text:
    Alester G., III and Mary O. FURMAN; William M. and Mary F. McGinty; Jackson H. and Beverly C. Brown; William C. and Helen M. Williams; and Frank S. and Rosalie H. Poe, Plaintiffs, v. UNITED STATES of America, Defendant.
    Civ. A. No. 83-1249-3.
    United States District Court, D. South Carolina, Greenville Division.
    July 27, 1984.

      Merline, Thomas & Stuart, P.A. by David A. Merline, Rainey, Britton, Gibbes & Clarkson by Frank H. Gibbes, III, Green-ville, S.C., for plaintiffs.
    Department of Justice by Mark Muedeking, Tax Div., Washington, D.C., for defendant.
   MEMORANDUM ORDER

GEORGE ROSS ANDERSON, Jr., District Judge.

This is a tax refund suit wherein several taxpayers seek refunds of taxes and interest paid for the year 1978, plus statutory interest thereon. Each of the taxpayers filed timely joint U.S. Individual Income Tax Returns for 1978 showing liability on those returns as follows:

TAXPAYERS TAX LIABILITY PER ORIGINAL RETURN
Alester G. Furman, III and Mary O. Furman $171,740.67
William M. McGinty and Mary F. McGinty $82,963.00
Jackson H. Brown and Beverly C. Brown $90,893.00
William C. Williams and Helen M. Williams $92,948.00
Frank S. Poe and Rosalie H. Poe $83,447.00

After audit of each of the returns listed above by the Commissioner of Internal Revenue (hereinafter the “Commissioner”), deficiencies were timely proposed and assessments were timely made as follows:

TAXPAYERS ASSESSMENTS ASSESSMENT DATE
Alester G. Furman, III $17,839.33 (T) 7/19/82
Mary O. Furman 5,420.46 (I) 7/19/82
William M. McGinty $12,281.00 (T) 7/19/82
Mary F. McGinty 3,731.58 (I) 7/19/82
Jackson H. Brown $16,811.00 (T) 7/26/82
Beverly C. Brown 5,108.01 (I) 7/26/82
William C. Williams $17,036.00 (T) 7/19/82'
Helen M. Williams 5,176.38 (I) 7/19/82
TAXPAYERS ASSESSMENTS ASSESSMENT DATE
Frank S. Poe $6,842.00 (T) 7/19/82
Rosalie H. Poe 2,078.94 (I) 7/19/82
(T) Tax Assessed.
(I) Interest Assessed. _

The plaintiffs paid these amounts and filed their first claims for refund (Forms 1040X) in March, 1982, requesting refunds of tax and assessed interest, plus statutory interest, as follows:

CLAIMS FOR REFUND
ASSESSED
TAXPAYERS TAX INTEREST TOTAL
Alester G. Furman, III and Mary O. Furman $34,653.00 $5,420.00 $40,073.00 *
William M. McGinty and Mary F. McGinty $39,608.00 $3,731.58 $43,339.58 *
Jackson H. Brown and Beverly C. Brown $44,384.00 $5,108.00 $49,492.00 *
William C. Williams and Helen M. Williams $44,245.00 $5,176.00 $49,421.00 *
Frank S. Poe and Rosalie H. Poe $28,921.00 $2,078.94 $30,999.94 *
* Plus statutory interest.

The Commissioner disallowed the plaintiffs’ first claims for refund on May 23, 1983, by letter sent certified mail. Thereafter, the plaintiffs timely filed this action on May 25, 1983. Pursuant to leave granted by this Court, the plaintiffs each filed timely second claims for refund in December, 1983 for the same amounts listed above. These second claims for refund, which put forth new theories for recovery, have also been disallowed by the Commissioner. Jurisdiction and venue are, therefore, proper.

The defendant, United States of America, moved for summary judgment. The plaintiffs thereafter filed a cross-motion for summary judgment. The Court concludes that the defendant’s motion should be granted and that the plaintiffs’ cross-motion must be denied.

The relevant facts with respect to the plaintiffs’ claims involve non-eompete agreements entered into by the male plaintiffs on January 4, 1977. (The female plaintiffs are parties to this action only by virtue of having filed joint income tax returns, and therefore, all references to the plaintiffs will be references to the male plaintiffs.) The plaintiffs were all stockholders and employees of The Furman Agency, Inc., during 1976. The Furman Agency, Inc. (hereinafter “The Furman Agency”) was a South Carolina corporation engaged in the sale of insurance. Its headquarters and principal place of business was Greenville, South Carolina.

NEGOTIATIONS

Beginning in February of 1976 the plaintiffs, as stockholders and members of the Board of Directors of The Furman Agency, began negotiations with Marsh & McLennan, Inc., a major subsidiary of Marsh & McLennan Companies, Inc., and a major multi-national insurance broker, for sale of The Furman Agency. Several proposals for the form of the sale or merger were discussed internally by the plaintiffs and proposed to Marsh & McLennan, Inc. (hereinafter “Marsh & McLennan”). The original proposal was for an exchange of all 66,400 outstanding shares of Furman Agency stock for 86,500 shares of unregistered shares of Marsh & McLennan stock. These shares of Marsh & McLennan stock were to be held for investment due to federal securities laws. This form was favored by plaintiffs Furman and Poe. However, this proposal was rejected because of possible unfavorable tax treatment for profits realized by the other three plaintiffs. These plaintiffs expressed concern that the profit on their stock would be taxed as income immediately upon transfer of the shares. Therefore, these plaintiffs countered with a proposal for a sale of stock for cash rather than for stock. These plaintiffs were worried about receiving enough cash to pay any taxes due on the sale or merger. On the basis of the above-described conflicts of interest, the plaintiffs agreed that they would individually continue negotiations with Marsh & McLennan and also consider other alternatives.

At a special meeting of the Board of Directors of The Furman Agency the plaintiffs again reviewed the status of their individual negotiations with Marsh & McLennan for the sale of their stock. A summary of this review as found in the minutes of the meeting showed that the individual plaintiffs had established tentative price agreements with Marsh & McLennan for the sale of their Furman Agency stock for cash at the following prices:

PURCHASE PRICE
TAXPAYER NUMBER OF SHARES FOR SHARES
Furman 32.000 $1,738,800.00
McGinty 4,200 $365,300.00
Brown 4.000 $366,800.00
Williams 3.000 $329,000.00
Poe . 18.000 $954,300.00

After this discussion of the sale of stock to Marsh & McLennan, the minutes of the special meeting show that the plaintiffs then took up a separate discussion of their negotiations with Marsh & McLennan concerning non-compete agreements. The minutes recorded during this discussion showed that there were substantial actual negotiations over the terms of the non-compete agreements as well as the consideration to be received for execution of these agreements. The recorded minutes showed that the negotiations for the non-compete agreements were separate and distinct from the negotiations for the sale of stock.

Based on these negotiations, each of the plaintiffs entered into two separate contracts with Marsh & McLennan. The first was an Agreement for Purchase of Stock, the second was an employment and non-compete contract.

THE AGREEMENTS FOR PURCHASE OF STOCK

On November 17,1976, each of the plaintiffs entered into an Agreement for Purchase of Stock with Marsh & McLennan. Plaintiffs McGinty, Brown and Williams each entered into separate, individual sales agreements. On the same date, Furman entered into two separate agreements for the sale of his stock. The first was an individual agreement with Marsh & McLennan for the sale of 2,697 shares of Furman Agency stock. Furman’s second sales agreement was entered into along with Poe. Under this agreement, plaintiffs Fur-man and Poe agreed to sell all of Poe’s stock (18,000 shares) and all of Furman’s remaining shares of Furman Agency stock (29,303 shares) to Marsh & McLennan.

Pursuant to these November 17, 1976 stock sales agreements the plaintiffs each sold their shares in The Furman Agency according to the following basic terms:

TOTAL TOTAL
NUMBER OF SALES
PLAINTIFF SHARES SOLD PAYMENT TERMS PRICE
Furman 32.000 1977 - $1,304,099 $1,738,800
1979 - 434,701
McGinty 4,200 1977 - $273,975 $365,300
1979 - 91,325
Brown 4.000 1977 - $275,100 $366,800
1979 - 91,700
Williams 3.000 1977 - $246,750 $329,000
1979 - 82,250
Poe 18.000 1977 - $715,725 $954,300
1979 - 238,575

These amounts actually received by the plaintiffs for the sale of their Furman Agency stock are the same as amounts negotiated for the sale of said stock as reported at the special meeting of the Board of Directors. The Agreements for Purchase of Stock entered into by each plaintiff are indistinguishable in all respects except for the names of the plaintiffs, the numbers of shares sold and the prices to be paid for those shares.

Each of the plaintiffs actually received the full amount contained in the stock purchase agreements. For each plaintiff part of the sales price was received in 1977, and the remaining balance was received in 1979. Each plaintiff took these amounts into income in 1977 and 1979 on his respective Schedule D for each year. Pursuant to this reporting of income, the plaintiffs claimed, and were allowed, long-term capital gain treatment for these amounts in 1977 and 1979.

