” i.e., balance of the up-front forgivable loan. (JA576-77.) The panel denied Connell's request for expungement of the Form U5. (JA577.)

5. Connell's tax filings for the 2011 tax year

For the 2011 tax year, Merrill issued Connell a Form 1099-C to report cancellation-of-debt income corresponding to the up-front forgivable loan that, under the FINRA panel award, Connell was entitled to retain. (JA34.) Merrill issued a Form W-2 reporting the awards of compensatory damages, attorney's fees, and costs that it paid to Connell pursuant to the FINRA award. (JA34.)

Connell filed an initial 2011 income tax return reporting an adjusted gross income of negative $112,635. (JA34.) In that return, Connell reported the cancellation-of-debt income as deferred-compensation ordinary income, rather than as a capital gain. (Id.) This deferred-compensation income was largely offset by a $2,495,732 deferred-compensation loss that he also reported. (Id.)

When the IRS examined the return, however, it determined that the $2,495,732 was a capital loss because it resulted from the sale of stock, and therefore concluded that it could not be used to offset Connell's ordinary income. (JA35.) Connell conceded the correctness of that determination. (Id.) But he filed an amended 2011 income tax return in which he which he took the position that the cancellation of debt based on the FINRA panel's determination that he was entitled to retain the balance of the forgivable loan actually resulted in a capital gain. (Id.) Connell's amended return thus sought the same refund ($129,911) that his initial return had requested. (Id.)

The IRS did not agree that the cancellation of debt was appropriately characterized as a capital gain, and accordingly determined an income tax deficiency for the 2011 tax year of $1,312,943. (JA7, 103.) Connell filed a timely petition for a redetermination in Tax Court. (JA44-56.)

B. The Tax Court's opinion

After a trial and briefing, the Tax Court issued an opinion sustaining the IRS's “determination that the extinguishment of Mr. Connell's debt to Merrill Lynch constitutes cancellation of debt income and that the amount of the extinguishment is taxable as ordinary income.” (JA39.) The Tax Court applied the origin-of-the-claim doctrine under which taxation of proceeds of a lawsuit “depends upon the nature of the claim and the actual basis of recovery.” (JA36 (citation omitted).) It concluded that, under this doctrine, “to the extent that amounts received for injury or damage to capital assets exceed the basis of the property, such amounts are taxable as capital gain, whereas amounts received for lost profits are taxable as ordinary income.” (JA36-37 (citation omitted).) And the Tax Court explained that, in order to decide “the character of the $3,242,248 extinguished as a result of the FINRA Panel's award” it must determine “in lieu of what were the damages awarded?” (JA37 (citation omitted).) The court stated that, because the FINRA panel did not itself explain the basis of its award, it must look to the filings before the FINRA panel to determine the nature of Connell's claims. (JA38 (citation omitted).)

The Tax Court then rejected Connell's contention that “his filings with the FINRA Panel make it clear that the award was to compensate him for the taking of his book of business.” (JA38-39.) The court agreed that Connell's FINRA filings emphasized “that Merrill Lynch lured [him] to Merrill Lynch in order to acquire his book of business and that thereafter it set out to ruin his professional reputation so as to keep him from working at a competing financial services firm.” (JA38.) It noted, however, that Connell forcefully argued that the FINRA panel should reject Merrill's claim that he breached the contract by failing to pay the balance of the up-front forgivable loan. (JA38-39.) And the court pointed out that Connell argued that in fact “Merrill Lynch breached the terms of the employment contract” and thereby caused him to suffer damages. (JA39.) The court determined that “[t]his argument, by itself, would relieve Mr. Connell of his obligation to pay the outstanding balance of the promissory note to Merrill Lynch.” (Id.)

The Tax Court explained that Connell bore the burden of establishing “that the amount at issue [i.e., the extinguishment of the balance of the forgivable loan] was solely for the acquisition of Mr. Connell's book of business.” (JA39.) The court found, “[o]n the basis of [its] examination of the record,” that Connell did not meet that burden. (Id.)

The Tax Court entered a decision determining, as relevant here, an income tax deficiency for 2011 in the amount of $1,021,556 (which corresponded to the parties' computation statement). (JA4, 2296.)

SUMMARY OF ARGUMENT

The Tax Court's decision rested on a factual finding. It found that Connell failed to prove that the FINRA panel's ruling — that he was entitled to retain the proceeds of the up-front forgivable loan — was based on a determination that Merrill converted Connell's book of business. Thus, the Tax Court determined that he failed to establish that the origin of the loan proceeds was payment for a capital asset. Rather than arguing that the Tax Court's finding is clearly erroneous, Connell purports to identify legal errors that underpin it.

