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T.C. Memo. 2005-104

UNITED STATES TAX COURT

SANTA MONICA PICTURES, LLC, PERRY LERNER, TAX MATTERS PARTNER,

Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent

CORONA FILM FINANCE FUND, LLC, PERRY LERNER, TAX MATTERS PARTNER,

Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 6163-03, 6164-03.*

Filed May 11, 2005.

George W. Connelly, Jr., Linda S. Paine, and Phyllis Ann

Guillory, for petitioner.

James P. Thurston, H. Clifton Bonney, Jr., and Kenneth C.

Peterson, for respondent.

Petitioner in docket No. 6163-03 is Santa Monica Pictures,

LLC (SMP), Perry Lerner, Tax Matters Partner. Petitioner in

docket No. 6164-03 is Corona Film Finance Fund, LLC (Corona),

Perry Lerner, Tax Matters Partner. By Order dated Jan. 16, 2004,

we consolidated these cases for purposes of trial, briefing, and

opinion. References to petitioner in this opinion are to Perry

Lerner in his capacity as tax matters partner of SMP and Corona.

- 2 TABLE OF CONTENTS

FINDINGS OF FACT

II.

III.

IV.

.......................................

The Ackerman Group .................................

Perry Lerner ...................................

Peter Ackerman .................................

Somerville S Trust .............................

Rockport Capital, Inc. .........................

Rockport Advisors, Inc. ........................

Crown Capital Group ............................

The Credit Lyonnais Group ...........................

Credit Lyonnais .................................

Consortium de Realisation .......................

Generale Bank Nederlands ........................

Metro-Goldwyn-Mayer, Inc. ...........................

History of MGM Before 1990 ......................

Pathe Acquisition of MGM ........................

Sealion Corp. ...................................

Cashflow Problems of MGM-Pathe ..................

Facility Agreements with CLBN ...................

Credit Lyonnais Takes Control of MGM ............

1993 Financial Restructuring ....................

Carolco Pictures, Inc. ..........................

Sealion Settlement .............................

Credit Lyonnais Decides to Sell New MGM .........

Safari Acquisition Co. ..............................

The Safari Consortium ...........................

Safari Indicates Its Interest In New MGM ........

Investigation of MGM ............................

Kerkorian Moves In and Buys MGM .................

Debt Release and Assumption Agreement ...........

Subparticipation Agreement ......................

Dissolution of MGM Holdings and Formation

of SMHC .........................................

The CDR Transaction .................................

Initial Contact with Mr. Jouannet ...............

Negotiation and Drafting Process ................

- 3 1.

Rockport Capital Confirms Its Interest ......

Draft Term Sheet and Letter Agreements ......

Further Negotiation and Drafting ............

Santa Monica Pictures, LLC, is Formed .......

Final Agreements and Documents ..................

1. Side Letter Agreement .......................

2. Exchange and Contribution Agreement .........

3. SMP LLC Agreement ...........................

a. Amendment No. 1 .........................

b. Amendment No. 2 .........................

4. Deposit Account Agreement ...................

5. Advisory Fee Agreement ......................

6. Consent .....................................

Assignment to Santa Monica Finance, B.V. ........

Exercise of the Put .............................

Film Rights Contributed to SMHC .....................

Film Titles and Development Projects ............

History of the EBD Film Library .................

1. Epic Productions ............................

2. EBD (Rotterdam) Finance, B.V. ...............

3. Selection of Film Titles for CDR ............

4. Assignments Before the Contributions

to SMHC .....................................

5. Storage Conditions of the EBD Film

Library .....................................

Due Diligence for the CDR Transaction ...............

James Rhodes ....................................

Troy & Gould ....................................

1. Chain-of-Title and Record Search ............

2. Access Letters ..............................

VIII.

Other Film Activities ...............................

IX.

Relationship with TroMetro Films, LLC ...............

VI.

VII.

John H. van Merkensteijn ........................

TroMetro Films, LLC .............................

TroMetro’s Purchases of SMP’s Receivables .......

1. First Note Purchase Agreement ...............

2. Second Note Purchase Agreement ..............

3. Purchase Price Determinations ...............

4. Payments on the TroMetro Notes ..............

- 4 X.

Distribution Agreements .............................