THE NON-COMPETE AGREEMENTS

In addition to the stock sale agreements, each of the plaintiffs also entered into a non-compete agreement with the buyer, Marsh & McLennan. In each case, the non-compete agreement was separate and distinct from the stock purchase agreement and was contained in a separate and distinct document. There was no mention of these non-compete agreements in the stock sale agreements and the plaintiffs produced no other documents which required the parties to enter into these later non-compete agreements. These non-compete agreements were dated January 4, 1977, 48 days after the date of the stock purchase agreements. Like the stock purchase agreements, the non-compete agreements are indistinguishable in all respects, except for the name of the promisor and the stated consideration to be paid for the promise not to compete.

Pursuant to these January 4, 1977 non-compete agreements, each of the plaintiffs actually received the following amounts on the following dates:

AMOUNT RECEIVED
PURSUANT TO JAN. 4,
1977 NON-COMPETE
PLAINTIFF AGREEMENT DATE PATD
Furman $108,000 1/4/78
McGinty $145,800 1/4/78
Brown $157,680 1/4/78
Williams $151,200 1/4/78
Poe $86,400 1/4/78

These amounts were separate amounts received by the plaintiffs and were not part or reductions of the amounts which each plaintiff received pursuant to the stock sales agreements.

The plaintiffs reported the separate amounts received pursuant to the January 4, 1977 non-compete agreements on their 1978 income tax returns as amounts allegedly received from “personal services.” Based on their allegation that these amounts were for “personal services,” each plaintiff included these amounts on their Form 4726, Maximum Tax on Personal Service Income, and claimed that they were subject to the 50% maximum tax rate on personal service income as provided by Internal Revenue Code Section 1348 (26 U.S. C.). Upon audit the Commissioner determined that the plaintiffs were not entitled to Section 1348 maximum tax treatment for these amounts.

This case also involves a third agreement. Prior to entering into either the stock sales agreements or the non-compete agreements the plaintiffs (as employees of the Furman Agency) entered into an Employment and Non-Compete Agreement with the Furman Agency. This Employment and Non-Compete Agreement with the Furman Agency (hereinafter referred to as the Furman Employment Contract) was entered into while the plaintiffs were also the controlling shareholders of The Furman Agency. While the Furman Employment Contract was similar in some respects to non-compete agreement entered into between the plaintiffs and Marsh & McLennan on January 4, 1977, the two agreements are different in several important respects.

First, the parties to the contracts were different. The Furman Employment Contracts were contracts between Furman Agency and the plaintiffs. The January 4, 1977 non-compete agreements were contracts between Marsh & McLennan and the plaintiffs. Second, the consideration passing to the plaintiffs was different. Under the Furman Employment Contracts the plaintiffs each received a yearly salary actually paid by The Furman Agency and received by the plaintiffs. However, under the January 4, 1977, non-compete agreement the plaintiffs each received lump sum payments from Marsh & McLennan on January 4, 1978. Third, the consideration passing from the plaintiffs to each of the other contracting parties was different. While both the Furman Employment Contract and the non-compete agreement with Marsh & McLennan were for three years and contained some similar provisions, the later Marsh & McLennan non-compete agreement contained several significant clauses not found in the earlier Furman Employment Contract. These additional clauses in the Marsh & McLennan non-compete agreement are clearly for the protection of Marsh & McLennan’s business, customer lists and employees. These additional promises made by the plaintiffs significantly benefit Marsh & McLennan to an extent not contemplated or covered by the Furman Employment Contract, even to the extent that Marsh & McLennan became the majority shareholder of The Furman Agency.

Finally, the remedy provided Marsh & McLennan under their non-compete agreement with the plaintiffs was significant. Under their January 4, 1977 non-compete agreement the plaintiffs agreed that an injunction would be the proper remedy for the plaintiffs’ violation of their duty not to compete with Marsh & McLennan. On the other, hand, even if the employment portion of the Furman Employment Contract could be read so broadly as to preclude the plaintiffs from doing any of the things prescribed by the January 4,1977 non-compete agreement (and, as noted above, it cannot be so broadly construed), the Furman Employment Contract does not provide for injunctive relief with respect to the employment contract portion of that agreement. Therefore, while the two agreements do admit of some similarities, the parties, the consideration passing to each of the parties and the remedy upon breach are quite different and distinct.

The plaintiffs in this action contest the ordinary income treatment afforded by the Commissioner to the amounts they received in 1978 pursuant to the Marsh & McLennan non-compete agreements.

The plaintiffs have taken three different legal positions concerning the tax treatment of those amounts. First, the plaintiffs claim that the amounts received pursuant to the non-compete agreements constituted “personal service income” subject to the 50% maximum tax limitation as imposed in the year 1980 by Internal Revenue Code Section 1348. Second, the plaintiffs alternatively allege that if they are not entitled to “personal service income” characterization and the 50% maximum tax rate, then the non-compete agreements are unenforceable the plaintiffs want the amounts received pursuant to those non-compete agreements to be deemed “additional consideration” received pursuant to the Agreement for Purchase of Stock. In this way, the plaintiffs seek to have the amounts received pursuant to the non-compete agreements reallocated by this Court to the “amount realized” (Internal Revenue Code Section 1001(b)) on the sale of their shares of stock in the Furman Agency, thus qualifying as long-term capital gain under Section 1221 of the Internal Revenue Code and the deduction for net capital gains provided by Internal Revenue Code Section 1202(c). The plaintiffs’ third and final contention is contained in their second claim for refund. There the plaintiffs allege that “ * * * [n]o negotiations took place concerning the terms of the Non-Compete agreements.” The plaintiffs allege that they are “ * * * entitled to long-term capital gain treatment for the payment allocated to the [January 4, 1977, non-compete] agreements because the Non-Compete agreements were not separately bargained for, the agreements were merely incidental to the sale of * * * stock in the Furman Agency, Inc. * * * and the amounts received were in reality paid for good will incidental to the sale of * * * stock.”

The taxpayers’ first allegation that the amounts they received pursuant to the non-compete agreements were amounts which constitute “personal service income” under Section 1348 of the Internal Revenue Code is contrary to the clear wording of that statute. Both Section 1348 and the regulations properly promulgated by the Secretary of the Treasury, make it clear that the plaintiffs are incorrect and that the amounts received pursuant to the non-compete agreements do not constitute “personal service income.”

The relevant portions of Internal Revenue Code Section 1348 provided as follows:

(a) General Rule. — If for any taxable year an individual has personal service taxable income which exceeds the amount of taxable income specified in paragraph (1), the tax imposed by section 1 for such year shall, unless the taxpayer chooses the benefits of part I (relating to income averaging), be the sum of—
(1) the tax imposed by section 1 on the highest amount of taxable income on which the rate of tax does not exceed 50 percent,
(2) 50 percent of the amount by which his personal service taxable income exceeds the amount of taxable income specified in paragraph (1) of this subsection, and
(3) the excess of the tax computed under section 1 without regard to this section over the tax so computed with reference solely to his personal service taxable income.
(b) Definitions. — For purposes of this section—
(1) Personal service income.—
(A) In general. — The term “personal service income” means any income which is earned income within the meaning of section 401(c)(2)(C) or section 911(b) or which is an amount received as a pension or annuity * * *.

Under the general rule contained in Section 1348, amounts which qualified as “personal service income” were subject to a 50% limitation on the rate of tax. In defining “personal service income” Section 1348 states that the 50% limitation applies to amounts which constitute “earned income” within the meaning of Section 401(c)(2)(C) or Section 911(b) of the Internal Revenue Code if those amounts were received pursuant to an employer-employee relationship. Section 911(b) of the Internal Revenue Code, as it was in effect in 1978, provided the following definition of earned income:

(b) Definition of Earned Income. —For purposes of this section, the term “earned income” means wages, salaries, or professional fees, and other amounts received as compensation for personal services actually rendered * * *.

In order to be subject to the 50% maximum tax rate provided by Section 1348, the amounts received must have been wages, salaries, professional fees or other amounts received for personal services “actually rendered” (emphasis added).

The regulations promulgated by the Secretary of the Treasury (hereinafter the “Secretary”) mirrored the definition contained in Internal Revenue Code Section 911(b). In defining “earned income,” the regulations provided that:

The term [earned income] does not include such income as dividends (including an amount treated as a dividend by reason of section 1373(b) and § 1.1373-1), other distributions or corporate earnings and profits, gambling gains, or gains which are treated as capital gains under any provision of chapter 1. The term also does not include amounts received for refraining from rendering personal services or engaging in competitive activity or amounts received as consideration for the cancellation of an employment contract.

Treas.Regs. Section 1.1348-3(a)(l)(i)(D). The regulations could not be clearer in that they specifically exclude from the purview of Section 1348 amounts received pursuant to non-compete agreements. In this regard, it is obvious that the regulation is consistent with the language of the statute which requires that amounts be received for services “actually” rendered. Amounts received pursuant to the non-compete agreements at issue in this case were not amounts received for services actually rendered, but rather were amounts received for not earning income in the manner set forth in the agreement. The amounts received were for refraining from rendering personal services rather than actually rendering personal services. Thus, the amounts received by the taxpayers are amounts which, under the language of the statute and the regulations, are clearly excluded from the benefits of Section 1348.

