Illinois Qui Tam Lawsuits—Private Enforcement Of a State Claim: A Bonanza For A Plaintiff’s Lawyer And A Rip-Off Of Retailers

Today’s Booze Rules post was authored by the newest member of the Hinman & Carmichael LLP team – John W. Edwards II. John is joining the firm on January 1st as Senior Counsel after a 40-year career as a partner at Jones Day. John is one of the country’s foremost litigators and will be managing the firm’s litigation, arbitration and mediation practice.

An Illinois lawyer has filed over 300 Qui Tam cases against out-of-state sellers of products in Illinois state court.  The most recent group of cases targets wineries that ship directly to consumers under permits issued by the State of Illinois (“DTC”) and wine retailers selling alcoholic beverages to Illinois residents outside of Illinois, which the buyer then ships into Illinois.  The cases against the wineries attempt to take advantage of the lawyer’s expansive reading of a confusing Illinois tax provision, and the cases against the out-of-state wine retailers challenge the legality of their business model.

This blog post outlines the defenses, explains the current thinking on appropriate prophylactic changes to websites to reduce the danger of being involved and points affected industry members to defense counsel coordinating these cases in Illinois.

Qui Tam – What is it?

A Qui Tam action is a private citizen whistleblower lawsuit in the name of the state to enforce a state law that ordinarily would be enforced by the state Attorney-General.  Typically, the Attorney-General must consent to the action.  The plaintiff is not motivated by public spirit.  Rather, the plaintiff is entitled to a percentage (at least 25% in Illinois) of what is recovered for the State, plus “reasonable attorneys” fees.”  Thus, the stakes in a Qui Tam action are substantially higher than they would be if the defendant merchant were to resolve its tax liability (if any) administratively with the state. The ability to bring a Qui Tam case exists in many states so if this plaintiff prevails this might be the beginning of other lawyers bringing similar actions in other states.

The Illinois cases have been filed by Stephen P. Diamond, PLC, 332 Michigan Avenue, Chicago, Illinois 60604.  Diamond files as the plaintiff himself, eliminating the need to share any recovery or settlements with a “client.”  Pretty nice work for a lawyer only interested in generating revenue.

Explaining the Illinois Use Tax Claims

            Most of Diamond’s cases, including those against wineries selling DTC, have been framed as an effort to collect unpaid Illinois Use Tax.  Illinois imposes two taxes on Illinois consumers who purchase goods outside of Illinois and then import them: (1) a sales tax on the selling price of the merchandise, and (2) a Use Tax of 6.25% on certain shipping and handling charges.  Although the tax is imposed on consumers, Illinois requires out-of-state entities selling into Illinois to collect the Sales and Use Taxes and to pay them to the State.  In this case wineries are permitted to ship into Illinois via a DTC permit and thus are subject to Illinois jurisdiction. Out of state wine retailers do not have the same privilege and are ineligible for a permit – more about the jurisdictional implications of this below.

            Surprised to hear that Illinois requires collection of a tax on shipping & handling charges?  So, apparently, were hundreds of other merchants who have been sued by Mr. Diamond.  Why the confusion?

            Illinois regulations state the Use Tax is not imposed on shipping charges if they are “separate from the price of goods” or reflect the retailer’s actual charges from a common carrier.  Use Tax is, however, imposed on shipping charges that exceed actual cost or that are “included in the selling price” of the goods.  While that seems straightforward enough, in 2009, the Illinois Supreme Court ruled that, even if an internet merchant separately states shipping & handling charges on its website, those charges are “included in the selling price” and thus subject to Use Tax, if the buyer has to pay those charges to obtain the goods.

            The regulations have not been amended to reflect the Supreme Court’s ruling.   Thus, merchants and their advisors who check the Illinois tax regulations are not alerted to the possibility that they may be liable to collect Use Tax on shipping & handling, even though those charges are separately stated on their websites.  Moreover, it appears that Illinois itself does not agree with the expansive view of Use Tax liability advanced in Diamond’s lawsuits because Diamond has filed claims against merchants that have been audited by the Department of Revenue and found to be compliant with Illinois law.

