Source: s3://data.kl3m.ai/documents/govinfo/USCOURTS/USCOURTS-cand-4_07-cv-04762/USCOURTS-cand-4_07-cv-04762-56/pdf.json

Nature of Suit Code: 870
Nature of Suit: Tax Suits
Cause of Action: 26:7402 IRS: Petition to Enforce IRS Summons

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United States District Court

For the Northern District of California

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UNITED STATES DISTRICT COURT

NORTHERN DISTRICT OF CALIFORNIA

UNITED STATES OF AMERICA,

Plaintiff,

v.

CHARLES CATHCART, ET AL,

Defendants.

__________________________________/

No. C-07-4762 PJH (JCS)

REPORT AND RECOMMENDATION RE

PLAINTIFF’S RENEWED MOTION FOR

DEFAULT JUDGMENT AS TO

DEFENDANT DERIVIUM USA [Docket No.

400]

I. INTRODUCTION

On December 17, 2007, Plaintiff filed a motion for default judgment as to Defendant

Derivium Capital (USA), Inc., which was referred to the undersigned magistrate judge for a report

and recommendation. Default against Derivium Capital (USA), Inc. (“Derivium USA”) was entered

by the Clerk’s office on December 21, 2007. Docket No. 19. Subsequently, the owner of Derivium

Capital (USA), Inc., Charles Cathcart (“Cathcart”), appeared in this action. Thereafter, Plaintiff

agreed to withdraw the Motion without prejudice to refiling it once Plaintiff’s claims against Charles

Cathcart had been determined in order to avoid the possibility of inconsistent outcomes. Docket No.

60. A trial on stipulated facts against Charles Cathcart was scheduled to begin on November 19,

2009. See Order dated November 23, 2009, Docket No. 399. The Court entered a stipulated

permanent injunction against Charles Cathcart. Id. Derivium USA did not appear or otherwise

defend the action.

Plaintiff now renews its motion for Default Judgment (“the Motion”) against Defendant

Derivium USA. Docket No. 400. The matter was again referred to the undersigned for a report and

recommendation. Docket No. 401. A hearing was held on February 12, 2010, at which Plaintiff

appeared by telephone. Defendant did not appear. For the reasons set forth more fully below, the

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Derivium USA is the only remaining defendant to this action. The case has been resolved

against every other defendant in the case. See Docket Nos. 9, 17, 129, 318, 319, 320, 325, 382, 399. 

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Derivium Capital was formerly a defendant in this action, but has since agreed to a permanent

injunction. Derivium Capital was a predecessor of Derivium USA.

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Court recommends that the Motion for Default Judgment as to Defendant Derivium USA be

GRANTED and a permanent injunction be entered.1

II. ANALYSIS

A. Background

The present action was filed by the Plaintiff United States of America in 2007 alleging that

Defendants are subject to penalty under Internal Revenue Code (“I.R.C.”) 26 U.S.C. §§ 6700 and

6701, and seeking an injunction pursuant to §§ 7402 and 7408 against, among others, Robert Nagy

and co-defendants Charles Cathcart and Derivium USA2

 based upon their participation in a 90%

stock loan program. Plaintiff sought to enjoin Defendants from: (1) organizing, promoting,

marketing, or selling any tax shelter plan, or any other arrangement that advises or encourages others

to attempt to violate the internal revenue laws or unlawfully evade the assessment or collection of

their federal tax liabilities; (2) engaging in conduct subject to penalty under § 6700, i.e., making or

furnishing, in connection with the organization or sale of a shelter, plan, or other arrangement, a

gross valuation or overstatement or a statement about securing any tax benefits that they know or

have reason to know is false or fraudulent as to any material tax matter; and (3) engaging in any

other conduct that interferes with the administration and enforcement of the internal revenue laws. 

Plaintiff has sought only injunctive relief against Derivium USA. 