The plaintiffs rely on four cases which they claim support their position that the amounts received pursuant to the non-compete agreements are “personal service income.” The first two of these cases, Tobey v. Commissioner, 60 T.C. 227 (1973), and Robida v. Commissioner, 460 F.2d 1172 (9th Cir.1972), are cases which were decided under Internal Revenue Code Section 911(b). Neither of these cases hold that amounts received pursuant to non-compete agreements constitute “earned income” under Section 911(b). In both of those cases amounts were earned by the taxpayer for actually doing some work. In Tobey v. Commissioner, supra, the taxpayer actually painted pictures and sold them. In Robida v. Commissioner, supra, the taxpayer earned money by manipulating slot machines so as to eliminate the element of chance and thereby guarantee his “winnings” as a gambler. The court noted that, like the Tobey case, the taxpayer in Robida actually performed services, albeit for himself. The taxpayer “earned” the money by what the Tax Court referred to as a “diligent application of an unusual skill or knowledge * * *.” Thus the court in that case found that the receipts were “earned” by the taxpayer and were not gambling receipts, which are more properly in the category of passive income, rather than compensation for services performed.

In both of the cases cited above, the courts noted that the amounts were received for the application of skill or the expenditure of time or energy. In other words, the pursuits of the taxpayers were active pursuits. In this case there was no expenditure of skill or time to constitute services “actually” rendered. The term “actually” as used in the statute requires that there be some active effort on the part of the taxpayer. This is demonstrated by these cases. The plaintiffs merely rely on dicta from these cases to support the proposition that this Court should not put too much emphasis on the phrase “personal services actually rendered.” However, that dicta does not displace the clear holding of those cases and does not persuade the Court that it should ignore the term “actually” found in the statute.

The plaintiffs also rely on the cases of Montesi v. Commissioner, 340 F.2d 97 (6th Cir.1965), and Davee v. United States, 444 F.2d 557, 195 Ct.Cl. 184 (1971). These cases do not purport to determine whether amounts received from non-compete agreements constitute “personal service income” or “earned income.” Rather, both of these cases hold that amounts received attributable to non-compete agreements constitute “ordinary income” to the recipient. Ordinary income is defined in Section 64 of the Internal Revenue Code. It is the Government’s position that these amounts are indeed “ordinary income” which are, by definition, not subject to the 50% limitation contained in Section 1348. Therefore, these cases are inapposite. .

In the face of the foregoing, the plaintiffs allege that Treas.Regs. Section 1.1348-3(a)(l)(i)(D), which is obviously controlling, is invalid. The plaintiffs first argue that the regulation is inconsistent with the statute itself. However, this Court, like the Tax Court, rejects this proposition. In the recent case of Gene L. Kreider, et al., para. 84,067 P-H Memo T.C. (decided Feb. 13, 1984) the Tax Court upheld the validity of the regulation questioned by the plaintiffs in this case. This Court adopts the standard applied by the Tax Court as well as its conclusion, stated therein as follows:

The regulation at issue here is not “plainly inconsistent” with section 1348. As in effect in 1977, section 1348(b)(1)(A) defines the term “personal service income” in relevant part as “any income which is earned income within the meaning of * * * section 911(b) * * Section 911(b) defines “earned income” as “wages, salaries, or professional fees, and other amounts received as compensation for personal services actually rendered * * *.” (Emphasis added by Tax Court.) While a good argument can be made for a rule different from the regulation consistent with the policy underlying section 1348, we do not act as a committee to revise the regulations. The Supreme Court has clearly described the limits of our role in this realm:
Alternatives to the Commissioner’s * * * rule are of course available. Improvements might be imagined. But we do not sit as a committee of revision to perfect the administration of the tax laws. Congress has delegated to the Commissioner, not to the courts, the task of prescribing “all needful rules and regulations for the enforcement” of the Internal Revenue Code. 26 U.S.C. Sec. 7805(a). In this area of limitless factual variations, “it is the province of Congress and the Commissioner, not the courts, to make the appropriate adjustments.” Commissioner v. Stridger [Stidger], 386 U.S. 287, 296 [87 S.Ct. 1065, 1071, 18 L.Ed.2d 53 (1967)] [19 AFTR 2d 959], The role of the judiciary in cases of this sort begins and ends with assuring that the Commissioner’s regulations fall within his authority to implement the congressional mandate in some reasonable manner. * * * [United States v. Correll, 389 U.S. 299, 306-07, 88 S.Ct. 445, 449-50, 19 L.Ed.2d 537 [20 AFTR 2d 5845] (1967) (fn. ref. omitted.)]

The regulation before us is not plainly inconsistent with the statute, and clearly precludes petitioners’ argument.

For these reasons, we reject petitioners’ argument that the regulation is invalid.

The plaintiffs also claim that, even if the regulation is valid, for procedural reasons it should not be applied to them. In this regard they rely on the case of Elkins v. Commissioner, 81 T.C. 669 (1983). However, that case is easily distinguished on its facts from the present case. In the Elkins case, supra, the Secretary issued regulations which changed the tax treatment of the taxpayer’s lease after the taxpayer had entered into that lease. That factual situation is distinguishable from the facts in this case in two important ways. First, the regulations first proposed by the Secretary with respect to Section 1348 in December of 1971 were silent on the treatment of non-compete agreements. They neither allowed nor disallowed maximum tax treatment for amounts received from the non-compete agreements. The final regulations (of which the plaintiffs complain) clearly took the position that amounts received from non-compete agreements were not subject to maximum tax treatment. In the Elkins case, however, the initial regulations took a clear and stated position while the later regulations took a contrary position. Because the later regulations took a contrary position the Tax Court held that they could not be applied retroactively against that taxpayer.

This raises the second important distinction between the facts in the Elkins case and the present case. In Elkins the later regulations were issued a few days after the taxpayer entered into the relevant agreement. However, in this case the regulation in question was issued in final form before the plaintiffs entered into the non-compete agents. The final regulations were issued on December 17, 1976 and the non-compete agents were entered into on January 4, 1977. Therefore, the Elkins facts and decision do not apply to this case.

The plaintiffs’ next contention is that, if the applicable regulation is valid, the non-compete agreements are invalid under South Carolina law. The parties agree, and the agreement provides that South Carolina law shall govern the enforcement and interpretation of the non-compete agreements.

The non-compete agreements are valid under South Carolina law. The validity and social necessity of such contracts which restrict parties’ competition with each other is well recognized. Indeed, case law from this state affirms this notion. Somerset v. Reyner, 233 S.C. 324, 104 S.E.2d 344, 346 (1958), states that the rule is well settled that restrictive covenants not to compete when sold together with a business and its good will, “will be upheld and enforced.” Such covenants must be reasonable and rationally related to the protection of the rights of the parties to the agreement. Citing earlier South Carolina authority, the South Carolina Supreme Court reaffirmed the validity of such covenants in Somerset v. Reyner, supra, when “(1) supported by a valuable consideration, (2) reasonably limited as to time, and (3) if reasonably restricted as to the place of the territory, that is, where the time is not more extended or the territory more enlarged than essential for a reasonable protection of the rights of the purchasing party.” See Metts, et al. v. Wenberg, 158 S.C. 411, 155 S.E. 734, 735 (1930).

In support of their contention that the covenants are invalid, the plaintiffs rely on the case of Sermons v. Caine & Estes Insurance Agency Inc., 275 S.C. 506, 273 S.E.2d 338 (1980) (hereinafter referred to as Sermons). The plaintiffs allege that the covenants not to compete in the Sermons case are very similar to the agreements entered into by the plaintiffs in the present case. Because the covenants in Sermons were held invalid, the plaintiffs contend that their covenants must also be invalid.

Analysis of the Sermons case shows the plaintiffs’ analysis to be erroneous. The language of the agreement in the Sermons case admits of no similarity to the agreements in the present case. The vital terms of the covenants, namely time and area restrictions, are completely different in each case. In Sermons the area restriction was state wide. In addition, one time restriction was indefinite. Clearly, the criteria used by the Sermons court to decide the case, namely the over-broad time and area restrictions, bear no similarity to the present case where the time restriction is only three years and the area restriction for actively engaging in the insurance business is only a 50-mile radius of the Furman office in Greenville, South Carolina. Indeed, the South Carolina Supreme Court opinion in Sermons suggests that if the area had been reasonably restricted to 50 miles and the time limited to two or three years, the covenants not to compete might have been valid. Supra at 273 S.E.2d 339. In a later case the Supreme Court of South Carolina specifically held that a three-year time limitation — the same time limitation contained in the non-compete agreements in this case — was valid under South Carolina law. Therefore, the three-year period in this case is clearly reasonable and does not make these non-compete agreements invalid. See Rental Uniform of Florence, Inc. v. Dudley, 278 S.C. 674, 301 S.E.2d 142 (1983).

It is important to note that the plaintiffs raise the alleged invalidity of these non-compete agreements for the first time in this tax case. These plaintiffs have taken no action against Marsh & McLennan to challenge these agreements and have to the present day complied with these agreements. Additionally, the non-compete agreements themselves provided as follows:

It is the desire and intent of the parties that the provisions of this paragraph (1) shall be enforced to the fullest extent permissible under the laws the public policies applied in each jurisdiction in which enforcement is sought. Accordingly, if any particular portion of this paragraph (1) shall be adjudicated to be invalid or unenforceable, this paragraph (1) shall be deemed amended to delete therefrom the portion thus adjudicated to be invalid or unenforceable, such deletion to apply only with respect to the operation of this paragraph in the particular jurisdiction in which such adjudication is made.