He argues that the Tax Court misinterpreted his contract with Merrill when it said that a breach of the employment agreement would relieve Connell of his obligation to repay the up-front forgivable loan. But the Tax Court's interpretation of the agreement is correct. The agreement effectively relieved Connell of his obligation to repay the loan if Merrill terminated his employment other than for cause. Not only that, Connell argued before the FINRA panel that Merrill did not have cause to terminate his employment and “violated the Agreement” by failing to give him the contractually-required opportunity to cure his alleged violation of company policy. Contrary to what he may say now, Connell's FINRA filings did not concede that he resigned for purposes of the relevant provision of his employment agreement and that he therefore owed the balance of the loan proceeds under the terms of the contract.

Connell's argument that the Tax Court incorrectly applied the origin-of-the-claim doctrine is based solely on his contention that the Tax Court placed “undue emphasis” on a particular case and “seemingly” misread his FINRA filings by focusing on the labels attached to his arguments instead of their substance. But Connell does not explain how placing “undue emphasis” on a correct statement of law amounts to reversible error, he fails to actually support his contention that the Tax Court unduly emphasized the statement in question, and he fails to specifically identify any misstatement of law in the Tax Court's opinion. His argument boils down to speculation about what may have led the court (allegedly) to misinterpret his FINRA filings. In other words, he does not truly assert a legal error at all. A lower court's determination of the nature of a taxpayer's claim in prior litigation for purposes of the origin-of-the-claim doctrine is a factual determination that is reviewed for clear error. Connell has not argued that the Tax Court clearly erred when it found that he failed to prove that he retained the proceeds of the up-front forgivable loan because the FINRA panel held that the proceeds were fair consideration for Merrill's conversion of his book of business. Because Connell has failed to make that argument, this Court need not address it.

If this Court were to address that issue, it should conclude that the Tax Court's finding is manifestly correct. Connell's contention in the Tax Court was that his conversion argument was the only argument he made to the FINRA panel in support of his claim for retention of the proceeds of the up-front forgivable loan. The Tax Court determined based on his FINRA filings that Connell in fact had made other arguments. The filings support that determination. Perhaps most notably, Connell made a breach-of-contract argument, a breach-of-covenant-of-good-faith-and-fair-dealing argument, and a fraud-in-inducement argument. Each of those arguments supplied a rationale for his retention of the balance of the up-front forgivable loan that did not require the FINRA panel to determine that that balance was equivalent to fair consideration for the conversion of Connell's book of business. Further, Connell's FINRA filings did not even clearly set out the conversion claim he now describes.

Finally, Connell's contention that the Tax Court required him to prove his case to a certainty rather than by a preponderance of the evidence is wrong. Absolutely nothing in the Tax Court's opinion supports that charge.

ARGUMENT
The Tax Court correctly decided that Connell's retention of the balance Merrill claimed he owed on a $3,637,217 up-front forgivable loan, pursuant to the FINRA panel's ruling that he was entitled to retain it, is ordinary income for tax purposes

Statement of the standard or scope of review

This Court reviews “the Tax Court's legal conclusions de novo and its factual findings for clear error.” Anderson v. Commissioner, 698 F.3d 160, 164 (3d Cir. 2012).

A. Introduction

In this appeal, Connell contends that the Tax Court committed three legal errors. First, he asserts that it misapplied the origin-of-the-claim doctrine by “seemingly” focusing on the labels used in his FINRA filings rather than on the nature of the underlying transaction from which his dispute with Merrill arose. (Br. 33-42.) Second, he charges that the court erroneously interpreted his contract with Merrill. (Br. 42.) Third, he contends that the court required him establish to a certainty that the FINRA award was based on conversion of his book of business, rather than deciding this factual issue under the preponderance-of-the-evidence standard. (Br. 43-45.)

What Connell has really done is to infer or imagine into the Tax Court's opinion things that simply are not there. And he has done this for a reason. The Tax Court's decision rested on its finding that he failed to prove that the FINRA panel's extinguishment of the balance allegedly due on the up-front forgivable loan was based on a conversion claim. This determination, the determination upon which the Tax Court's decision rests, is a factual one. Connell attempts to transform it into a legal one by positing that it was “seemingly” predicated upon a formalistic misreading of his FINRA filings that obscured the true origin of his claim, which was apparently occasioned by the court's having placed “undue emphasis” on a particular case. (See Br. 38-39.) This is pure speculation about the reasons for the Tax Court's factual finding, not a true assertion of a legal error. Moreover, the Tax Court's opinion contains no indication whatsoever that it required him to prove his case to certainty instead of by a preponderance of the evidence. (See Br. 43-45.)