B. The Stipulated Permanent Injunction Against Charles Cathcart

On the morning of trial, November 19, 2009, Defendant Charles Cathcart, informed the

district court that he would not contest the factual allegations against him. As a result, the district

court entered an order, based upon stipulated facts, finding that Cathcart had engaged in conduct

covered by 26 U.S.C. § 6700, and ordered an injunction under I.R.C. § 7408 to prevent him from

engaging in such further conduct. The court found that, under I.R.C. § 7402(a), injunctive relief

against Cathcart was “necessary or appropriate for the enforcement of the Internal Revenue laws.” 

Pursuant to I.R.C. § § 7402(a) and 7408, the court entered the following injunction against

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Defendant Cathcart, preventing him from, directly or indirectly, by use of any means or

instrumentalities:

1. Organizing, promoting, marketing, selling, or implementing the “90% Loan” program that

is the subject of the complaint herein;

2. Organizing, promoting, marketing, selling, or implementing any program, plan or

arrangement similar to the 90% Loan program that purports to enable customers to receive valuable

consideration in exchange for stocks and other securities that are transferred or pledged by those

customers, without the need to pay tax on any gains because the transaction is characterized as a

loan rather than a sale;

3. Engaging in any conduct subject to penalty under I.R.C. § 6700, i.e., by making or

furnishing, in connection with the organization or sale of a plan or arrangement, a gross valuation

overstatement or a statement Cathcart knows or has reason to know to be false or fraudulent as to

any material matter under the federal tax laws; and

4. Selling or organizing, or causing the sale or organization, of any type of corporation, trust,

limited liability company, arrangement of business entities, or plan which he knows or has reason to

know advocates or facilitates material non-compliance with the federal tax laws.

In addition, the district court ordered that he United States may conduct post-judgment

discovery to monitor compliance with the injunction, and also retained jurisdiction over the action

for the purposes of implementing and enforcing the final judgment and any additional orders

necessary and appropriate to the public interest.

C. Jurisdiction

When a plaintiff seeks entry of default judgment against a defendant who has failed to appear

or otherwise defend the action, the court has an affirmative duty to determine whether it has

jurisdiction over both the claims and the parties. In re Tuli, 172 F.3d 707, 712 (9th Cir. 1999). The

Court will therefore assess whether it has subject matter jurisdiction over this action and whether

personal jurisdiction over the Defendant Derivium USA exists.

1. Subject Matter Jurisdiction

District courts have original jurisdiction over civil cases arising under the

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Constitution, laws or treaties of the United States. 28 U.S.C. § 1331. As stated in greater detail

above, Plaintiff the United States of America has asserted claims against Defendant Derivium USA

to enjoin him for alleged violations of the federal tax laws. The district court may therefore properly

exercise jurisdiction over this matter.

2. Personal Jurisdiction

In the present case, Plaintiff contends that the district court has specific personal

jurisdiction over the defendants. Defendant Derivium USA is a Delaware corporation registered to

do business in the State of South Carolina. Compl. ¶ 13. Plaintiff alleges that Defendant directed its

activities to the forum state, California, by marketing the 90% Loan scheme to customers located in

this district. Motion at 4 (Docket 400), citing Yahoo! Inc. v. La Ligue Contre Le Racisme Et

L’Antisemitisme, 433 F.3d 1199, 1205-07 (9th Cir. 2006) (discussing standards for personal

jurisdiction). In addition, Plaintiff alleges that Derivium USA had staff based in San Francisco

during its period of active promotion of the 90% Loan scheme. Motion at 2 citing Second Amended

Complaint at ¶¶ 2, 28. 

Because Defendant had an office and staff in San Francisco and marketed its products to

California residents, there is sufficient evidence of systematic and continuous contacts with this

forum, as well as sufficient evidence of purposeful availment, for the Court to find that there is both

specific and general personal jurisdiction over Defendant Derivium USA in California. See e.g., 

Perkins v. Benguet Consolidated Mining Co., 342 U.S. 437, 447-49 (1952) (upholding finding of

general jurisdiction where the president of a Phillippines-based corporation maintained an office in

the forum state, had bank accounts in the forum state, and held several directors’ meetings in the

forum state). 

Moreover, the Court finds that exercising personal jurisdiction over Defendant Derivium

USA would be reasonable. Derivium USA purposefully availed itself of the privilege of doing

business in California through its substantial, continuous, and systematic contacts with California. 

