The convictions of two tax attorneys for conspiring to peddle illegal tax shelters at Ernst & Young were vacated yesterday by a federal appeals court.

The U.S. Court of Appeals for the Second Circuit threw out the convictions on all counts of attorneys Martin Nissenbaum and Richard Shapiro in a conspiracy that included five different tax shelters from 1999 to 2001.

The circuit also let stand the convictions of a third tax attorney in the Ernst & Young tax shelter case, Robert Coplan.

The panel was divided, 2-1, on vacating most of the convictions, with Judges Jose Cabranes (See Profile) and Joseph McLaughlin (See Profile) in the majority holding there was insufficient evidence to find that Shapiro and Nissenbaum knew about the conspiracy and participated in it.

Judge Amalya Kearse (See Profile) dissented on the grounds there was sufficient evidence to support the convictions of the two men for conspiracy and tax evasion in United States v. Coplan, 10-583.

The circuit, in a 75-page opinion authored by Cabranes, also rejected the appeal of accountant Brian Vaughn, formerly of Ernst & Young, and refused to set aside the guilty plea to a single conspiracy charge by Charles Bolton, an investment advisor and asset-management company owner and operator.

The decision shakes up the result of a 10-week trial before Southern District Judge Sidney Stein (See Profile) that ended with a judgment of conviction in May 2009 for all four defendants on charges of conspiracy to defraud the government and two counts of tax evasion. Nissenbaum and Coplan were also convicted of obstruction of the Internal Revenue Service and Vaughn and Coplan of false statements to the IRS.

The government was able to persuade the jury that the four trial defendants were engaged in a scheme to provide cover from the IRS for high net-worth clients who were seeking to shelter at least $20 million from taxes.

Coplan, Nissenbaum and Shapiro were also accused of personally investing in a fifth tax shelter that, like the others, allegedly lacked “economic substance.”

At trial, the government tried to show the defendants hid the real nature of the tax shelters by creating “cover stories” as to their purpose, though they touted and supported the shelters by providing legal opinion letters that could be shown in defense to the IRS.

In 2010, Stein sentenced Coplan to three years in prison, Nissenbaum to 30 months, Shapiro to 28 months and Vaughn to 20 months. The appeals of the four men, plus Bolton, were heard by the Second Circuit on Nov. 14, 2011.

Cabranes in his opinion explained that the core of the government’s case at trial was to prove a “Klein conspiracy” under 18 U.S.C. §371 after United States v. Klein, 247 F.2d 908 (2d Cir. 1957), with the objects of the conspiracy to defraud the United States, evade taxes and make false statements.

In order to prove a “Klein conspiracy,” he said, prosecutors must show a defendant entered into an agreement to obstruct a lawful function of government by deceitful or dishonest means and have committed at least one overt act to further that conspiracy.

The defendants tried to challenge the validity of the Klein doctrine on appeal and, citing Skilling v. United States, 130 S.Ct. 2896 (2010), urged the circuit to “pare” the body of §371 precedent “down to its core.”

But Cabranes, while noting “infirmities in the history and deployment” of the statute that has been criticized for having too broad a reach, said it was for the U.S. Supreme Court, and not the Second Circuit, to change the status quo, for it is “now well-established that the term ‘defraud’” reaches any conspiracy whose aim is to impair, obstruct or defeat the lawful functioning of any department of government.

‘Probably’ Isn’t Enough

Where Nissenbaum and Shapiro prevailed, however, was on their challenge to the sufficiency of the evidence before Stein as to each of the three objects of the conspiracy.

The “centerpiece” of the case against Shapiro, a tax lawyer of nearly four decades experience, Cabranes said, was that he coached fellow partner Thomas Dougherty to lie to the IRS and come up with non-tax explanations for one of the shelters, COBRA.

But “crucially,” Cabranes said, Dougherty testified at trial that Shapiro himself “believed [COBRA] worked under the law.”

Cabranes then found that the evidence was insufficient against Shapiro as to the tax evasion and false statements to the IRS objects of the conspiracy.

He said the conspiracy count required proof that Shapiro joined the conspiracy with the “specific intent” to violate the law but the evidence, even viewed in a light most favorable to the government, “remains, at best, in equipoise.”

Citing Sullivan v. Louisiana, 508 U.S. 275 (1993), Cabranes said it isn’t enough for a jury to determine that a defendant is “probably guilty.”

The principal conspiracy evidence against Nissenbaum was that he participated in the development of a template for a shelter called PICO Amnesty. But here, Cabranes said, Dougherty testified that Nissenbaum only reviewed template letters Dougherty had prepared and had done nothing more than make “non-substantive comments” such as “take out the bold” and “correct a typo.”

Other evidence that Nissenbaum was involved in keeping a trade account open on one shelter and reviewing documents on a solicitation letter for a third shelter was also scant, Cabranes said.

As with Shapiro, the court found the evidence insufficient as to all three objects of the conspiracy as related to Nissenbaum, and then found the evidence insufficient as well for the two counts of tax evasion.

And it vacated Nissenbaum’s conviction for violating §7212(a) in making four misleading statements to the IRS in an IRS Information Document Request (IDR) regarding another shelter—Tradehill— with Cabranes citing the “equivocal testimony” of two witnesses as to whether tax avoidance was the only objective of the Tradehill transaction, and the primary role of another attorney in drafting the response to the IDR.

The panel rejected several arguments offered by Coplan, including that Stein gave an unwarranted instruction to the jury on conscious avoidance.

It also held that Stein accurately stated the law when telling the jury to examine whether a tax transaction lacks “economic substance.” A tax transaction lacks economic substance, Stein had said, where “there was no reasonable possibility that the transaction would result in a profit.”

The dissent by Kearse came on the conspiracy counts and tax evasion counts. In both crimes, she said, the prosecution had produced sufficient evidence to support the convictions.

Assistant U.S. Attorney Richard Tarlowe argued for the government.

Denis P. Riordan of Riordan & Hogan in San Francisco argued for Coplan.

Nathan Lewin of Lewin & Lewin in Washington D.C. argued for Nissenbaum.

Lewin said the court’s opinion establishes what Nissenbaum had been contending from the beginning, “that there was absolutely no basis to bring any criminal prosecution against him and he did nothing wrong.”

“He is totally vindicated and its unfortunate he had to go through trial and the wait of an appeal,” Lewin said. “We are happy to see that justice is done.”

Alexandra A.E. Shapiro of Macht, Shapiro, Arato & Isserles argued for Richard Shapiro. “We’re extremely pleased with the right and just result,” Shapiro said.

Robert Anderson of Butler, Snow, O’Mara, Stevens & Cannada argued for Vaughn.

Marc N. Garber of The Garber Law Firm in Marietta, Georgia argued for Bolton.