The one error that Connell asserts that actually would be a legal error, if it was an error at all, is his contention that the Tax Court erroneously interpreted his contract with Merrill. In truth, it is Connell who either incorrectly interprets the contract documents or seeks to obfuscate their meaning. And because Connell's erroneous representation about what the contract documents mean colors much of the rest of his argument, it makes sense to begin our analysis with the point he puts second — whether the Tax Court erroneously concluded that a breach of contract by Merrill would relieve Connell of his obligation to pay the balance of the up-front forgivable loan.

B. The Tax Court correctly interpreted the contract

Connell argues (Br. 42) that the Tax Court wrongly concluded that a breach of the employment contract by Merrill would relieve him of his obligation to pay the outstanding balance of the loan. He then asserts (Br. 42) that “neither the Agreement nor the Note provides that Connell shall be relieved from his obligations, or shall be entitled to retain any unpaid balance due, under the Note in the event of a breach of that Agreement by Merrill.” This statement is, at the very least, quite misleading.

The employment agreement effectively provided exceptions to the promissory note's repayment requirement by stating that Connell would be entitled to a lump-sum payment equivalent to the balance of his transition compensation (i.e., the up-front forgivable loan) under certain circumstances, including if his employment is terminated other than for cause. (JA11, 637.) In other words, while it is true that the promissory note stated that the balance would be due and payable if Connell's employment is terminated “for any reason,” that balance would, under the terms of the employment agreement, effectively be paid by Merrill in the form of a lump-sum payment of the remainder of Connell's transition compensation unless he was terminated for cause or resigned. (JA11, 637.) Thus, as the Tax Court stated (JA39), a breach of the employment contract by Merrill that amounted to termination of Connell's employment other than for cause would essentially relieve Connell of his obligation to pay the balance of the up-front forgivable loan by entitling him to a lump-sum payment equivalent to that balance.

It serves Connell's purposes here to convey the impression that he went before the FINRA panel and conceded that the loan was due and owing under the terms of the contract, but contended that those terms should not be enforced solely under an unjust-enrichment theory because Merrill perpetrated a conversion his book of business. That's just not accurate. In actuality, he argued before the FINRA panel that he was entitled to retain the balance of the up-front forgivable loan because Merrill violated the employment agreement. Merrill argued that it did not have to pay Connell a lump sum equivalent to the balance of the up-front forgivable loan because “it had cause to terminate [his] employment.” (JA558.) In response, Connell argued, first, that Merrill did not have cause because he did not violate the confidentiality agreement that Merrill accused him of violating. (JA544-45.) Second, he argued that, by failing to give him notice and an opportunity to cure the alleged violation before his employment was terminated, Merrill “violated the Agreement.” (JA559.) Third, he argued that his alleged violation of the confidentiality agreement was curable because Merrill allowed the other members of his team, who engaged in the same conduct, to remain employed and, in fact, substantially increased their compensation. (Id.) He asserted that, by failing to provide him an opportunity to cure his alleged offenses, Merrill “breached its Agreement.” (JA560.)

In short, the contract documents support the Tax Court's statement that a breach of the employment agreement by Merrill “would relieve Mr. Connell of his obligation to pay the outstanding balance of the promissory note.” (JA39.) Not only that, Connell in fact argued, in the context of a contract claim seeking retention of the up-front forgivable loan as well as other damages, that Merrill breached its agreement because it did not have cause to terminate his employment, and it did not give him the agreed-upon process to avoid termination of his employment. (JA559-60.) That fits with the way Connell's attorney in the FINRA proceeding (Thomas Lewis) initially described the argument in his Tax Court testimony: “We took a position that Bob [i.e., Connell] should not have to pay back the promissory note, because effectively, what Merrill Lynch did to Bob was to terminate him.” (JA1763-64.)

Connell may respond that, notwithstanding this testimony, he resigned his employment with Merrill and the agreement makes clear that he would not be entitled to the lump-sum payment equivalent to the balance of his transition compensation (i.e., the up-front forgivable loan) if he resigned. But it is eminently reasonable to interpret Connell's FINRA filings as arguing (JA558-60) that he was entitled to retain the balance of the loan because Merrill terminated his employment without cause and without giving him the contractually required opportunity to cure his alleged violation.