A. The TroMetro Distribution Agreement .............

B. The Troma Distribution Agreement ................

C. Troma Entertainment, Inc. .......................

D. Troma’s Distribution of the EBD Film Library ....

1. Distribution History ........................

2. Distribution Revenue and Expenses ...........

XI.

Transactions with Imperial Credit Industries, Inc. ..

XII.

Subsequent Transactions Involving TroMetro

and Troma ..........................................

Business Characteristics of SMP, Corona, and SMHC ..

SMP ............................................

Corona .........................................

SMHC ...........................................

Partnership Tax Returns ............................

XIV.

Capital Contribution Agreement .................

Assumption Agreement ...........................

Transfer and Assignment of the Carolco

Securities .....................................

SMHC and Troma Merger ..........................

1. SMHC Merges into Troma .....................

2. SMHC’s Dissolution .........................

3. Tax Return Treatment of the Transaction ....

4. Termination of the Distribution

Agreements .................................

Letter Agreement with TroMetro .................

Troma Finance, LLC .............................

XIII.

Imperial Credit Industries, Inc. ................

Shopping for Tax Deals ..........................

Proposed Transaction with SMP ...................

Proposed Transaction with Corona ................

1. Formation of Corona Film Finance

Fund, LLC ...................................

2. The Corona Transaction ......................

3. Initial Purchase of SMP’s Interest

in Corona ...................................

4. Additional Purchase of SMP’s Interest

in Corona ...................................

5. Sale of the $79 Million Receivable ..........

6. Imperial’s Capital Contribution ..... .......

7. Treasury Bills ........................ .....

- 5 A.

SMP ............................................

Corona .........................................

Mr. and Mrs. Ackerman ..........................

101

Notices of Final Partnership Administrative

Adjustments ........................................

103

SMP ............................................

Corona .........................................

103

104

OPINION

...................................................

105

Partnership Tax Rules

.............................

108

In General .....................................

Claimed Application of Partnership Tax Rules ...

108

112

II.

Burden of Proof ....................................

113

III.

Economic Substance .................................

115

117

120

121

122

XV.

Parties’ Contentions ...........................

General Legal Principles .......................

Summary of Conclusions .........................

Subjective Business Purpose ....................

1. Banks’ Purposes ............................

a. Banks’ Prior History With

Film Business ..........................

b. Banks’ Regulatory Environment ..........

c. Why the Ackerman Group? ................

d. Inattention to Film Rights in

Negotiations ...........................

e. Selection of EBD Film Rights ...........

f. Conclusion .............................

2. Ackerman Group’s Purposes ..................

a. Mr. Lerner’s and Mr. Ackerman’s

Backgrounds ............................

b. Focus on Tax Attributes ................

c. Nature of EBD Film Rights ..............

d. Purported Interest in CDR Library ......

e. Purported Springboard for New Library ..

f. Acquiring NOLs for a Film Business .....

g. Contemporaneous Expression of Purpose ..

3. Conclusion .................................

Objective Economic Substance ...................

1. Economic Significance of Banks’

“Contributions” ............................

125

128

129

130

131

132

134

135

145

147

149

150

151

152

- 6 a.

Advisory Fee and Put Price .............

Banks’ Understanding ..............

ii. Ackerman Group’s Understanding ....

iii. Negotiation and Drafting Process ..

b. Redemption and Liquidation Rights ......

c. SMP’s Conversion Option ................

d. Distribution Rights ....................

e. Carolco Securities .....................

2. Economic Benefits for the Ackerman Group ...

3. EBD Film Library ...........................

a. Petitioner’s Expert ....................

Income Projections ................

ii. Cost Projections ..................

iii. Net Cashflows .....................

iv. Valuations ........................

Market Approach ...................

b. Respondent’s Expert ....................

Income Projections ................

ii. Cost Projections ..................

iii. Net Cashflows .....................

iv. Valuations ........................

Market Approach ...................

c. Court’s Analysis .......................

Reconciliation of Expert Opinions .

ii. Exclusion of Certain Film Titles ..

iii. Analysis of Expert Opinions .......

iv. Conclusion ........................

4. Carolco Securities .........................

5. Net Operating Losses .......................

6. Conclusion .................................

Other Considerations ...........................

1. SMP’s Other Film-Related Activities ........

2. Relationship Between the Parties ...........

3. Ackerman Group’s Exploitation of

Tax Attributes .............................

4. Congressional Intent .......................

Conclusion .....................................