Due to its ties with California, including the presence of an office and staff here, the Court concludes

that Derivium USA had fair warning that it could be haled into court in California. Accordingly, 

asserting jurisdiction over Derivium USA is reasonable and does not offend “traditional notions of

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fair play and substantial justice.” Int’l Shoe Co. v. State of Washington, 326 U.S. 310, 316 (1945).

D. Legal Standard Applicable to Default Judgment Motions

Pursuant to Rule 55(b)(2) of the Federal Rules of Civil Procedure, the court may enter a

default judgment where the clerk, under Rule 55(a), has previously entered the party’s default based

upon failure to plead or otherwise defend the action. Fed. R. Civ. P. 55(b). A defendant’s default,

however, does not automatically entitle the plaintiff to a court-ordered default judgment. Draper v.

Coombs, 792 F.2d 915, 924-25 (9th Cir. 1986). The district court has discretion in its decision to

grant or deny relief upon an application for default judgment. Aldabe v. Aldabe, 616 F.2d 1089,

1092 (9th Cir. 1980); Lau Ah Yew v. Dulles, 236 F.2d 415, 416 (9th Cir. 1956) (affirming district

court’s denial of default judgment). The Court may consider the following factors in deciding

whether to enter a default judgment: 

(1) the possibility of prejudice to the plaintiff, (2) the merits of

plaintiff’s substantive claim, (3) the sufficiency of the complaint, (4)

the sum of money at stake in the action; (5) the possibility of a dispute

concerning material facts; (6) whether the default was due to

excusable neglect, and (7) the strong policy underlying the Federal

Rules of Civil Procedure favoring decisions on the merits.

Eitel v. McCool, 782 F.2d 1470, 1471-72 (9th Cir. 1986). 

In considering the sufficiency of the complaint and the merits of the plaintiff’s substantive

claims, facts alleged in the complaint not relating to damages are deemed to be true upon default. 

Geddes v. United Fin. Group, 559 F.2d 557, 560 (9th Cir. 1977); Fed. R. Civ. P. 8(d). On the other

hand, a defendant is not held to admit facts that are not well-pleaded or to admit conclusions of law. 

Nishimatsu Constr. Co. v. Houston Nat’l Bank, 515 F.2d 1200, 1206 (5th Cir. 1975). As a result,

where the allegations in a complaint are not “well-pleaded,” liability is not established by virtue of

the defendant’s default and default judgment should not be entered. Id. 

E. Analysis of Eitel Factors

1. Possible Prejudice to Plaintiff

Plaintiff would suffer prejudice if default judgment is not entered because Plaintiff would be

without another course of recovery. Denying a plaintiff a means of recourse is by itself sufficient to

meet the burden posed by this factor. See e.g., Phillip Morris, USA, Inc. v. Castworld Prods., Inc.,

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At the trial, Defendant Cathcart stipulated to the majority of the United States’ allegations

against him. See Docket No. 398, 1a & d (Minute entry reflecting Cathcart’s stipulation to the majority

of the United States’ proposed findings of fact).

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219 F.R.D. 494, 499 (C.D. Cal. 2003). Moreover, the allegations in this case, accepted as true on

default, demonstrate that Defendant Charles Cathcart frequently changed the names of the entities or

created new entities through which to conduct the loan scheme. Second Amended Compl. at ¶¶ 20,

22-24. Derivium USA was created in order to take over the marketing of the 90% Loan Program. 

Id. at ¶¶ 33-34. Therefore, Plaintiff would be prejudiced by not having an injunction against

Derivium USA, similar to that ordered by the district court as to Defendant Cathcart. Without it,

Derivium USA could continue with the unlawful scheme. 