And Connell's FINRA attorney's testimony that he argued that Connell was effectively terminated (JA1763-64) supports this interpretation of the filings and belies the notion that Connell conceded before the FINRA panel that he resigned for purposes of paragraph 3(c)(i)(b) of the employment agreement (JA637). (See also JA1765 (Connell's FINRA attorney stated that in the financial services industry, being permitted to resign “is the same as being terminated”).) Such a concession (that he resigned) would have been tantamount to an admission that Merrill was entitled to repayment of the balance of the loan under the terms of the employment agreement. Connell was decidedly not making such an admission; his position in the FINRA proceeding was that Merrill was not entitled to repayment. See, e.g., JA468 (referring to the amount owing on the up-front forgivable loan as a “amounts allegedly due”); JA509 (similar); JA514 (similar); JA517 (similar); JA554-56 (similar). Also, in his FINRA filings, Connell repeatedly stated that he was forced to resign. (See, e.g., JA467, 470, 474, 481, 495-96, 501, 509, 514, 519, 523, 526, 541-42, 545, 549, 552-53, 563, 569.)

Finally, it is far from clear that Connell actually did “resign” for purposes of paragraph 3(c)(i)(b) of his employment agreement. (JA637.) The dictionary definition of “resign” is “to give up one's office or position.” Merriam-Webster.com, Merriam-Webster (2020); see also, e.g., “resign,” Dictionary.com, Dictionary.com, LLC (2020) (“to give up an office or position, often formally”). Given that definition, resignation would appear to require at least some degree of volition. Indeed, courts have concluded that a person who was forced to resign to avoid being fired “was effectively terminated.” Rodriguez v. City of Doral, 863 F.3d 1343, 1345 (11th Cir. 2017); Stevens v. City of Forest Park, 635 F. App'x 690, 698 (11th Cir. 2015) (determining that the plaintiff “was effectively terminated” when she resigned “to avoid a termination record”); Miller v. Butcher Distributors, 89 F.3d 265, 267 (5th Cir. 1996) (concluding that a person offered a choice between a part-time position and termination “was at the very least constructively terminated” and determining that the “evidence presented at trial allowed the jury to conclude that [the person] was terminated”). The record here supports the conclusion that Connell did not really have a choice. (JA495 (Connell represented that he believed he would be fired if he did not resign and that his belief was proved well founded by Merrill's internal emails); JA440 (Connell's former supervisor at Merrill stated that Connell was not given any alternative to resigning).) Indeed, the Tax Court credited Connell's own testimony that he was “basically told” by Merrill that he “was going to be resigning.” (JA17 (quoting Connell's testimony).).

To be sure, there was some internal tension in Connell's FINRA filings. He also took the position that he “voluntarily resigned” and that it was actionable for Merrill to indicate otherwise on the Form U5 (the form filed with FINRA by a brokerage firm whenever a financial adviser leaves the firm). (JA514-16.) But the FINRA panel rejected Connell's claim for expungement of his Form U5. (JA577.) A fair reading of the panel's decision, therefore, is that it found Connell's contention that he was forced to resign more persuasive that his conflicting contention that his Form U5 should have stated that his resignation was voluntary. In other words, the panel's decision is consistent with a determination that Merrill effectively terminated Connell's employment.

C. The Tax Court correctly applied the origin-of-the-claim doctrine

1. Legal framework

Under the origin-of-the-claim doctrine, the classification of litigation proceeds for tax purposes “depends upon the nature of the claim and the actual basis of recovery.” Freda v. Commissioner, 656 F.3d 570, 574 (7th Cir. 2011) (citation omitted); Tribune Pub. Co. v. United States, 836 F.2d 1176, 1178 (9th Cir. 1988) (“[T]he nature of the underlying claim controls the tax treatment of the proceeds of litigation.”). As courts have frequently explained, “[t]he test for characterizing proceeds of litigation is stated most simply as 'In lieu of what were the damages awarded?'” Tribune, 836 F.2d at 1178 (quoting Raytheon Production Corp. v. Commissioner, 144 F.2d 110, 113 (1st Cir. 1944) (citations omitted)); Gail v. United States, 58 F.3d 580, 582 (10th Cir. 1995) (“Our general rule for characterizing the proceeds of a judgment for tax purposes focuses upon what the judgment replaces. In making this inquiry, we ask: 'In lieu of what were the damages awarded' and characterize the judgment accordingly.”) (citations omitted); see also Francisco v. United States, 267 F.3d 303, 319 (3d Cir. 2001) (“[W]e determine the tax implications of a settlement by ascertaining the obligation or claim initially resolved by judgment in lieu of which the settlement was made.”).