153

155

157

159

167

169

171

174

177

180

181

183

184

185

186

187

189

190

191

192

193

196

203

208

215

216

217

219

Step Transaction Doctrine ..........................

227

Legal Principles ...............................

Parties’ Arguments .............................

Court’s Analysis ...............................

Conclusion .....................................

227

229

231

236

Basis Arguments ....................................

237

238

IV.

Worthlessness Issue ............................

1. Contribution of Worthless Assets ...........

219

222

226

- 7 2. Worthlessness of Debts .....................

Bona Fide Indebtedness Issue ...................

240

244

VI.

Corona Transaction .................................

254

VII.

Sales of Receivables to TroMetro ...................

257

VIII.

Summary of Conclusions So Far ......................

259

IX.

At-Risk and Passive Activity Loss Rules ............

261

SMP’s Basis in SMHC Stock ..........................

262

XI.

Accuracy-Related Penalties .........................

264

Burden of Production ...........................

Gross Valuation Misstatements ..................

20-Percent Accuracy-Related Penalties ..........

1. Negligence .................................

2. Substantial Understatement of Income Tax ...

Reasonable Cause ...............................

1. August 1996 Memorandum From

Shearman & Sterling ........................

2. Ernst & Young Memorandum ...................

3. May 12, 1997, Shearman & Sterling

Memorandum .................................

4. October 10, 1997, Shearman & Sterling

Memorandum .................................

5. February 26, 1998, Shearman & Sterling

Memorandum .................................

6. Grant Thornton Memorandum ..................

7. Opinion From Chamberlain Hrdlicka ..........

8. Conclusion .................................

265

267

275

279

284

Evidentiary Matters ................................

312

313

316

317

318

319

322

325

328

XII.

Daubert Issues .................................

1. Mr. Crawford ...............................

2. Ms. Nemschoff ..............................

a. Ms. Nemschoff’s Expert Opinion .........

b. Petitioner’s Arguments .................

c. Court’s Analysis .......................

3. Mr. Shapiro ................................

a. Mr. Shapiro’s Expert Opinion ...........

b. Court’s Analysis .......................

Mr. Jouannet’s Response (Exhibit 226-P) ........

289

292

293

298

301

303

307

311

- 8 MEMORANDUM FINDINGS OF FACT AND OPINION

THORNTON, Judge:

These consolidated cases stem from

transactions that occurred in the wake of the 1996 sale of the

legendary motion picture company Metro-Goldwyn-Mayer (MGM) by the

French banking giant Credit Lyonnais.

Peter Ackerman, his business partner Perry Lerner, and their

related entities (collectively, the Ackerman group) had helped

organize a consortium which made a bid to purchase MGM from

Credit Lyonnais.

winning bid.

The consortium lost out to Kirk Kerkorian’s

The Ackerman group then set out to acquire MGM’s

parent company, Santa Monica Holdings Corp. (SMHC), which Credit

Lyonnais still owned.

SMHC was largely devoid of assets; it owed about $1 billion

to Credit Lyonnais and its cluster of subsidiaries, adjuncts, and

associated companies (the Credit Lyonnais group).1

however, tantalizing tax attributes:

There were,

Credit Lyonnais’s purported

tax basis in the SMHC indebtedness was about $1 billion; its

purported tax basis in the SMHC stock was about $665 million.

This debt represented part of the approximately $2 billion

that the Credit Lyonnais group had previously lent or advanced to

MGM during its brief, unprofitable relationship with MGM, first

as lenders to MGM and then, after foreclosing, as owners of MGM.

Credit Lyonnais had transferred the approximately $1 billion of

debt from the MGM operating company to Santa Monica Holdings

Corp. (SMHC) (or more precisely to its predecessor, MGM Group

Holdings Corp.) partly to facilitate the 1996 sale of the MGM

operating company to Kirk Kerkorian.

- 9 To acquire SMHC in a manner that might preserve the tax

attributes, the Ackerman group formed a new limited liability

company, Santa Monica Pictures, LLC (SMP), which elected to be

treated as a partnership for Federal tax purposes.

The Credit

Lyonnais group agreed to contribute to SMP the high-basis, lowvalue indebtedness and SMHC stock after first contributing to

SMHC a library of what might charitably be called B-grade films.