2. Sufficiency of the Complaint and Substantive Merits of Claim

Plaintiff alleges that Charles Cathcart created Derivium USA to take over the responsibility

of marketing the 90% Loan program. Second Amended Compl. at ¶33-34. Charles Cathcart is the

sole owner of Derivium USA. Id. ¶ 11. Derivium USA promoted “the 90% Stock Loan” and other

products to people who held appreciated securities with a relatively low basis, promising that the

transactions would allow customers to “monetize” their securities without paying taxes on their

capital gains. Id. ¶¶ 49-52. The Complaint alleges that Derivium USA made numerous false or

fraudulent statements to prospective customers with respect to the tax benefits of the 90% Loan

program (id. at ¶¶ 76-82), including the statement that the transactions were not taxable because they

are genuine loans. Id. ¶77. The evidence at the trial of this matter against Cathcart provides further

support for Plaintiff’s allegations against Cathcart’s company, Derivium USA.3

 As the district court

found previously in this case, the Loan transactions were simply sales of securities disguised as

loans in order to avoid taxes. Id. ¶54, 82; see also Order dated September 22, 2009, Docket 333

(order granting summary judgment to the plaintiff on the loan-versus-sale issue). Derivium USA

has failed to respond in any way to the lawsuit, and has not presented any defense, meritorious or

otherwise. For the reasons stated more fully below, the Court finds that this factor weighs in favor

of granting the motion for default judgment and entering an injunction identical to that ordered as to

Defendant Charles Cathcart, Derivium’s sole owner.

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a. IRC §§ 6700 and 7408

Section 7408 authorizes a court to enjoin persons who have engaged in any conduct subject

to penalty under § 6700 if the court finds that injunctive relief is appropriate to prevent the

recurrence of such conduct. 26 U.S.C. § 7408. Section 6700 penalizes anyone who organizes or

assists in the organization of: 

a partnership or other entity, any investment plan or arrangement, or any other plan or

arrangement, or participates directly or indirectly in the sale of any interest in an entity or

plan or arrangement, . . . and makes or furnishes or causes another person to make or furnish

(in connection with such organization or sale) a statement with respect to the allowability of

any deduction or credit, the excludability of any income, or the securing of any other tax

benefit by reason of holding an interest in the entity or participating in the plan or

arrangement which the person knows or has reason to know is false or fraudulent as to any

material matter, or a gross valuation overstatement as to any material matter. 

26 U.S.C. § 6700.

To establish a violation of § 6700 warranting an injunction under § 7408, the government

must prove that defendant: (1) organized or sold, or participated in the organization or sale of, an

entity, plan, or arrangement; (2) made or caused to be made, false or fraudulent statements

concerning the tax benefits to be derived from the entity, plan, or arrangement; (3) knew or had

reason to know that the statements were false or fraudulent; (4) the false or fraudulent statements

pertained to a material matter; and (5) an injunction is necessary to prevent recurrence of this

conduct. United States v. Estate Preservation Servs., 202 F.3d 1093, 1098 (9th Cir. 2000) citing

I.R.C. §§ 6700(a), 7408(b). “Under § 6700, any ‘plan or arrangement’ having some connection to

taxes can serve as a ‘tax shelter’ and will be an ‘abusive’ tax shelter if the defendant makes the

requisite false or fraudulent statements concerning the tax benefits of participation.” United States

v. Raymond, 228 F.3d 804, 811 (7th Cir. 2000). “Congress designed section 6700 as a ‘penalty

provision specifically directed toward promoters of abusive tax shelters and other abusive tax

avoidance schemes.’ ” United States v. White, 769 F.2d 511, 515 (8th Cir. 1985) (emphasis in

original). The district court has previously found in this case that the Plaintiff need not specifically

prove that Defendants were involved in an abusive tax shelter to establish a violation of § 6700

warranting an injunction under § 7408. Rather, the district court concluded that Plaintiff must only

prove the five elements set forth by the Ninth Circuit in Estate Preservation Servs., 202 F.3d at

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The following factual findings are taken directly from Judge Hamilton’s Order dated September

22, 2009. Docket No. 333.

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1098. Section 6700 is directed not only toward promoters of abusive tax shelters, but also toward

other abusive tax avoidance schemes. Id.

Under § 7408, conduct may be enjoined if the court finds: 1) that the person has engaged in

any conduct subject to penalty under section 6700 (relating to penalty for promoting abusive tax

shelters, etc.) or section 6701 (relating to penalties for aiding and abetting under-statement of tax

liability), and (2) that injunctive relief is appropriate to prevent recurrence of such conduct. 26

U.S.C. § 7408(a). 