Therefore, even if this Court were to find that certain portions of the non-compete contracts were invalid, the remedy would not, by the terms of the plaintiffs’ agreements, be invalidity of the entire agreement.

Even if the non-compete agreements were completely invalid under South Carolina law, the plaintiffs would still not be entitled to have this Court restructure their agreements with Marsh & McLennan by reallocating the amounts specifically received pursuant to these non-compete agreements to other agreements or contracts which provide for their own agreed-upon consideration. As noted above, the Stock Purchase Agreements provide for separate and unrelated consideration to be paid to the plaintiffs. Therefore, even if it is assumed that the non-compete agreements are invalid, these amounts should not, ipso facto, be allocated to unrelated and otherwise self-contained agreements. For well-established policy reasons, such reallocations are very rare and are made only upon a showing by the plaintiffs of extraordinary circumstances.

It has long been settled that the consideration paid for a covenant not to compete is taxable to the recipient as ordinary income. Nelson Weaver Realty Co. v. Commissioner, 307 F.2d 897, 904-905 (5th Cir.1962); Beal’s Estate v. Commissioner, 82 F.2d 268, 270 (2d Cir.1936); Salvage v. Commissioner, 76 F.2d 112, 113 (2d Cir.1935), aff'd, 297 U.S. 106, 56 S.Ct. 375, 80 L.Ed. 511 (1936); Montesi v. Commissioner, 340 F.2d 97, 100 (6th Cir.1965). Conversely, the consideration paid for stock is ordinarily taxable to the seller (to the extent it exceeds his basis in the stock sold) as gain on the sale of a capital asset. This gain may receive favorable capital gains treatment. From a buyer’s standpoint, any sum allocated to the purchase of the stock gives rise to no immediate tax benefits since this sum merely increases the buyer’s basis in the stock. But, an amount allocated to a covenant not to compete can be amortized over the life of the covenant, thus reducing the buyer’s gross income subject to taxation. See Balthrope v. Commissioner, 356 F.2d 28, 31 (5th Cir.1966). Accordingly, the plaintiffs and Marsh & McLennan had conflicting interests from a tax standpoint when they negotiated the stock purchase agreements and the covenants not to compete. Because any favorable tax consequences to one party would be precisely matched by adverse tax consequences flowing to the other party, the United States had little, if any, reason to look beneath the form that the parties have chosen for the transaction. However, once taxpayers have by their free negotiations chosen the form of a transaction, it is generally accepted that one of those taxpayers may not then try to alter one side of that bargain for tax purposes. In other words, a taxpayer who freely negotiated a transaction with an adverse party should not be allowed to restructure the unfavorable attributes of that deal for tax purposes only. As the Supreme Court noted in Commissioner v. Nat. Alfalfa Dehydrating, 417 U.S. 134, 149, 94 S.Ct. 2129, 2137, 40 L.Ed.2d 717 (1974):

This Court has observed repeatedly that, while a taxpayer is free to organize his affairs as he chooses, nevertheless, once having done so, he must accept the tax consequences of his choice, whether contemplated or not, Higgins v. Smith, 308 U.S. 473, 477 [60 S.Ct. 355, 357, 84 L.Ed. 406] (1940); Old Mission Portland Cement Co. v. Helvering, 293 U.S. 289, 293 [55 S.Ct. 158, 160, 79 L.Ed. 367] (1934); Gregory v. Helvering, 293 U.S. 465, 469 [55 S.Ct. 266, 267, 79 L.Ed. 596] (1935), and may not enjoy the benefit of some other route he might have chosen to follow but did not.

Accord, Gray v. Powell, 314 U.S. 402, 414, 62 S.Ct. 326, 334, 86 L.Ed. 301 (1941) (“choice of disregarding deliberately chosen arrangements for conducting business affairs does not lie with the creator of the plan”); Federal Bulk Carriers, Inc. v. Commissioner, 558 F.2d 128, 130 (2d Cir.1977); see also the cases cited in In re Steen, 509 F.2d 1398, 1402-1403, n. 4 (9th Cir.1975). To allow a taxpayer to unilaterally reform one end of a bargain could encourage taxpayers to ignore agreements as written in the hope that the courts will give them more advantageous tax treatment. Both parties to a transaction could enjoy tax benefits due to inconsistent reporting of the same transaction. To allow taxpayers to so “whipsaw” the Commissioner would have disastrous effects on our tax system. See generally Lake, The Whipsaw Problem in Federal Tax Controversies, 34th Annual N.Y.U. Institute (1976), p. 867.

Because of the well reasoned and established rule contained in Supreme Court cases such as Commissioner v. Nat. Alfal fa Dehydrating, supra, and Higgins v. Smith, supra, courts have established very strict standards for taxpayers who seek to unilaterally alter one side of a bargain for tax purposes. These cases impose a considerable burden on the plaintiffs in this case.

In the case of Deshotels v. United States, 450 F.2d 961 (5th Cir.1971), a taxpayer sought to contradict the clear and traditional state law meaning of words in a contract affecting his federal tax liability. Though state law allowed the use of parol evidence to reform a contract, the federal court held that for federal tax purposes parol evidence would be insufficient to change the meaning of a document for tax purposes. Also see United States v. Ivey, 414 F.2d 199 (5th Cir.1969).

The courts’ hostility to such agreements by taxpayers has been demonstrated in scores of other cases which stand for the proposition that a “taxpayer cannot elect a specific course of action and then, when finding himself in an adverse situation, extricate himself by applying the age-old theory of substance over form.” Cornelius v. Commissioner, 494 F.2d 465, 471 (5th Cir.1974). In applying this logic to cases similar to this case, the courts have almost uniformly required taxpayers to live by the terms of their written bargains. Though the courts have applied different standards in rejecting taxpayer attempts to escape adverse tax consequences of non-compete agreements, the result has been the same. See Ullman v. Commissioner, 264 F.2d 305 (2d Cir.1959); Sonnleitner v. Commissioner, 598 F.2d 464 (5th Cir.1979); Balthrope v. Commissioner, 356 F.2d 28 (5th Cir.1966); Harvey Radio Laboratories, Inc. v. Commissioner, 470 F.2d 118 (1st Cir.1972); Montesi v. Commissioner, 340 F.2d 97 (6th Cir.1965). See also Commissioner v. Danielson, 378 F.2d 771 (3d Cir.1967); Spector v. Commissioner, 641 F.2d 376 (5th Cir.1981); Sullivan v. United States, 618 F.2d 1001, 1004 (3d Cir.1980); Forward Communications Corp. v. United States, 608 F.2d 485, 490, 221 Ct.Cl. 582 (1979); Connery v. United States, 460 F.2d 1130, 1134 (3d Cir.1972); Winn Dixie Montgomery, Inc. v. United States, 444 F.2d 677, 682 (5th Cir.1971). See generally Proulx v. United States, 594 F.2d 832, 219 Ct.Cl. 363 (1979).

The Fourth Circuit seems to have adopted its own standard derived from the whole of the logic of the cases cited above. In General Insurance Agency, Inc. v. Commissioner, 401 F.2d 324 (4th Cir.1968) (hereinafter “General Insurance Agency, Inc.”), the Fourth Circuit appears to have combined both the “economic reality” and the “intent” tests which are generally referred to in the case cited above. In General Insurance Agency, Inc., the parties entered into a non-compete agreement upon the advice of the seller’s lawyer. However, unlike this case', the parties made no actual allocation of any portion of the purchase price to this non-compete agreement. The Court, therefore, first considered whether or not the parties “intended to allocate any part of the purchase price to [the] covenant at the time they executed their formal sales agreement.” Supra at 329.

In this case the parties not only intended to make such an allocation, they actually did make the allocation. Specific amounts were paid under the terms of the stock sales agreements and other specific amounts were received pursuant to the non-compete agreements. Neither agreement refers to the other nor depends upon the other for its validity. After entering into the stock sales agreements on November 17, 1976, neither the plaintiffs nor Marsh & McLennan were bound to enter into the later January 4, 1977 non-compete agreements. Thus it was clearly the intent of the parties to have separate agreements with separate consideration paid for each.

The Court in General Insurance Agency, Inc. also applied what it called the “economic reality” test. Supra at 330. This test requires that the taxpayers establish that the covenant “have some independent basis in fact or some arguable relationship with business reality such that reasonable men, genuinely concerned with their economic future, might bargain for such an agreement.” (Footnote omitted.) Supra.

The minutes of the meetings of the Board of Directors of The Furman Agency show clearly that there were actual and intensive negotiations between the plaintiffs and Marsh & McLennan over the terms of the January 4, 1977 non-compete agreements. The terms of the agreements were discussed at length by the plaintiffs. It was noted in the minutes that “each [of the plaintiffs] was negotiating a Non-Compete Agreement for sizable consideration, in addition to the sale of stock.” Indeed, the plaintiffs even authorized a continuation of life insurance policies to protect against loss of each plaintiffs “non-compete value” because of death prior to entering into the January 4, 1977 non-compete agreement. Thus, it is clear that the non-compete agreements had economic substance and that each plaintiffs “non-compete value” had economic reality sufficient as' to cause the plaintiffs to retain life insurance coverage for that value.

