Wachovia Bank, National Assn. v. Schmidt, Daniel, et al. (01/17/2006)

Question presented: Whether, for the purposes of federal diversity jurisdiction, a national banking association is "located" in, and thus deemed to be a citizen of, every state in which the association maintains a branch, and whether the word "located," as used in 28 U.S.C. sec. 1348, is ambiguous?

BY SUEVON LEE, MEDILL NEWS SERVICE

On Aug. 26, 2005, accounting giant KPMG admitted to criminal tax fraud on charges brought by the U.S. Department of Justice. It agreed to pay $456 million in penalties for its role in tax shelter-fraud, having designed and sold investment deals targeted specifically at wealthy individuals between 1996 and 2003. Grouped under acronyms such as BLIPS, FLIP, OPIS and SOS, these tax shelters created a fake "loss" that investors could use to minimize their taxes.

One of these hooked wealthy individuals was Daniel Schmidt. The businessman from Pickens County, South Carolina, had sold his physical therapy companies on May 1, 1998, and was encouraged by his bankers at First Union Bank in South Carolina to participate in FLIP, or Foreign Leveraged Investment Program, which used the guise of a "company" based in the Cayman Islands to reduce tax liability and increase his disposable income. Court documents allege that Schmidt was assured by his bankers, his CPA and KPMG representatives that the investment strategy was not an abusive tax shelter and therefore, could not be penalized by the IRS.

First Union Bank charged Schmidt $100,000 for referring him to KPMG's investment plan.

Four years later, the IRS exposed these shelters as illegal, risk-free investments that had resulted in $12 billion in phony losses and a cost to the U.S. Treasury of a cool $2.5 billion.

According to IRS reports, the 57 investors who participated in the FLIP and OPIS transactions collectively lost approximately $1.4 billion based on investments totaling about $114 million.

Schmidt was audited by the IRS and forced to make back payments in taxes and penalties stemming from his 1998 investments. He claimed his personal losses amounted to $3 million.

On April 10, 2003, Schmidt filed a complaint in South Carolina state court against KPMG, Pillsbury Winthrop, First Union (now Wachovia Bank following a 2001 merger), QA Investments and Quellos Group, alleging tax fraud and wrongful inducement towards an illegitimate tax scheme. His suit called for a jury trial.

All defendants moved to compel arbitration in South Carolina state court, with the exception of Wachovia Bank, which invoked the statute of diversity jurisdiction to move the case to the U.S. District Court of South Carolina. Wachovia claimed that as a bank whose principal place of business was North Carolina, it would seek the jurisdiction of the federal court.

"Banks would prefer to have as much access to federal courts as possible," said Andrew Lewis Frey, of Mayer, Brown, Rowe & Maw, who represents Wachovia Bank. "Anybody who's who in the banking business thinks it's important. The state court system…is more plaintiff-friendly."

Although Wachovia Bank is headquartered in North Carolina, it maintains branches in South Carolina, Schmidt's hometown.

The federal judge denied Wachovia's motion. The bank appealed to the 4th Circuit Court of Appeals.

In what was supposed to be an appeal over Wachovia's right to arbitration, the case took an unexpected turn when two days before oral argument was scheduled on June 3, 2004, Schmidt's lawyers stumbled upon a gem.

During a night of heavy research, Susan Foxworth of McCutchen, Blanton, Johnson & Barnette, said she came across a case which brought up the entirely new issue of jurisdiction.

"A few days before we went to Richmond, VA, to argue [the case], we found a case that found…Wachovia didn't have a right to be in federal court," Foxworth said.

Curiously enough, the case Schmidt's counsel used to defend their position was filed in 2001 by First Union Bank against American Casualty Company of Reading, PA. First Union argued that American Casualty could not remove its suit to district court because First Union had branches in Pennsylvania—thus, the parties were not of diverse citizenship.

"First Union was making an argument four years ago which was the same argument that we're trying to make now," Foxworth said. Counsel for Schmidt proceeded to argue before the 4th Circuit that because Wachovia maintained a branch bank in South Carolina, it could not invoke diversity jurisdiction and have its case heard before federal court.