In an order dated September 22, 2009, the district court granted in part and denied in part,

Defendants’ motions for summary judgment. The court found that the undisputed evidence revealed

that4

: as part of the loan transaction in question, legal title of a customer’s securities transfers to

Derivium USA (for example) during the purported loan term in question, which vests possession of

the shares in Derivium’s hands for the duration of the purported loan term; that the customer must

transfer 100% of all shares of securities to Derivium USA and that once transferred, Derivium USA

sells those shares on the open market, and that once sold, Derivium USA transfers 90% of that sale

amount to the customer as the “loan” amount, keeping 10% in Derivium USA’s hands; that during

the term of the loan, the Master Loan Agreement provides that Derivium USA has the right to

receive all benefits that come from disposition of the customer’s securities, and that the customer is

not entitled to these benefits; that the customer is furthermore prohibited from repaying the loan

amount prior to maturity and is not required to pay any interest before the loan maturity date; and

that, at the end of the purported loan term, the customer is not required to repay the amount of the

loan (but merely allowed to do so as one option at the loan’s maturity date) and can exercise the

option to walk away from the loan entirely at the maturity date without repaying the principle; and

thus, can conceivably walk away from the transaction without paying interest at all on the loan. 

The district court concluded that analysis of these and other undisputed facts pursuant to

either the benefits/burdens approach outlined in Grodt & McKay Realty, Inc. v. Commissioner of

Internal Revenue, 77 T.C. 1221, 1236 (Tax Court 1981), or the approach outlined in Welch v.

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Comm’r, 204 F.3d 1228, 1230 (9th Cir. 2000), compelled the conclusion that the transactions in

question constituted sales of securities, rather than bona fide loan transactions. See e.g., Grodt, 77

T.C at 1236-37 (applying multi-factor test to determine point at which the burdens and benefits of

ownership are transferred for purposes of qualifying a transaction as a sale); Welch, 204 F.3d at

1230 (examining factors necessary to determine whether a transaction constitutes a bona fide loan). 

The district court also found that the “substance over form doctrine” further supported the

conclusion that, in looking beyond the actual language of the Master Loan Agreement to the totality

of the undisputed facts, the substance of the transaction between the parties constituted a sale, and

not a bona fide loan. See, e.g., Harbor Bancorp & Subsidiaries v. Comm’r, 115 F.3d 722, 729 (9th

Cir. 1997) (it is axiomatic that tax law follows substance and not form). 

The district court therefore granted the government’s motion for partial summary judgment

on the issue whether the 90% loan transactions in question constituted sales of securities, as a matter

of law. The element of scienter was the primary issue left to the finder of fact. A trial was held on

November 19, 2009, at which Defendant Cathcart appeared and did not contest the majority of the

factual allegations against him. The court held a trial on stipulated facts and entered a permanent

injunction against him.

Reviewing the above evidence and legal authorities cited above, the Court concludes that the

evidence against Defendant Derivium USA is strong and that the merits of the case support entry of

default judgment here. The Court concludes that an injunction against Derivium is necessary or

appropriate for the enforcement of the internal revenue laws. See e.g., United States v. Thompson,

395 F.Supp.2d 941, 945-46 (E.D. Cal., 2005) (“Injunctive relief is appropriate if the defendant is

reasonably likely to violate the federal tax laws again.”)

3. The Sum of Money at Stake

In the Complaint, the United States seeks only equitable relief. Therefore, the Court finds

that the fourth Eitel factor’s concern with awarding large sums of money without an adjudication on

the merits does not alter the analysis above. This factor supports entry of default judgment. See

e.g., Levi Strauss & Co. v. Toyo Enterprise Co., 2009 WL 3353097 at *10 (N.D. Cal. 2009).