The plaintiffs seek to avoid their recorded negotiations and concern with the economic reality of the non-compete agreements by arguing that an analysis of the entire negotiation process shows that there is really no economic substance to the non-compete agreements.

The plaintiffs’ affidavits state that they were initially offered $4,844,000 for their Furman Agency stock by Marsh & McLennan. This amount was not to be paid in stock, however, but in a specified number of unregistered Marsh & McLennan stock. The above amount was calculated by the plaintiffs by looking to the per share value of Marsh & McLennan stock traded on the New York Stock Exchange. The plaintiffs argue that there is no substance to the non-compete agreements because they were ultimately paid virtually the same amount in cash for both their stock and the non-compete agreements ($4,966,080). The plaintiffs argue that, contrary to the recorded negotiations contained in the minutes referred to above, amounts were merely “backed put” of the total sales price and allocated to non-compete agreements in order to create a tax deduction for Marsh & McLennan.

The plaintiffs’ argument lacks persuasiveness and economic reality in two regards. First, their comparison of the total amount actually received pursuant to the non-compete agreements and the stock sales agreements with their prior valuation of the earlier Marsh & McLennan stock offer is defective. The prior negotiations were for unregistered Marsh & McLennan stock. Such stock must be held for investment and generally does not have as high a fair market value as the registered and traded stock which the plaintiffs used to value their deal. Additionally, the deal as struck provided for the payment of cash and not stock. It is obvious that in most cases a buyer would be willing to part with more of its own unregistered investment securities than cash. When a seller acquires assets with its own stock it has the double benefit of a beneficial acquisition as well as a stable and fixed contribution to its capital. For these reasons the plaintiffs have obviously overstated the cash value of the early proposals. Considering these factors it is apparent that the early history of the negotiations do not support the plaintiffs’ argument that the total amount paid under the two separate agreements was in reality intended to be for the sale of stock only.

The second problem with the plaintiffs agreement lies in the allegations that there is no substance to the non-compete agreements because amounts were merely “backed out” of the total sales price and allocated the non-compete agreements. The problem with this agreement is aptly demonstrated by the following table which compares the amounts received pursuant to the stock sales agreements and the non-compete agreements:

AMOUNT AMOUNT RECEIVED
RECEIVED UNDER TERMS OF
FOR SALE NON-COMPETE
PLAINTIFF OF STOCK CONTRACT PERCENTAGE
Furman $1,728,800 $108,000 6%
McGinty 1 $365,300 $145,800 40%
Brown $366,800 $157,680 43%
Williams $329,000 $151,200 46%
Poe $954,300 $86,400

If the amounts were simply “backed-out” as the plaintiffs allege the percentages would certainly not have been so diverse and detailed. If the plaintiffs allegations were correct that amounts were merely “backed-out” it would be unnecessary to have such detail. When the foregoing table is considered along with the detailed discussion by the plaintiffs of their negotiations with respect to the non-compete agreements as contained in the minutes of the director’s meeting of The Furman Agency, this Court must come to the conclusion that the amounts so allocated were based on the relative non-compete value of each of the plaintiffs.

Finally, the plaintiffs have argued that the amounts received under the non-compete agreements were actually received in exchange for “good will.” However, if it is the good will of The Furman Agency, then it need only be noted that the agreements as structured were not for the sale of assets of The Furman Agency, but rather for sales by the individual stockholders of their shares of stock in The Furman Agency. In this regard, it is clear that The Furman Agency (a corporation), and the plaintiffs (shareholders) are separate and distinct legal entities. The plaintiffs, then, are not entitled to sell a corporate asset (here the good will of The Furman Agency) because they, as stockholders, do not directly own ' that asset. Sonnleitner v. Commissioner, 598 F.2d 464, 467, n. 10 (5th Cir.1979); Balthrope v. Commissioner, 356 F.2d 28, 32 (5th Cir.1966).

If the “good will” sold is their own personal good will, i.e., their good will in the sense that they will not compete or otherwise affect Marsh & McLennan’s side of the bargain, then the plaintiffs’ argument is merely a semantical exercise and must also be rejected.

Based on the foregoing this Court must conclude that the plaintiffs are not entitled to either capital gains treatment or maximum tax treatment on the amounts which they clearly received pursuant to the January 4, 1977 non-compete agreements. Therefore, the Court hereby concludes that the defendant’s motion for summary judgment should be granted and that the plaintiffs’ cross-motion for summary judgment should be denied.

IT IS SO ORDERED.

      . In addition, Furman also sold 5,124 shares of stock in The Furman Life Insurance Brokerage Co., Inc. to William M. Mercer Co., Inc. on November 17, 1976. In consideration for this sale, Furman received $109,177 upon closing in 1977 and $36,393 in 1979, for a total sales price of $145,570.

      . This amount does not include amounts received from the sale of stock of The Furman Life Insurance Brokerage Co., Inc. to William M. Mercer. See fn. 1, supra.

      . This is also true with respect to the agreement entered into by plaintiff Furman for the sale of stock of The Furman Life Insurance Co., Inc. See fns. 1 and 2, supra.

      . Section 1348 was repealed in 1981 for tax year beginning after December 31, 1981.

      . The plaintiffs allege that the amounts received under the non-compete agreements were part of the total amount to be received for the sale of stock and thus argue that the relevant date in this regard is November 17, 1976, the date they entered into the stock sale agreements. The Court specifically rejects this agreement infra, and notes that the November 17, 1976 stock sale agreements nowhere refer to or require the execution of the later and separate January 4, 1977 non-compete agreements. The plaintiffs have not shown that they or Marsh & McLennan were required to execute the January 4, 1977 non-compete agreements.

      . It should be noted that in General Insurance Agency, Inc. the court was not faced with the problem of one party seeking inconsistent tax treatment as both parties to the agreements were joined as parties to the lawsuit. Cf. Better Beverages, Inc. v. United States, 619 F.2d 424 (5th Cir.1980).


source: Caselaw Access Project

author: KEETON, District Judge.

license: Public Domain

text:
    Carol PALLAZOLA, Administratrix of the Estate of Betty Ann Michaud, Plaintiff, v. Carolyn RUCKER, R.N., June Pickering Nurses Registry, Lynn Hospital, Michael Schwartz, M.D., Eugene Smith, M.D., Charles Peters, M.D., and Guenther Herpfer, M.D., Defendants.
    Civ. A. No. 80-2605-K.
    United States District Court, Massachusetts.
    Aug. 7, 1984.
    On Motion to Review Sept. 28, 1984.
    Order Feb. 20, 1985.
    Ann Marie Maguire, Andrew C. Meyer, Jr., Lubin & Meyer, Boston, Mass., for plaintiff.
    Raymond Kenney, Jr., Clement McCarthy and Daniel Griffin, Boston, Mass., for Eugene Smith, M.D.
    Barbara Hayes Buell, Bloom & Buell, Somerville, Mass., for Schwartz.
    Richard L. Fox and John Britt, Carragher, Fox & Lampert, Chelmsford, Mass., for Rucker.
    Ropes & Gray, John C. Kane, Jr., Boston, Mass., for Pickering.
    Edward McCarthy, McCarthy & Keane, Cambridge, Mass., for Guenther Herpfer, M.D. and Lynn Hosp.

      Craig M. Brown, Melick & Porter, Boston, Mass., for Charles Peters, M.D.
    Wilson D. Rogers, Jr., Dunn & Rogers, P.C., Boston, Mass., for Lynn Hosp.
   KEETON, District Judge.

The original complaint in this case, filed in November 1980, alleged claims of professional malpractice against all defendants, as well as claims against some that arguably sound in negligence other than malpractice. Numerous extensions of time were allowed, with the consent of defendants who had been served, because of difficulties encountered in locating and serving other named defendants. Plaintiff was allowed leave to amend in April 1983. Answers were filed on June 1, 1983, by defendant Pickering, on July 29 by defendants Herpfer and Lynn Hospital, on August 23, 1983, by defendant Peters, on September 9, 1983, by defendant Smith, on November 4, 1983, by defendant Jaffe (formerly Rucker), and on November 21, 1983, by defendant Schwartz. All defendants moved that claims against them be referred to a malpractice tribunal convened by the Superior Court Department of the Trial Court of the Commonwealth of Massachusetts. See Mass.Gen.Laws Ann. ch. 231, § 60B (West Supp.1984); Feinstein v. Massachusetts General Hospital, 643 F.2d 880 (1st Cir.1981); Austin v. Boston University Hospital, 372 Mass. 654, 363 N.E.2d 515 (1977). After delay incident to a dispute as to whether some of the claims were of a type subject to being referred to a malpractice tribunal, this court entered an order referring plaintiffs claims against all defendants to the tribunal. The tribunal entered an order in favor of three defendants (Dr. Peters, Dr. Michael Schwartz, and June Pickering Nurses Registry) and in favor of plaintiff against the remaining four defendants. As a prerequisite to proceeding against each of the three defendants for whom it decided, the tribunal ordered that plaintiff post a cash bond of $2,000 per defendant within thirty days. This order was dated April 12, 1984.