In exchange, the Credit Lyonnais group was to receive preferred

interests in SMP and a $5 million “advisory fee”.2

Pursuant to a

side agreement, the Ackerman group committed to purchase these

preferred interests from the Credit Lyonnais group, upon demand,

for a $5 million “put” price.3

In late 1996, the Credit Lyonnais group made the agreed-upon

contributions to SMP.

Some 3 weeks later, the Credit Lyonnais

group exercised its “put”, sold its SMP interests to Somerville S

Trust (Mr. Ackerman’s grantor trust), and so departed SMP.

SMP

was left holding, instead of the proverbial bag, the high-basis,

low-value assets that the Credit Lyonnais group had contributed

and, indirectly (through SMHC), the B-grade films.

More precisely, the $5 million advisory fee was to be

paid to one of the Credit Lyonnais group members, Credit Lyonnais

International Services (CLIS).

More precisely, the commitment to purchase the Credit

Lyonnais group’s preferred interests was made by one of the

Ackerman group members, Rockport Capital, Inc.

- 10 Relying upon certain partnership basis rules (i.e., sections

704(c), 743 and 754), the Ackerman group claimed to succeed to

Credit Lyonnais’s purported $1 billion tax basis in the

contributed SMHC indebtedness and purported $665 million tax

basis in the SMHC stock.4

In separate transactions in 1997 and

1998, SMP sold to TroMetro Films, LLC (TroMetro) portions of the

SMHC indebtedness for much less than the claimed basis.

SMP also

formed another partnership, Corona Film Finance Fund, LLC

(Corona) and contributed to it part of the SMHC indebtedness.5

SMP then sold most of its ownership interest in Corona to

Imperial Credit Industries, Inc. (Imperial), for much less than

its claimed basis.

On its partnership tax returns for 1997 and

1998, SMP claimed capital losses totaling, altogether, about $300

million from these various transactions.

These claimed losses

passed through for the primary benefit of Mr. Ackerman.

Corona, meanwhile, sold to TroMetro the SMHC indebtedness

that SMP had contributed at Corona’s formation.

On its

Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the taxable years at

issue and, in certain references, as amended. All Rule

references are to the Tax Court Rules of Practice and Procedure.

In our findings of fact, we use terms such as

“indebtedness” or “contributions” only for convenience and not to

denote any legal significance.

- 11 partnership tax return for 1997, Corona claimed a capital loss of

about $79 million from this transaction.6

Respondent issued separate notices of final partnership

administrative adjustment (FPAAs) to Perry Lerner as tax matters

partner for SMP and Corona with respect to their partnership

taxable years ended December 31, 1997, and December 31, 1998.

the FPAAs, respondent disallowed SMP’s and Corona’s

aforementioned claimed capital losses.7

On a number of theories,

including the application of substance over form principles,

respondent argues that SMP and Corona are not entitled to the

indebtedness bases or the associated capital losses that those

This claimed loss essentially duplicated losses that Santa

Monica Pictures, LLC (SMP) had claimed from its sale to Imperial

Credit Industries, Inc. (Imperial), of SMP’s ownership interest

in Corona Film Finance Fund, LLC (Corona). Most of Corona’s

claimed loss passed through for the benefit of Imperial. As a

“fee” for the tax benefits it received, Imperial paid, indirectly

to SMP through Corona, almost $15 million.

At some point in these proceedings, Imperial filed a

bankruptcy petition. Consequently, any partnership items of

Imperial, including the loss that passed through from Corona,

became nonpartnership items on the date the bankruptcy petition

was filed. Sec. 301.6231(c)-7(a), Temporary Proced. & Admin.

Regs., 66 Fed. Reg. 50561 (Dec. 4, 2001). Imperial is not a

party to these proceedings.

In the notice of final partnership administrative

adjustment issued to Corona for its 1998 taxable year, respondent

determined, as the lone adjustment in that FPAA, an $80 million

increase in Corona’s reported distributions. Respondent concedes

that this adjustment is no longer a partnership item and that

this Court lacks jurisdiction to redetermine that adjustment.

Based on that concession, the Court will dismiss the taxable year

1988 as moot at docket No. 6164-03.

- 12 entities claimed on their respective 1997 partnership tax returns

and that SMP claimed on its 1998 partnership tax return.

Petitioner disagrees.

Petitioner contends, among other

things, that substance over form principles do not apply because,

when the contribution of SMHC stock and debt occurred (and

thereafter), the Ackerman group had the legitimate business

purpose of getting into the film business with the Credit

Lyonnais group.

