Supreme Court Denies RICO for Cities Pursuing Online Cigarette Taxes

The decision could play into congressional efforts to further regulate online cigarette sales and to set up a nationwide tax collection system for online sales. The House approved the Prevent All Cigarette Trafficking Act last spring and the Senate Judiciary Committee approved a similar bill in the fall, while the proposed Main Street Fairness Act, expected since the current Congress started (WID April 24/09 p4), still hasn’t been introduced.

"Because the City cannot show that it lost the tax revenue ‘by reason of’ the alleged RICO violation … we hold that the City cannot state a claim under RICO” for civil penalties, said the majority opinion written by Chief Justice John Roberts. The opinion overturned a 2nd U.S. Circuit Court of Appeals ruling against Hemi Group. Justices Stephen Breyer, John Paul Stevens and Anthony Kennedy dissented, saying it was “reasonably foreseeable” that Hemi’s refusal to turn over customer information would prevent the city’s attempt to compel owed taxes. The majority suggested, though, it would consider New York State’s use of RICO to pursue owed taxes. Justice Sonia Sotomayor, who heard the case as a 2nd Circuit judge, recused herself.

Roberts acknowledged online cigarette purchasers are “often reluctant to pay [taxes] and tough to track down” without the information required by law from cigarette sellers. New York City said it had lost “tens if not hundreds of millions of dollars a year” because of Hemi’s withholding of customer information from New York State, which passes it to the city. It claimed that counts as mail and wire fraud under RICO, depriving the city of “business or property” -- lost tax revenue. Hemi didn’t contest the city’s claim that violating the Jenkins Act can be a “predicate offense” actionable under the RICO statute, and Roberts said the court would “assume without deciding” that claim was legitimate.

While passing on the “business or property” question, Roberts focused on the “causation” requirement under RICO. A previous Supreme Court ruling denied that the Securities Investor Protection Corp., which reimburses certain customers of broker-dealers who can’t meet their financial obligations, was a “proximate” victim of stock manipulation that eventually led to $13 million in SIPC payouts. “The City’s causal theory is far more attenuated” than in the SIPC case, Roberts said. It requires the court to “extend RICO liability to situations where the defendant’s fraud on the third party (the State) has made it easier for a fourth party (the taxpayer) to cause harm to the plaintiff (the City).” Hemi’s only obligation was to file reports with the state, and its customers were solely liable for paying owed taxes, Roberts said.

But he left a door open for states. New York State charges a cigarette tax nearly double the city’s, giving it “concrete reasons to try” a similar RICO suit, Roberts said, without handicapping the state’s chances of convincing the court. The city, however, comes up short. RICO proximate-cause precedent would become a “mere pleading rule,” Roberts said, if the city succeeded in its argument that Hemi practiced a “systemic scheme to defraud the City of tax revenue.” Regardless of intention, “the only fraudulent conduct alleged here is a violation of the Jenkins Act,” he said. The city’s belated claim at oral argument that Hemi’s website discouraged customers from paying owed taxes, making it liable, contradicts the city’s argument that the website statements weren’t “part of the fraud itself,” Roberts said.

Roberts was blunt in describing the essence of the case: “It is about the RICO liability of a company for lost taxes it had no obligation to collect, remit, or pay, which harmed a party to whom it owed no duty,” with the threat of triple damages and attorney’s fees. Justice Ruth Bader Ginsburg concurred in the judgment but not its proximate-cause analysis. New York City didn’t even base its claims on the Jenkins Act, so it “effectively admits that its claim is outside the scope of the very statute on which it builds its RICO suit,” she said.

The dissent written by Justice Breyer ticked off the facts as laid out by the city: Hemi’s prices are lower than in-state competitors largely because they don’t include sales tax, it tells customers it doesn’t report their sales to any taxing authority, and New York City collects about 40 percent of owed taxes through Jenkins Act enforcement. The city’s losses were “reasonably foreseeable” from Hemi’s misrepresentations, and thus a proximate cause of them, he said: “It knew the loss would occur; it intended the loss to occur; one might even say it desired the loss to occur.” There’s no reason to think the Jenkins Act, directed to states, treats differently cities who collect taxes under authority of state law, he said.

The effect of Hemi’s behavior was not only foreseeable but “increases the risk” of taxes not being paid, Breyer said. The court majority actually reverses court precedent on “directness,” which has expanded liability beyond what was foreseeable. New York State essentially acts as a third party to the transaction, since it’s contractually bound to forward customer information to the city, Breyer said: “This Court has never suggested … that a defendant is not liable for (foreseeable) harm (intentionally) caused to the target of a scheme to defraud simply because the misrepresentation was transmitted via a third (or even a fourth or fifth) party."

The majority is misreading the SIPC case and another “competitive injury” case it used to justify the opinion, Breyer said. In each, “the kind of harm that the plaintiff alleged is not the kind of harm that the tax statutes primarily seek to prevent.” If the Roberts’ opinion were to influence future jurisprudence, it would remove from RICO liability the theoretical operators of a pump-and-dump scheme who only communicated with intermediaries who “simply repeated the information to potential investors,” he said.

Breyer acknowledged concern among lower courts that RICO could become a tax-collection statute if lost tax revenues were judged business or property. But Justice Department guidelines mitigate this possibility, requiring “high-level” officials to approve any such use of RICO, and only for cases with a “large fraud loss or a substantial pattern of conduct, he said. Given Hemi’s actions, it would appear to qualify for such treatment by Justice, Breyer said.