On April 17, 1984, plaintiff filed in the superior court a motion to reduce the amounts of the three bonds to be posted, presenting it for hearing before the single justice who presided over the tribunal. Mass.Gen.Laws ch. 231, § 60B declares in relevant part:

Said single justice may, within his discretion, increase the amount of the bond required to be filed. If said bond is not posted within thirty days of the tribunal’s finding the action shall be dismissed. Upon motion filed by the plaintiff, and a determination by the court that the plaintiff is indigent said justice may reduce the amount of the bond but may not eliminate the requirement thereof.

On May 11, 1984, the single justice made a temporary order (explicitly stating that it would apply only until completion of his consideration of the motion to reduce) reducing each bond to $25. On the same day, May 11, 1984, plaintiff’s counsel delivered to the clerk of this court a check in the amount of $75 to serve as cash bonds of $25 each as to defendants Peters, Schwartz, and June Pickering Nurses Registry. Thereafter, on May 14, 1984, the single justice of the superior court vacated his order of May 11 and reinstated the previous order requiring that plaintiff post bonds of $2,000 per defendant. Plaintiff has not posted such bonds.

On May 3, 1984, plaintiff moved in this court for reconsideration of the adverse findings of the medical malpractice tribunal entered April 12, 1984. This motion was heard orally on May 10, 1984, and a schedule for submission of briefs was established.

On May 18, 1984, plaintiff moved in this court for reconsideration of the single justice’s actions on plaintiff’s motion to reduce bonds.

Extensions of times earlier set for briefing of the May 3 motion (for reconsideration of the tribunal’s findings) were allowed, and at a conference with counsel on July 25, 1984, the court required final submissions on that motion to be filed on or before July 27,1984. At that conference it was understood that further submissions on the May 18 motion (for reconsideration of the single justice’s denial of reduction of the bonds) might be deferred pending action by this court on the May 3 motion. I turn to plaintiff’s May 3 motion for reconsideration of the tribunal’s adverse findings.

I.

A threshold question concerns when and where the malpractice tribunal’s ruling is reviewable when the case is pending in a United States district court. When this question was before me in another case, and in a somewhat different context, I held in an unreported opinion that even though in the state system the judge to whom the case is assigned for trial or other disposition does not review the tribunal’s decision, applicable federal procedural law requires that this claim of error be heard first by the United States district court before an appealable judgment is entered rather than being first considered by a United States court of appeals. Defendants Peters, Schwartz and Pickering argue both that this ruling was incorrect and, in any event, that in the particular circumstances of this case the review sought by plaintiff should be allowed only in the Court of Appeals for the First Circuit. They argue that the only proper order for this court to enter as to defendants who prevailed before the tribunal is one of dismissal.

That plaintiff is entitled to a review of the tribunal’s determination is not disputed. A dispute has arisen in the present case, however, as to the standard of review. I turn first to that issue since resolving it eliminates the need for considering some of the arguments advanced by the parties as to where review may or must occur.

Under Massachusetts law, the tribunal decides only whether the evidence proffered by the plaintiff is sufficient to show a prima facie case. The standard of judgment the tribunal is required to apply is the same as the standard a trial judge applies in considering a motion for directed verdict. See, e.g., Denton v. Beth Israel Hospital, 392 Mass. 277, 279-80, 465 N.E.2d 779, 781 (1984); Little v. Rosenthal, 376 Mass. 573, 578, 382 N.E.2d 1037, 1041 (1978). Given this standard, any review to determine whether the tribunal erred must necessarily be based upon the proffer before the tribunal. Additional proof, adduced before the reviewing court by affidavit or otherwise but never brought to the attention of the tribunal, cannot properly be considered in determining whether the tribunal erred. To hold otherwise would undercut manifest objectives of the statute. Cf. Denton v. Beth Israel Hospital, 392 Mass. at 280, 465 N.E.2d at 782 (“discovery is an ancillary purpose of the tribunal hearing”).

A right to review in the state system, to determine whether the tribunal erred in applying the directed verdict standard, is a right of such nature and substance that, under the principles and policies underlying the Rules of Decision Act, 28 U.S.C. § 1652, and the doctrine announced in Erie Railroad Co. v. Tompkins, 304 U.S. 64, 58 S.Ct. 817, 82 L.Ed. 1188 (1938), it applies also in cases pending in this court. Cf. Feinstein, 643 F.2d at 883-87.

As to claims of malpractice pending in the superior court, a plaintiff is entitled to have a claim of tribunal error reviewed only in the appellate court — after trial if plaintiff elects to file a bond, and after dismissal by the superior court if no bond is filed. The apparent reason that, in the state system, the review first occurs on appeal is that a state trial judge has already expressed judgment on the matter as the presiding officer of the tribunal. In the federal system, on the other hand, were this court to decline to review the claim of error of the tribunal, the Court of Appeals for the First Circuit, on appeal from an order of this court, would hear arguments on an issue not previously considered by this court.

Defendants argue that I should nonetheless decline to review the claim of tribunal error because, first, defendants have a right under state law to a judgment of dismissal when a required bond is not filed, and, second, under Erie and Feinstein this is a substantive right that applies as well in federal courts to preclude any review of tribunal error before a judgment of dismissal has been entered. Their argument proceeds on both jurisdictional and policy grounds.

The jurisdictional argument is that once a judgment of dismissal has been entered, the trial court loses jurisdiction and therefore cannot provide the review to which the plaintiff is admittedly entitled. It must then be provided, the argument goes, in the court of appeals. This argument lacks merit. In the first place, if this court enters an order of dismissal against defendants Peters, Schwartz, and June Pickering Nurses Registry, before trial of the remaining claims, it will be an interlocutory order, not appealable until some further action is taken — entry of an order under Rule 54(b), or entry of a final judgment as to all claims, or entry of a certification under 28 U.S.C. § 1292(b).

Even during an appeal a federal trial court in this circuit has continuing jurisdiction to act in aid of the appeal. That jurisdiction is quite limited, Commonwealth of Puerto Rico v. SS Zoe Colocotroni, 601 F.2d 39 (1st Cir.1979), and in view of other grounds of decision, I need not determine whether it would extend to the present circumstances.

Independently of the foregoing points, I reject the suggestion that important issues should be governed by the unstated premise of defendants’ argument — that “dismissal” implies loss of jurisdiction and that when an order of “dismissal” is entered one must, to be logical, derive from “dismissal” the consequence that the dismissing court has no power to perform any further function in the case. This is a classic illustration of misuse of derivative reasoning — applying it without evaluating the implicit unstated major premise from which the result is logically derived. In so stating I do not denigrate the important role of logic in judicial decisionmaking. Rather, I emphasize the contribution of informative reasoning that uses logic to illumine choice and improves decisionmaking by aiding the court to understand the implications of each of the opposing premises, stated or unstated, that the arguments of opposing advocates claim to be authoritative.

I turn to other arguments advanced by defendants, which do focus upon grounds for the premise that a federal trial court either cannot or should not review tribunal error. Putting aside the distracting terminology of “dismissal” in which defendants prefer to cast the argument, we may rephrase one aspect of the defendants’ contention in this way: When a plaintiff fails to win before the tribunal, under Massachusetts law plaintiff is forced to elect either to file a bond (in which case the claim may proceed to trial, and review of plaintiff’s claim of tribunal error will be deferred until appeal from judgment after trial) or to stake all on the claim of tribunal error (since dismissal will then be entered in the trial court, and if the claim of tribunal error is not sustained on appeal, the opportunity to file a bond and proceed with the claim will have been forfeited). Forcing this election on the plaintiff was central to the legislative objective of discouraging frivolous claims. The underlying policies of the Rules of Decision Act and Erie require that federal courts enforce the terms of this election upon plaintiffs whose cases are pending in the federal courts under diversity jurisdiction. So stated, this aspect of defendants’ argument is compelling. I conclude that it has merit. Thus, I am not permitted to engage in review of the claim of tribunal error in such a way that plaintiff is relieved of the burden of this election that the Massachusetts malpractice tribunal law imposes.

It does not follow, however, that I must do no more than enter an order of dismissal, with the consequence that the first review of tribunal error in this case will occur in the Court of Appeals for the First Circuit. Rather, after first ruling that dismissal will occur should the claim of tribunal error be rejected, and holding that plaintiff will not then have a second opportunity to post a bond, I may review the claim of tribunal error without in any way impairing the incentive against frivolous claims that the Massachusetts legislation provides.

Defendants argue, as well, that Massachusetts law provides for panel decisions and not single-justice decisions both at the tribunal level and at the appellate level. The reason for requiring a panel rather than action by the single justice at the tribunal level, however, is that the statute “contemplates that the judge may be aided by the insights of a health care professional and an attorney.” Broadard v. Hubbard Regional Hospital, 388 Mass. 1012, 446 N.E.2d 405, 406 (1983). That point has no bearing on whether a panel of justices (or judges) or a single justice (or judge) should hear the contention that the tribunal erred as a matter of law. Moreover, the Massachusetts decisions allowing review only at the appellate level for tribunal error are not derived from any special provision of Mass.Gen.Laws ch. 231, § 60B. Indeed that statute says nothing at all on this subject. The procedure derives instead from rules generally applicable to civil litigation. Those rules are less likely to occupy such an integral role in the operation of the malpractice tribunal law as to fall within the underlying policies of the Rules of Decision Act and Erie.