What Diamond is doing is diabolically clever

Diamond has been ordering a small amount of merchandise—typically, a single bottle of wine—on one or two occasions, and then printing out the web page showing that the merchant collected Illinois taxes on the merchandise, but not shipping & handling.  Diamond then files a Qui Tam action to collect the unpaid Use Tax on all of the merchant’s sales to Illinois consumers over the preceding six years under the Illinois statute of limitations.  He also claims that the merchant (at least those who filed tax returns) violated the Illinois False Claims Act by filing “false” (i.e., erroneous) tax returns.  That Act allows recovery of three times the amount of tax owed and a civil penalty of $5,000-10,000 per violation.  Diamond also seeks “reasonable attorneys’ fees” for representing himself.  The various multipliers and add-ons, of course, transform even a fairly modest amount of uncollected Use Tax into a significant potential liability, designed to motivate settlements on terms favorable to Diamond.

The claims against out-of-state wine retailers

            Diamond has recently filed a series of cases against wine retailers in states other than Illinois that sell alcoholic beverages to Illinois residents under terms that make clear that title to the goods passes to the consumer in the state where the retailer is located, not in Illinois.  The consumer, not the retailer, is responsible for shipping the goods to the destination of his or her choice, whether Illinois or elsewhere.   The Uniform Commercial Code (“UCC), adopted in Illinois and almost every other state, specifically permits a buyer and seller to agree on where and when title to the goods passes.  The sellers’ website Terms & Conditions typically provide that title passes to the buyer in the wine retailer’s home state at the time the transaction closes and that subsequent shipment is at the buyer’s discretion and risk.  Under those circumstances, the buyer, not the wine retailer, should be obligated to pay Illinois Sales Tax, if the buyer chooses to ship the goods to Illinois, and the Use Tax should not apply, since the buyer separately chooses how and where to ship the goods.

            In the recent cases, Diamond claims that the out-of-state wine retailers failed to obtain the required permits to sell alcohol DTC in Illinois and, separately, that they violated the False Claims Act by failing to collect Sales and Use Tax on the out-of-state transactions.  The first claim directly challenges the retailers’ business model, premised on the UCC provisions allowing the buyer and seller to agree on where and when title to the goods passes and, of course, ignores the fact that out of state wine retailers are ineligible for DTC permits in Illinois.  So far as we are aware, this is the first (and perhaps the most important) direct challenge to that business model. Of note is the fact that many small wineries also use this business model in lieu of creating a network of DTC permits around the country.

Potential Defenses –Where can we go with these cases?

            Every case will present somewhat unique facts, depending on the defendant’s website language, practices, and Illinois tax history.  Common defense themes also run throughout these cases, including the following.

            The “no-knowledge” defense: To recover under the Illinois False Claims Act, Diamond must prove that the defendant “knowingly” failed to collect Use Tax on its shipping & handling charges and then filed false tax returns.  Illinois law defines “knowingly” to mean actual knowledge, deliberate ignorance of the facts, or reckless disregard of the facts.  However one chooses to interpret that statutory psychobabble, it at least means that an innocent or even negligent mistake does not suffice to support liability under the False Claims Act with its enhanced penalties.  The fact that Diamond has found over 300 internet retailers who were unaware of what Diamond claims to be their obligation to collect Use Tax on shipping & handling and who relied on the plain language of the Illinois tax regulations (unchanged since the Supreme Court’s ruling) alone supports the conclusion that, if all of those retailers erred, they did so innocently and are not liable under the False Claims Act.

            The “unclean hands” defense:  The “unclean hands” or “in pari delicto” (“in equal fault”)  defenses involve the fact that Diamond, who knows of his expansive reading of the Illinois Use Tax and is himself liable for that tax, if due (the retailer being obligated only to collect it), and is purchasing something from the defendant, sees that Use Tax is not collected on shipping & handling, and then sues the defendant for failing to collect the tax that Diamond himself owes.  Most reasonable people would conclude that Diamond should not be entitled to collect an enormous bounty for the retailer’s innocent failure to collect the tax that Diamond knowingly failed to pay.