Courts commonly look to the filings in the prior litigation in order to answer this question. For instance, in Raytheon, the case in which the in-lieu-of-what inquiry was first articulated, the court looked to the plaintiff's declaration in the underlying litigation and concluded that the litigation proceeds were for destruction of his business and goodwill rather than for lost profits. Raytheon, 144 F.2d at 113-14. Likewise, in Dye v. United States, 121 F.3d 1399 (10th Cir. 1997), the court looked to the amended complaint in the prior litigation, determined which of the claims asserted impairment of capital and which related to lost income, and explained that this should be the basis for determining the tax treatment of an undifferentiated settlement award. Id. at 1410; see also Gail, 58 F.3d at 585 (rejecting taxpayer's argument that a litigation judgment should be characterized entirely as a capital gain because “[i]n her complaint in the [prior] action, [she] clearly sought to recover royalties” which the court determined were income). And this Court in Commissioner v. Murdoch, 318 F.2d 414, 416 (3d Cir. 1963), upheld the Tax Court's determination that proceeds of a settlement were taxable based on “the nature and basis of [the taxpayer's] law suit and its settlement [that] were revealed in her complaint and the papers which documented the settlement.”

Finally, a lower court's determination of the nature of a taxpayer's claim in the prior litigation is a factual finding reviewed for clear error. In Freda, the Seventh Circuit upheld the Tax Court's determination that a litigation settlement was for “lost profits, lost opportunities, operating losses and expenditures” rather than for “misappropriation of a capital asset.” 656 F.3d at 573-75. The court explained that this determination was a “finding of fact” and held that it was “not clearly erroneous, particularly when it is viewed, as it must be, in the light most favorable to the finding.” Id. at 574 (citing Alexander v. I.R.S., 72 F.3d 938, 944 (1st Cir. 1995), which ruled that a Tax Court determination of the substance of the underlying claim “is a factual determination” reviewed for “clear error”). This Court also has reviewed for clear error a lower court's determination concerning the nature of a prior lawsuit for purposes of determining the tax treatment of the resulting settlement. Francisco, 267 F.3d at 322-23 (“On the basis of the facts presented, we cannot conclude that the District Court clearly erred in refusing to credit the Taxpayers' assertions that the 'payor's intent' in settling the lawsuit was only to compensate for personal injuries and not the delay damages to which Taxpayers' would be otherwise entitled.”).

2. The Tax Court correctly articulated and applied the origin-of-the-claim doctrine

Connell argues (Br. 33-42) that the Tax Court committed a legal error in its application of the origin-of-the-claim doctrine. He fails, however, to identify any misstatement of law in the Tax Court's opinion. And the Tax Court's articulation of the law was correct. The Tax Court focused on the key question “[i]n lieu of what were the damages awarded?” (JA37, 39.) It appropriately looked to the filings in the FINRA proceeding in order to answer that question. (JA38-39.)

The substance of Connell's argument (Br. 38) is that the Tax Court committed legal error because it “placed undue emphasis on the language of State Fish Corp. [v. Commissioner, 48 T.C. 465 (1967)] . . . and seemingly focused on form over substance and the labels used in Connell's [FINRA] pleadings.” Connell does not actually say that State Fish is incorrect in stating that the “the recovery is to be determined from the claims made in the pleadings or complaint filed in the prior action.” 48 T.C. at 474. Indeed, State Fish cited this Court's decision in Murdoch, as well as the First Circuit's decision in Raytheon, in support of that proposition. Id. And, as explained above, pp. 43-44, courts of appeals continue to look to the pleadings in the prior action to determine the nature of the claim. Connell does try to imply tension between this statement in the State Fish opinion and Gail, in which the Tenth Circuit declined to rely simply upon “'magic words' in a complaint,” 58 F.3d at 583. But the decisions are in no way inconsistent. State Fish did not hold or suggest that the nature of the claim should be determined solely by labels or “magic words” in the pleadings. And Gail did not hold or suggest that it was inappropriate for courts to look to the pleadings in the prior litigation in order to determine the nature of the claim. Indeed, in Gail the court determined based upon the taxpayer's complaint in the prior litigation that the litigation award was partly in lieu of taxable royalties. 58 F.3d at 585. It's hard to understand how a court can commit a reversible legal error by placing “undue emphasis” on a correct statement of law. But, even supposing that were possible, Connell has failed to point to anything in the Tax Court's decision that would support that assertion.