Defendants argue also that to allow review of alleged tribunal error by the trial court in the federal system gives plaintiffs two chances to win on review in the federal system in contrast with only one chance— in the appellate court — in the state system. One weakness of this argument is that it overlooks the point that a defendant, too, has two chances if review occurs first in the trial court in the federal system. That is, if a defendant loses before the federal trial judge, defendant has a second chance on appeal. A second difficulty with this argument against review in the federal trial court is its implicit premise that the limitation in the state system to review on appeal is a core element of the malpractice tribunal law. As noted above, ch. 231, § 60B says nothing at all on this subject.

The final defense argument that I consider is the contention that Massachusetts law denies appeal from a tribunal decision on an interlocutory basis, and that review by the trial court in the federal system could produce an outcome inconsistent with this rule of Massachusetts law. This argument — rather like the argument noted above that a trial court must order “dismissal” and then lacks jurisdiction to do more — depends more on terminology than on substantive content. Insofar as it seeks the substantive advantage of imposing an election on the plaintiff, that can be accomplished, as already noted, without deferring review to the appellate level of the federal system in contravention of the usual federal practice that, except in certain well-defined instances, the court of appeals considers no contention that was not first presented in the trial court. Moreover, even if the federal trial court reviews and then enters either an order of dismissal (if no tribunal error is found) or an order striking the requirement of a bond (if the tribunal erred as a matter of law), it is not an apt description of what has occurred to call it review on an “interlocutory” basis. Indeed, the policies against piecemeal adjudication that underlie constraints upon interlocutory appeals are likely to be better rather than less well served if the federal trial court hears and promptly determines the claim of tribunal error as a matter of law rather than passing it on, without considering its merits, to the court of appeals.

I conclude that the rule of law determining whether, in cases pending in federal courts, the claim of tribunal error will be first heard in the district court or instead on appeal to the Court of Appeals for the First Circuit is “procedural” rather than “substantive” in the .EWe-related sense. The Massachusetts rule as to where the claim of error is first heard concerns “merely a form and mode” of according the right of review and is “not a rule intended to be bound up with the definition of the rights and obligations of the parties,” Byrd v. Blue Ridge Rural Electric Cooperative, 356 U.S. 525, 536, 78 S.Ct. 893, 900, 2 L.Ed.2d 953 (1958), and does not “bear substantially on the question whether the litigation would come out one way in the federal court and another way in the state court if the federal court failed to apply” the particular state rule, id. at 536-37, 78 S.Ct. at 900-01. Thus, federal procedural law applies. I conclude that federal procedural law requires that the claim of error be heard by the district court before entry of final judgment. Cf. United States v. Zenon, 711 F.2d 476, 478 (1st Cir.1983) (citing precedents against consideration of points first argued on appeal). See also Feinstein, 643 F.2d at 890 n. 15, citing Johnston v. Holiday Inns, Inc., 595 F.2d 890, 894 (1st Cir.1979).

In summary, if after review it is determined that the tribunal’s decision was erroneous as to a particular defendant, plaintiff is entitled to proceed to trial without posting a bond. If the tribunal decision was not erroneous, this action must be dismissed as to the defendants who prevailed before the tribunal.

II.

Given the posture of this case arising from proceedings incident to plaintiff’s motion for reduction of the amounts of the bonds required as to claims against the defendants Peters, Schwartz and June Pickering Nurses Registry, another question is presented: Is there a right of review in a federal trial or appellate court of the single justice’s denial of the motion for reduction? If so, must that review occur— either in this court or on appeal — before review of the claim of tribunal error?

It appears likely that in the state system the only available review of a single justice’s denial of a motion to reduce bond is on appeal. Denton v. Beth Israel Hospital, 392 Mass. 279-81, 465 N.E.2d at 781-82. My tentative view is that, in the federal system, for reasons virtually identical to those stated in part I above, a review to determine whether the single justice acted contrary to law or in abuse of discretion should occur first in this court rather than on appeal. This issue, however, was not among those as to which it was understood at the conference of July 25, 1984, that all briefs were due on or before July 27, 1984. Before ruling on this issue, I will allow further submissions by all parties, simultaneously, on or before August 20,1984, with simultaneous responses thereto on or before August 27, 1984.

ON MOTION TO REVIEW

The Memorandum and Order of August 7, 1984, allowed time for further submissions as to whether this court should act on plaintiff’s request for review of the single justice’s denial of plaintiff’s motion to reduce bonds. The time for submissions, as extended, having expired, and the court having determined that they do not show cause for a ruling different from the tentative view stated in the last paragraph of that memorandum, it is ORDERED:

(1) Plaintiff’s request that this court review the single justice’s denial of plaintiff’s motion to reduce bonds is allowed.

(2) Hearing on review of the tribunal’s decision and hearing on review of the single justice’s denial of the motion to reduce bond is scheduled for Wed., November 14, at 4:30 pm.

ORDER

The court having reviewed the decision of the malpractice tribunal in favor of defendants Peters, Schwartz, and June Pickering Nurses Registry and having concluded that it was not erroneous, and having reviewed the decision of the single justice denying plaintiff’s motion to reduce bonds, and having concluded that it was not erroneous and did not constitute an abuse of discretion, and the plaintiff having failed to file bonds within the time prescribed by law, it is therefore, for the reasons stated in the Memorandum of August 7, 1984, ORDERED

This action is dismissed as to defendants Peters, Schwartz, and June Pickering Nurses Registry.


author: O’KELLEY, District Judge.

text:
    William GRIZZLE v. GUARANTEE INSURANCE CO.
    Civ. No. C-83-126-G.
    United States District Court, N.D. Georgia, Gainesville Division.
    Aug. 30, 1984.

      Jefferson W. Willis, Gainesville, Ga., for plaintiff.
    R. Clay Porter, Atlanta, Ga., for defendant.
   ORDER

O’KELLEY, District Judge.

Presently pending before the court in this diversity action is the defendant’s motion for summary judgment and partial summary judgment.

Plaintiff William Grizzle purchased a Yamaha motorcycle from Cape’s Motorcycle Sales on April 10, 1980. At the time of the purchase Grizzle also purchased insurance from defendant Guarantee Mutual Insurance Company (Guarantee). Following the issuance of Guarantee policy number GAC4392797, Grizzle was injured in a motorcycle accident on June 3, 1980.

Grizzle seeks to recover from Guarantee on the basis of four theories. First, Grizzle contends that Guarantee has breached its contract of insurance by failing to provide personal injury protection (PIP) and medical payments coverage (Medpay). Second, Grizzle contends that Guarantee and its agent K & K Insurance Agency (K & K) were negligent in that they failed to procure the insurance applied for and to issue a policy consistent with the insured’s application. Grizzle also argues that Guarantee and K & K breached their duties to inspect the policy of insurance and the application for insurance for misrepresentations and advice inconsistent with Georgia law. Finally, Grizzle alleges that Guarantee is guilty of fraud and deceit, and argues that Guarantee should be estopped from denying PIP and Medpay coverage after representing that such coverage was automatically provided unless rejected in writing.

Grizzle’s claim of negligent failure to procure insurance is precluded by the decision in King v. Brasington, 252 Ga. 109, 312 S.E.2d 111 (1984). King involved a business loan conditioned upon the assignment of life and disability insurance policies. Upon Mrs. King’s death, Mr. King discovered that while his own life had been insured, no policy had ever been issued covering his wife. In rejecting King’s claim for failure to procure, the court held that “if these were [sic] a failure of coverage, it was in the failure of the existing life insurance policy to cover Mrs. King’s life as well as Mr. King’s life.” 252 Ga. at 111, 312 S.E.2d 111. The court held that under such circumstances Mr. King had a duty to inspect the policy and reject it if the coverage was not what he desired. This holding appears to preclude an action for negligent failure to procure if any policy has in fact been procured and the insured has had an opportunity to inspect the policy. See, also, Hodges v. Mays, 240 Ga. 643, 242 S.E.2d 160 (1978); Ethridge v. Associated Mutuals, Inc., 160 Ga.App. 687, 288 S.E.2d 58 (1981). In the instant case it is clear that some insurance was procured, and that the plaintiff had an opportunity to read the contract. In fact, Grizzle’s deposition unequivocally states that he read the policy in its entirety. In light of this testimony, the plaintiff’s claim for negligent failure to procure insurance is even weaker than the claim asserted in King, supra, and cannot survive defendant’s motion.

The plaintiff’s argument that Guarantee should be estopped from denying coverage does not comport with the well established rule in Georgia that “neither waiver nor estoppel can be used to create a liability not created by the contract and never assumed by the insurer under the terms of the policy.” Washington v. Hartford Accident & Indemnity Co., 161 Ga.App. 431, 432, 288 S.E.2d 343, quoting Quillian v. Equitable Life Assurance Society of the United States, 61 Ga.App. 138, 6 S.E.2d 108 (1939). See also, Parris & Son, Inc. v. Campbell, 128 Ga.App. 165, 169, 196 S.E.2d 334 (1973); Allstate Ins. Co. v. Walker, 114 Ga.App. 732, 152 S.E.2d 895 (1966).