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After entry of default, the United States amended its complaint on two occasions to add

defendants and plead more facts concerning those defendants. Docket Nos. 57 & 124. Because the

amended complaints did not add new claims against Derivium USA and because Derivium USA was

in default, service of the subsequent complaints was not required under the Federal Rules of Civil

Procedure. Fed.R.Civ.P. 5(a)(2); Employee Painters’ Trust v. Ethan Enterprises, Inc., 480 F.3d 993,

999 & n.6 (9th Cir. 2007)

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4. Possibility of Dispute Concerning Material Facts

The fifth Eitel factor examines the likelihood of dispute concerning the material factors

surrounding the case. As detailed above, Plaintiff has sufficiently alleged and has submitted exhibits

demonstrating Defendant’s violations of the tax laws. In addition, Derivium USA’s sole owner,

Charles Cathcart, stipulated to the majority of the factual allegations against him at his trial. It is

therefore unlikely that Defendant would be able to present facts raising any dispute as to these

allegations. Accordingly, this factor favors entry of default judgment.

5. Excusable Neglect

There is no indication that Derivium USA’s failure to answer or appear was the result of

excusable neglect. The Complaint in this action was served on Derivium USA on October 10,

2007.5

 Docket No. 15 (proof of service). There has been no attempt on Derivium USA’s part to

respond to Plaintiff’s allegations. Therefore, the Court concludes that Defendant’s failure to respond

was not due to excusable neglect. 

6. Policy for Deciding on the Merits

The last Eitel factor examines whether the strong policy favoring deciding cases on the

merits prevents a court from entering default judgment. Default judgments are disfavored, and cases

should be decided on the merits when possible. Pena v. Seguros La Comercial, S.A., 770 F.2d 811,

814 (9th Cir. 1985). Where, as here, a Defendant’s failure to appear “makes a decision on the merits

impractical, if not impossible,” entry of default judgment is warranted. Pepsico, Inc. v. Cal. Sec.

Cans, 238 F.Supp.2d 1172, 1177 (C.D.Cal.2002). Despite Defendant Cathcart’s decision to litigate

this case for years, his company, Derivium USA, has not defended against the action. Derivium

USA has had ample notice of the suit and many opportunities to appear. On this record, it is clear to

the Court that given that Defendant Derivium USA has failed to appear or respond in this matter, a

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decision on the merits is impossible. This final factor favors entry of default judgment as well.

III. CONCLUSION

For the foregoing reasons, the Court recommends that Plaintiff’s Motion for Default

Judgment be GRANTED. The Court recommends that the district court find that:

A. Derivium USA has engaged in conduct covered by 26 U.S.C. § 6700, and that injunctive

relief is appropriate under I.R.C. § 7408 to prevent it from engaging in such further conduct;

and

B. under I.R.C. § 7402(a), injunctive relief against Derivium is “necessary or appropriate for the

enforcement of the Internal Revenue laws.”

In addition, the Court recommends that the district court enter the following injunction:

A. Pursuant to I.R.C. § § 7402(a) and 7408, Derivium USA is enjoined and restrained from,

directly or indirectly, by use of any means or instrumentalities:

1. Organizing, promoting, marketing, selling, or implementing the “90% Loan”

program that is the subject of the complaint herein;

2. Organizing, promoting, marketing, selling, or implementing any program, plan or

arrangement similar to the 90% Loan program that purports to enable customers to receive

valuable consideration in exchange for stocks and other securities that are transferred or

pledged by those customers, without the need to pay tax on any gains because the transaction

is characterized as a loan rather than a sale;

3. Engaging in any conduct subject to penalty under I.R.C. § 6700, i.e., by making or

furnishing, in connection with the organization or sale of a plan or arrangement, a gross

valuation overstatement or a statement Derivium USA knows or has reason to know to be

false or fraudulent as to any material matter under the federal tax laws; and

4. Selling or organizing, or causing the sale or organization, of any type of

corporation, trust, limited liability company, arrangement of business entities, or plan which

he knows or has reason to know advocates or facilitates material non-compliance with the

federal tax laws.

Finally, the Court recommends that the United States be permitted to conduct post-judgment

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discovery to monitor compliance with the injunction and retain jurisdiction over this action for the

purposes of implementing and enforcing the final judgment and any additional orders

necessary and appropriate to the public interest.

IT IS SO ORDERED.

Dated: February 12, 2010

_________________________________

JOSEPH C. SPERO

United States Magistrate Judge

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