What that means is that Connell's asserted legal error boils down to the charge that the Tax Court “seemingly focused on form over substance and the labels used in [his FINRA] pleadings.” (Br. 38.) In other words, Connell just hypothesizes that the Tax Court must not have actually read or understood the substance of his FINRA pleadings “but merely focused on the labels attached to the arguments.” (Br. 40.) Going further still, he asserts (Br. 40) that a conclusion that the FINRA panel's extinguishment of the balance of his forgivable loan was “for something other than Merrill's conversion of [his] book of business” ignores “the economic realities of the situation” and “flies in the face of basic common sense.”

A litigant cannot convert a factual finding into a legal error by stating, in essence, that only a judge who doesn't understand the law could make such a finding. A lower court's determination of the nature of a taxpayer's claim in the prior litigation is a factual finding subject to clear-error review. Francisco, 267 F.3d at 322-23; Freda, 656 F.3d at 574; Alexander, 72 F.3d at 944. Thus, the correct inquiry is whether the Tax Court clearly erred when it found that Connell failed to prove that the extinguishment of the forgivable loan was solely predicated upon his argument that Merrill converted his book of business. Because Connell's brief does not address this question, this Court could dispose of this appeal by simply ruling that he has failed to articulate any error of law evinced in the Tax Court's decision. Nevertheless, we now turn to the question whether the Tax Court's finding is supported by the record.

3. The Tax Court's finding — that Connell failed to prove that the FINRA panel relied on his conversion theory to extinguish the amount allegedly due on the up-front forgivable loan — is amply supported by the record

Before the Tax Court, Connell contended that the FINRA award could only have been based on a determination that “the unpaid portion of the Loan proceeds . . . represented fair compensation for Merrill Lynch having taken his book of business.” (JA38.) More specifically, his contention was that the only argument he made in the FINRA proceeding was that he was entitled to keep the loan proceeds as fair compensation for the conversion of his book of business because otherwise Merrill would be unjustly enriched, and thus the FINRA award must have been based on acceptance of that argument. (See JA38.)

The Tax Court determined that Connell's argument was contradicted by the evidence. That is, it found that, in actuality, Connell did not only argue that he was entitled to keep the loan proceeds as fair compensation for the conversion of his book of business because otherwise Merrill Lynch would be unjustly enriched. (JA38-39.) The court thus determined that Connell failed to meet his burden of proving that the FINRA panel's extinguishment of the amount allegedly owing on the up-front forgivable loan was based upon the conclusion that that amount represented fair compensation for Merrill's conversion of his book of business. That conclusion is supported by the record in numerous ways.

First, as explained above, pp. 35-42, Connell's FINRA filings can reasonably be interpreted as arguing (JA558-60) that he was entitled to retain the balance of the loan because Merrill terminated his employment without cause and without giving him the contractually required opportunity to cure an alleged violation that Merrill considered curable.

Second, it would be strange to interpret Connell's FINRA filings as making only an unjust-enrichment argument (which was alternatively titled “conversion of client accounts” in Connell's FINRA briefs) when Connell expressly recognized in his FINRA filings that “under Pennsylvania law, a claim for unjust enrichment is inapplicable when a written or express contract exists.” (JA 556 (citing Mitchell v. Moore, 729 A.2d 1200, 1203 (Pa. Super. Ct. 1999)); see also, e.g., Wilson Area Sch. Dist. v. Skepton, 586 Pa. 513, 520, 895 A.2d 1250, 1254 (2006) (“[I]t has long been held in this Commonwealth that the doctrine of unjust enrichment is inapplicable when the relationship between parties is founded upon a written agreement or express contract, regardless of how 'harsh the provisions of such contracts may seem in the light of subsequent happenings.'”) (citations omitted).

Third, besides his contract claim, Connell made other claims that asserted that he was entitled to keep the balance of the forgivable loan because Merrill unlawfully terminated his employment — not merely because Merrill was unjustly enriched by its alleged conversion of his book of business. For example, Connell argued that he was entitled to retain the proceeds of the loan as a remedy for Merrill's breach of the covenant of good faith and fair dealing inherent in the employment agreement. (JA510-12.) The gravamen of that claim was that irrespective of the technical language of the contract, Merrill should not benefit from a contract that it entered into in bad faith. The same claim could be made by any person enticed by some incentive to change jobs when the firm unjustifiably snatches the benefit away and leaves the person much worse off than the person would have been if he or she had not changed jobs. In other words, Connell's recovery under this theory did not depend on establishing that a conversion took place, that Merrill was unjustly enriched, or that the outstanding balance of the loan represented fair compensation for Connell's book of business (or for the portion of it Merrill took).