In support of his claim that Guarantee was negligent in “breaching its duty to inspect its policy of insurance and application for misrepresentations and advice inconsistent with the laws of Georgia,” Grizzle relies upon cases construing contracts of insurance to derive the basis for a claim based upon negligence, and therefore sounding in tort. Plaintiff cites, for example, Travelers Indemnity Co. v. Whalley Construction Co., 160 Ga.App. 438, 287 S.E.2d 226 (1981) for the proposition that Guarantee “has the burden in preparing its policy to use language that is clear and precise.” Plaintiff also relies on Cincinnati Insurance Co. v. David, 153 Ga.App. 291, 265 S.E.2d 102 (1980) for the premise that the test when construing an insurance contract is what a reasonable person in the position of the insured would understand it to mean. Undoubtedly these principles are correct, however they apply to the interpretation of contracts in actions arising ex contractu, not ex delicto. Plaintiff fails to refer the court to any authority which creates a duty on the part of the drafter of a contract to use unambiguous language which duty would, if breached, give rise to an action sounding in tort. In actuality the principles embodied in Whalley Construction and David are simply rules of construction designed to aid a court in construing an ambiguous phrase in a contract. In order to give rise to an action for damages, a misrepresentation must be made either knowingly or with reckless disregard for the consequences. In other words the fraud must be actual. Irvin v. Lowe’s of Gainesville, 165 Ga.App. 828, 302 S.E.2d 734 (1983). “Innocent” or “constructive” fraud, wherein the defendant misrepresents without reckless disregard or knowledge, exists only as an equitable doctrine and will not support an action in tort for damages. Irvin, supra. This has been the law in Georgia since the decision in Penn Mutual Life Insurance Co. v. Taggart, 38 Ga.App. 509, 144 S.E. 400 (1928). Thus scienter is an essential element in actions for damages based on fraud. Hertz Corp. v. Cox, 430 F.2d 1365 (5th Cir.1970). As a result, summary judgment must be granted for the defendant as to the claim of negligent failure to procure insurance.

In Georgia there are five elements to the tort of fraud. These are a false representation by a defendant, scienter, intention to induce the plaintiff to act or refrain from acting, justifiable reliance by the plaintiff, and damage to the plaintiff. Hardy v. Gordon, 146 Ga.App. 656, 247 S.E.2d 166 (1978); Shaw v. Cook County Fed. Savings & Loan, 139 Ga.App. 419, 228 S.E.2d 326 (1976). Questions of fraud, bad faith and materiality of misrepresentation are normally for the jury. Preston v. National Life and Accident Ins. Co., 196 Ga. 217, 237, 26 S.E.2d 439 (1943); Adkins v. Lee, 127 Ga.App. 261, 193 S.E.2d 252 (1972). In order to survive a motion for summary judgment, however, the existence of some issue of material fact must be evident. As Fed.R.Civ.P. 56(e) states

When a motion for summary judgment is made and supported as provided in this rule, an adverse party may not rest upon the mere allegations or denials of his pleadings, but his response, by affidavits or as otherwise provided in this rule, must set forth specific facts showing that there is a genuine issue for trial. If he does not so respond, summary judgment, if appropriate, shall be entered against him.

Plaintiff’s deposition contains the unequivocal statement that he never had any discussion or written correspondence with anyone at either Guarantee or K & K prior to his accident (Grizzle deposition at 29-30). In light of this statement, and the plaintiffs failure to controvert or explain it in any way, it is inconceivable that the defendant intended to deceive the plaintiff, or that the plaintiff was in fact deceived. Even if the employee of Cape’s Motorcycle Sales deceived the plaintiff, no evidence of an agency relationship between the defendant and Capes has been introduced. Accordingly, the court must conclude that no issue of material fact exists with regard to the plaintiff’s claim of fraud, and that summary judgment must be granted for the defendant on the fraud claim.

Guarantee also moves for summary judgment with regard to Grizzle’s contract claim. Comprehensive Automobile Policy number GAC4392797 contains a section on its first page (the declarations page) marked “Attention,” which states that

Insurance is provided only for those coverages for which a specific Limit of Liability is shown and a Premium charged; and under Section D coverage to such vehicles as described herein, in accordance with the terms of this policy. Under no circumstances shall the Company’s Liability exceed the Limit as stated herein____

No limit of liability is shown, and no premium was charged, under either Section B, dealing with automobile medical payments, or that part of Section D covering personal injury protection.

Attached to the policy is a sheet entitled Supplemental Motorcycle Conditions Endorsement E-101. Paragraph B of the endorsement states that

In consideration of the premium charged and the mutual covenants contained in the Policy, it is hereby agreed that where the word “automobile” appears in the Policy or Endorsements forming a part or attached thereto, it means a motor vehicle of the type described as a Motorcycle, Motorbike or Motorscooter.

Section D of the declarations page provides that it is “subject to endorsements and coverage page(s)/form(s) identified here by number.” Forms E-101C, E-372 and E-374 are identified by number. In addition, the letters SI are listed. A Supplemental Information (SI) sheet is also attached to the policy, and is at the heart of plaintiff’s contract claim.

The SI sheet contains eight separately numbered and bordered .sections, including sections dealing with PIP and Medpay. Section two of the SI sheet carries the heading Rejection of Uninsured Motorists Coverage. Above the heading are the italicized instructions “do not sign below if uninsured motorists coverage desired.” The plaintiff’s signature and the date are present in the appropriate spaces. Section four of the SI sheet carries the heading Rejection of Personal Injury Coverage, and also contains instructions stating “do not sign below if personal injury protection desired.” The section also contains the following language:

I understand that the state requires the [sic] Personal Injury Protection be afforded me under my motor vehicle liability policy unless I specifically reject this coverage. Accordingly I expressly reject Personal Injury Protection Insurance and direct the Insurer to issue my policy without the said coverage.

No signature is present.

Section six of the SI sheet carries the heading Rejection of Medical Payments Coverage. Located above the heading are instructions stating “do not sign below if medical payment desired.” The section states that

In accordance with the provisions of state statutes which permits [sic] an insured named in a policy to reject Medical Payments Coverage, the undersigned does hereby reject such coverage, being the coverage provided for medical payments or chiropractic payments, or both, for the protection of persons operating or riding in the insured vehicle from losses resulting from bodily injury or death. This rejection continues in effect on all future policies until further notice.

No signature is present in the appropriate spaces.

Contrary to the representations made in the SI sheet, the Georgia Motor Vehicle Accident Reparations Act (the act), O.C.G.A. § 33-34-1 et seq., does not require Medpay or PIP coverage for motorcycles. The act defines a motor vehicle in relevant part, as a vehicle having more than three load-bearing wheels. O.C.G.A. § 33-34-2. Guarantee argues that Med-pay and PIP coverage in connection with motorcycles is not required by state law, and it is correct. The court cannot, therefore, hold that the coverage was extended by operation of law. Although the SI sheet clearly indicates that coverage will be provided in the absence of a signature indicating waiver by the insured the sheet does not indicate what amount of insurance is provided if the waiver is not made. Nor, as previously noted, does the declarations page provide a limitation of liability, or state a premium for the coverage which the plaintiff contends was provided. Under the Act, the minimum amounts of coverage for automobile insurance are governed by law. The Act does not require or provide for PIP or Medpay insurance with regard to motorcycles, and therefore no amount of coverage may be inferred by looking to the Act. Viewed in this light, it becomes apparent that although the plaintiff contends that he contracted for insurance, he cannot point to the amount of coverage provided, or to the premium paid for such coverage. The premium to be charged is an essential element of a contract for insurance. Associated Mutuals, Inc. v. Pope Lumber Co., 200 Ga. 487, 496, 37 S.E.2d 393 (1946). See also, Thurmond v. Sovereign Camp Woodmen of World, 171 Ga. 446, 155 S.E. 760 (1930) (no recovery on incomplete contract of insurance); Charter Investment & Development Co. v. Urban Medical Services, Inc., 136 Ga.App. 297, 220 S.E.2d 784 (1975) (alleged contract is unenforceable in absence of agreement as to cost). In Charter a corporation was retained to obtain a loan, and was promised a brokerage fee consisting of two percent of the loan amount. The broker failed to obtain a loan and eventually a loan was obtained from another source. The Georgia Court of Appeals held that the broker could not prevail, where its two percent commission could not be determined due to the fact that the broker did not procure a loan. The lack of mutuality of obligation was held to be fatal to the plaintiffs case. An analogous situation exists in the instant case, in which neither the premium to be paid nor the limit of liability were established. The terms are simply too indefinite for a contract for Medpay or PIP coverage to be found.

In light of the foregoing the court is constrained to conclude that the defendant’s motion for summary judgment must be granted. The clerk is directed to enter judgment for the defendant.

      . This definition differs from that contained in Title 40 (motor vehicles and traffic). O.C.G.A. § 40-1-1(29) defines motor vehicle as “every vehicle which is self-propelled.”