            The False Claims Act requires the plaintiff to prove that he or she had knowledge of the facts underlying the claim that did not come from public sources.  While defendants have had limited success in using that provision as a basis to dismiss Diamond’s claims, it does provide a basis for resisting discovery demands.

            The UCC defense: For the cases involving out-of-state wine retailers (and wineries) selling alcohol to Illinois residents in the retailer’s home state, the UCC provisions discussed earlier provide the central defense.  No Illinois Sales Tax is due on the sale, because it occurred in a different state, and no Use Tax is due, because the buyer had complete discretion as to whether to ship and to where.  For those merchants that are not licensed in Illinois, have no presence there,  have never made a sale there, and have themselves never shipped any products to Illinois, there is a real question as to whether the Illinois courts have jurisdiction over them.

The litigation to Date

            Most of the cases that Diamond has filed to date have settled on terms favorable to him.  The cases that have been contested have had mixed results.  In a 2012 decision involving J. Crew, Inc., the Illinois trial court refused to dismiss Diamond’s claims at the pleading stage, holding that he had alleged enough to allow discovery and, likely, trial as to the issue of whether the defendant acted “knowingly.”  The court also rejected the defendant’s argument that Diamond had acquired knowledge of the facts from public sources.

            More recently, the same court ruled in two cases that the defendant had not knowingly filed false claims.  In both cases, the defendant had been audited by the Illinois Department of Revenue, which had concluded that no Use Tax was owed.  The court did not, however, hold that the audit was a complete bar to Diamond’s claim.  Moreover, both rulings were made after the cases had been tried to the court, not on pretrial motions.

The next steps in being defended

            Diamond is now in the process of serving his next round of cases.  We are coordinating our defense efforts through Mark Rotatori of the Chicago Office of Jones Day, who has extensive experience with these cases.  If you are served with a summons and complaint, please notify us immediately, so that we can timely protect your rights, contact Mark directly if you desire to be defended or consult with your counsel with respect to your options.

            If you have not yet been served, it would be prudent to monitor your website for orders from Stephen Diamond or anyone at the 332 South Michigan Avenue address in Chicago.   We are recommending to our clients that, if they receive an order from that address, they politely decline to fill it.  We believe that Diamond needs to consummate a sale in order to sue in Chicago.  If you already filled an order from that address, monitor your mail and please review the preceding paragraph.

How to avoid involvement

Going forward, there are two possible ways to protect against future liability.  Both involve reprogramming your website:

·         Your best chance (there are no guarantees) of avoiding exposure under Diamond’s expansive reading of the Illinois Supreme Court’s ruling is by clearly separating shipping & handling charges from the sale transaction.  Giving your buyers the option of having you ship the goods, picking them up at your location, or independently arranging for shipping themselves should sufficiently separate the sale and shipment transactions to avoid any question of Use Tax liability.  Many wine merchants who are not licensed for DTC sales in Illinois already utilize these provisions.  We will be working with our clients on terms that appropriately protect them going forward. We recommend that you work with your own counsel on this, and that you do it quickly.

·         You can begin to collect Illinois Use Tax on shipping & handling, which will cut off liability going forward.  However, as noted above, it is unclear that the Illinois Department of Revenue agrees with Diamond that collection of the Use Tax is required, and that does solve past liability exposure.  Depending on your circumstances, it may be possible to reach a settlement with the Department of Revenue on your liability, if any, for past Use Tax collection on terms more favorable than could be obtained from Diamond. This alternative is being explored by counsel in Illinois.

            The Illinois Qui Tam actions are an unfortunate but serious threat to the DTC industry, and particularly to merchants that are not licensed to ship directly to Illinois but make sales to Illinois residents in other states.