Similarly, Connell's claim for “fraud in the inducement” (JA512-14) did not require him to establish that Merrill converted his book of business. The gist of that claim was that Merrill entered into the employment relationship under false pretenses by providing compensation it did not intend to allow Connell to keep and promising future compensation it had no intention of actually providing. Under this theory, Connell was entitled to damages, including retention of the proceeds of the forgivable loan provided as transition compensation, and irrespective of any conversion, because he justifiably relied to his detriment on Merrill's knowingly false promise that he would retain the benefit of the offered transition compensation and would have the opportunity to obtain the benefit of future bonus compensation. (JA513.)

Fourth, while Connell did label the sixth count of his counterclaim before the FINRA panel as “Quantum Meruit, Unjust Enrichment, and Conversion of Client Accounts” (JA516, 800), he did not clearly set out a conversion claim. Under Pennsylvania law, “[c]onversion is a tort by which the defendant deprives the plaintiff of his right to a chattel or interferes with the plaintiff's use or possession of a chattel without the plaintiff's consent and without lawful justification.” Pittsburgh Const. Co. v. Griffith, 2003 PA Super 374, ¶ 19, 834 A.2d 572, 581 (2003). Connell's FINRA filings did not set out that standard or attempt to establish that Merrill's taking of his book of business qualified as a conversion under that standard.

Furthermore, Connell does not contend that he owned his client accounts or had a legal right to retain them. So his conversion claim would have had to have been based upon Merrill's depriving him of his former clients' goodwill. Yet Pennsylvania courts have held that “business goodwill and other intangibles” are not chattels and cannot be converted “unless they have been merged into a tangible document.” Romy v. Burke, No. 1236 MAY.TERM 2002, 2003 WL 21205975, at *4 (Pa. Com. Pl. May 2, 2003); Liss v. Liss, No. 03502 JUNE TERM 2002, 2005 WL 1579502, at *8 (Pa. Com. Pl. June 29, 2005), aff'd, 911 A.2d 193 (Pa. Super. Ct. 2006) (same). Whether this is the correct view of the law or not, Connell's (purported) conversion claim was plainly not of the garden variety. If, as Connell now strenuously asserts, this claim was the sum and substance of his argument in favor of extinguishment of the balance of the up-front forgivable loan, one would expect some discussion of how the elements of conversion were satisfied in this non-standard situation. But his FINRA filings contained no such discussion.

Likewise, one would expect Connell's FINRA filings to contain some argument that the balance remaining on the loan happened to equal the fair market value of his book of business. Under Pennsylvania law, “[i]n conversion the measure of damages is the full value of the chattel, at the time and place of the tort.” PTSI, Inc. v. Haley, 71 A.3d 304, 314 (2013) (quoting Restatement (2d) of Torts). We do not understand Connell to be arguing (or to have argued before the FINRA panel) that he sold Merrill his book of business and that the forgivable loan was a payment for his book of business.

Connell had no intention of selling his book of business to Merrill. In fact, he bargained for a special provision in his contract with Merrill that would exempt the clients he brought over from Smith Barney from the one-year-no-solicitation agreement. (JA14-15.) Moreover, both Connell and Merrill treated the monthly $42,980.07 loan-forgiveness payments as compensation for tax purposes. Merrill included the payments on Connell's Forms W-2, and Connell reported them as wages on his tax returns for 2009 and 2010. (JA1681.) So the up-front forgivable loan plainly was part of a compensation package. It functioned like a signing bonus and was designed to incentivize Connell to change firms; it was not the proceeds of the sale of Connell's book of business.

Because the up-front forgivable loan was not payment for Connell's book of business, it would have been incumbent upon Connell to prove to the FINRA panel that value of his book of business at the time of the alleged conversion just happened to be equivalent to the remaining balance of the up-front forgivable loan. Certainly, the size of loan, as well as the amount of other compensation, was tied to Connell's assets under management. But that fact provides no logical support for Connell's bald assertion (Br. 40-41) that the remaining balance was equivalent to the value of Connell's book of business at the time of Merrill's alleged conversion of it. Had the FINRA panel determined that Connell was entitled to retain the balance of the loan under a conversion theory, it would have needed evidence of the value of Connell's book of business — such as evidence of what another financial advisor or firm would have been willing to pay (or had paid) for the transfer of a book of business like Connell's. Nothing in Connell's FINRA filings or in the record here indicates that this kind of evidence was before the FINRA panel.⁴