In a 2-1 opinion issued Nov. 1, 2004, the court agreed.

"If a bank is said to be ‘located' only in the place in which it primarily conducts its business, and in no other place in which it is physically located--as the Seventh Circuit has held--then we are certain that words have little if any meaning beyond that which the particular speaker employing them says they do," wrote Judge Michael Lutttig for the majority.

Lawyers for Wachovia say that the strict application of the word "location" in this situation skews congressional intent.

"It borders on the frivolous to say the word ‘locate' is unambiguous," Frey said. "Congress never intended to disfavor national banks. Yet that's the result of the 4th Circuit's interpretation. That is not a plausible or sensible interpretation.

"If you were any kind of corporation other than a national bank, your citizenship would be your principal state of business. National banks are not incorporated, so the principal place of business would be parallel."

The debate over the issue of jurisdiction revolves heavily on the interpretation of Section 1348, which states, "All national banking associations shall, for the purposes of all other actions by or against them, be deemed citizens of the States in which they are respectively located."

But that same paragraph states, "The district courts shall have original jurisdiction…against…any action by a banking association established in the district for which the court is held."

The 4th Circuit majority reasoned that Section 1348 was making a distinction between the terms "established" and "located," stating the former referred to a bank's charter location and the latter any place where the bank has an actual, physical presence. It determined that branch banks are, in fact, "located" in those states they are set up despite the principal state of business being held elsewhere.

In its petition for certiorari to the U.S. Supreme Court, Wachovia responded that Congress had not intended to make any distinction between "established" and "located" and that it was due to the piecemeal construction of the statute that led to its ambiguity.

"The words were not chosen at the same time by the same Congress," the brief states. "Because Section 1348 thus was formed from pre-existing bits, there is every reason to believe that Congress did not give any thought to, or see any significance in, the use of different words in the provision's two sentences."

In 1887, Congress first set the "location" clause in place under Section 1348. The law was reenacted in 1911 to include the "established" part to give national banks the same federal jurisdictional access as state banks. It was not until the passage of the McFadden Act in 1927 that national banks were even permitted to engage in intrastate, and eventually, interstate, branch banking. When the law was codified in 1948, the language of Section 1348 remained intact, despite changes to the overall structure and geography of the national banking system.

The dispute arises as much from congressional intent as it does from linguistic ambiguity. In 2001, the 7th Circuit Court of Appeals recognized this when it ruled in Firstar Bank, N.A. v. Faul that a national bank is only considered located in its principal state of business or in the state specified by its "organization certificate."

"Congress will use clear language if it intends to alter an established understanding about what a law means…For sixty years leading up to the 1948 codification of " 1348, the term ‘located' was construed to mean that national banks would enjoy parity with state banks and corporations, and we must presume that Congress intended for that construction to continue," the 7th Circuit's ruling stated.

On June 13, 2005, the U.S. Supreme Court accepted the case for review. Justice Clarence Thomas took no part in that decision.

According to Greg Taylor of the Washington, D.C.-based American Bankers Association, which filed an amicus brief in support of Wachovia Bank, many cases currently pending within the federal system will be affected by the outcome of the Court's decision.

"You will see courts taking a look at their docket for cases involving national banks and reassessing whether they have continued jurisdiction," the associate general counsel of litigation said. "You will see cases dismissed out of the federal system. Banks will have to reassess where they file their cases.

"Everyone's going back looking at the last 130 years. [1348] is one of those weird little provisions that got overlooked," Taylor added.

On Jan. 17, 2006, the Court reversed, holding 8-0 for Wachovia Bank that a national bank is a citizen of the state in which its main office, according to its articles of incorporation, resides.

In so holding, the Court rejected the argument that national branch banks are to be treated as a citizen of every state in which they maintain a branch, in which case it would be unlikely that such banks would have their cases heard in federal court.

Justice Ruth Bader Ginsburg wrote the Court opinion. Justice Clarence Thomas recused himself from the case.