Fifth, the FINRA panel not only denied Merrill's claims, it also awarded Connell compensatory damages of $476,500, an amount equal to half of the first bonus Connell would have been entitled to if his employment had not been terminated. (JA576.) This fact cuts strongly against the notion that the FINRA panel accepted only Connell's unjust-enrichment argument. Acceptance of that argument alone would have provided no basis for compensatory damages over and above retention of the forgivable loan. The $476,500 compensatory damages award indicates that the FINRA panel accepted Connell's breach-of-contract argument, or his implied-covenant-of-good-faith-and-fair-dealing argument, or his fraud-in-the-inducement argument (or all three). In each of these arguments, Connell sought lost compensation and referenced both “upfront transition compensation of more than $3.6 million,” i.e., the up-front forgivable loan (JA511; see also JA508, 513) and backend bonus compensation of $5.5 million that would have been due to him if his employment had not been terminated, including the more-than-$950,000 that would have been due just a few days after his employment terminated (JA509-14). Because the panel would have needed to accept one of these arguments in order to have a sound basis for its $476,500 compensatory damages award, the award is likely based on Connell's breach-of-contract argument, or his implied-covenant-of-good-faith-and-fair-dealing argument, or his fraud-in-the-inducement argument (or all three). And those arguments also provide a basis for a determination that Connell is entitled to retain the proceeds of the up-front forgivable loan.

Sixth, Connell's request for damages for “[i]ncome lost from the sale of [his] book of business to Merrill Lynch or to a financial advisor with Merrill Lynch upon [his] retirement” (JA523) undercuts the notion that conversion was his only (or even primary) theory for retention of the up-front forgivable loan proceeds. The assertion that the loan proceeds represent fair compensation for the conversion of his book of business is obviously at odds with the assertion that he should be compensated for not being able to sell his book of business. In other words, to read his FINRA filings in the way Connell now asserts they should be read is to read them as contending that he should be paid twice for the same book of business.

In sum, Connell's FINRA filings can be reasonably understood to argue, inter alia, that Merrill violated the employment agreement by effectively terminating his employment not for cause, that the termination represented a breach of the covenant of good faith and fair dealing inherent in that agreement, and that Merrill lured him into an employment relationship by fraud never intending to convey the benefits it promised to him. Those FINRA filings do not even clearly set out, much less only argue, that the remaining balance of the up-front forgivable loan is equivalent to the fair market value of his book of business and that he is entitled to retain that money as legal consideration in exchange for Merrill's conversion of his book of business. As such, the record evidence indicates that the FINRA panel's determination that Connell was entitled to retain the proceeds of the up-front forgivable loan was not predicated on a determination that that amount represented fair consideration for Merrill's conversion of his book of business. Instead, the balance that Merrill contended Connell owed was much more likely extinguished in lieu of employment compensation of which Connell would, if Merrill prevailed on its claim for repayment, have been wrongfully deprived. Thus, the Tax Court's finding that Connell failed to prove that the FINRA panel's determination was based on a conversion theory is not error at all, much less clear error.

D. Nothing in the Tax Court's opinion supports Connell's assertion that the Tax Court required him to prove his case to a certainty

Connell correctly states (Br. 43) that his burden before the Tax Court was to prove by a preponderance of the evidence that the IRS's determination of an income tax deficiency was incorrect. See, e.g., Estate of McKelvey v. Commissioner, 906 F.3d 26, 34 (2d Cir. 2018) (“Generally, the Commissioner's determinations in a notice of deficiency are presumed correct, and the taxpayer bears the burden of proving them incorrect by a preponderance of the evidence.”) (citations omitted).

Nothing in the Tax Court's opinion suggests that it held Connell to a higher standard of proof.

Connell purports (Br. 45) to restate the Tax Court's reasoning, indicating that it relied upon the fact that, as a theoretical matter, there was more than one possible basis for the FINRA award. But that simply is not accurate. The Tax Court directly determined that, notwithstanding his statements to the contrary, Connell did not rely solely upon a conversion theory in the FINRA proceeding; he made other arguments in support of his contention that Merrill should not recover the balance of the up-front forgivable loan. (JA38-39.) As explained above, that determination was well supported.

CONCLUSION

This Court should affirm the Tax Court's decision.

Respectfully submitted,

RICHARD E. ZUCKERMAN
Principal Deputy Assistant Attorney General

Nathaniel S. Pollock

BRUCE R. ELLISEN (202) 514-2929
NATHANIEL S. POLLOCK (202) 514-8139
D.C. Bar No. 1013075
Attorneys
Tax Division
Department of Justice
Post Office Box 502
Washington, D.C. 20044

MARCH 2020