Ultimately, we must decide:

(1) Whether SMP is entitled to

a $147,486,000 capital loss on its sale to TroMetro of a $150

million receivable in 1997; (2) whether SMP is entitled to

capital losses of $11,647,367 and $62,237,061 on its sales to

Imperial of portions of its Corona membership interest in 1997;

(3) whether SMP is entitled to a $80,190,418 capital loss on its

sale to TroMetro of an $81 million receivable in 1998; (4)

whether Corona is entitled to a capital loss on its sale to

TroMetro of a $79 million receivable in 1997;8 (5) whether

accuracy-related penalties under section 6662(a) or (h) apply

with respect to the partnership adjustments to SMP’s 1997 and

1998 returns and Corona’s 1997 return.9

Corona claimed a $78,768,955 capital loss from the sale of

the $79 million receivable in 1997. We do not have jurisdiction

over the portion of this loss that passed through to Imperial;

i.e., $74,671,378. See supra note 5.

On SMP’s FPAA for 1998, respondent also determined a

(continued...)

- 13 FINDINGS OF FACT

SMP is a Delaware limited liability company with its

principal place of business in New York, New York.

Corona is a

Delaware limited liability company with its principal place of

business in New York, New York.

The parties have stipulated many facts, which are

incorporated herein by this reference.

The Ackerman Group

Perry Lerner

During the taxable years at issue, Perry Lerner was the

managing member and the tax matters partner of SMP and Corona.

Mr. Lerner is a successful tax lawyer.

He graduated from

Clairmont McKenna College in Clairmont, California, in 1965 and

from Harvard Law School in 1968.

From 1968 to 1970, Mr. Lerner

worked as a clerk/attorney advisor to Judge Arnold Raum of the

U.S. Tax Court.

From 1970 to 1976 and again from 1979 to 1980,

Mr. Lerner worked for the law firm of Kindall & Anderson in Los

Angeles.

From 1976 to 1979, Mr. Lerner worked as an attorney

advisor for the U.S. Treasury Department, Office of International

Tax Counsel, in Washington, D.C.

(...continued)

$211,407 adjustment for certain long-term capital gain that SMP

did not pass through on its 1998 partnership tax return.

Respondent does not seek to impose accuracy-related penalties

pursuant to sec. 6662 with respect to this adjustment.

- 14 From approximately 1980 to 1995, Mr. Lerner worked for the

law firm of O’Melveny & Myers, LLP.

He worked in the firm’s Los

Angeles office until 1986 or 1987, before leaving to head up the

firm’s London office.

In 1992, he returned to the firm’s Los

Angeles office for about a year before moving to the firm’s New

York office.

In 1996, Mr. Lerner retired from O’Melveny & Myers

to become a sole practitioner.

Peter Ackerman

Peter Ackerman is a successful businessman.

He attended

Colgate University, where he received a bachelor’s degree.

attended graduate school at the Fletcher School of Law and

Diplomacy, ultimately receiving a Master of Arts and Law and

Diplomacy, and a Ph.D. in international affairs.

From 1978 to 1989, Mr. Ackerman worked at Drexel Burnham

(formerly Burnham & Co.) with Michael Milken in the high-yield

and convertible bond department.

While there, he was exposed to

buying and selling high-yield bonds, recapitalizing (leveraging)

companies, restructuring troubled businesses, and financing and

investing in businesses.

During the period of Mr. Ackerman’s employment there, Drexel

Burnham arranged the financing for major film companies,

including Warner Brothers, Paramount, Turner, CNN, and Orion.

Mr. Ackerman was actively involved in structuring the financing

- 15 for the transaction wherein Kirk Kerkorian sold the MGM library

(for the first time) to Ted Turner.

In 1990, Mr. Ackerman was invited to become a visiting

scholar at the International Institute for Strategic Studies in

London.

He stayed there until 1994 while he wrote and published

a 400-page book called “Strategic Nonviolent Conflict.”

this period, Mr. Ackerman met Mr. Lerner.

During

Mr. Lerner represented

Mr. Ackerman in certain legal matters, including issues stemming

from Drexel Burnham’s bankruptcy and issues relating to Mr.

Ackerman’s estate planning.

Somerville S Trust

During the taxable years at issue and at all relevant times,

Mr. Ackerman was the beneficiary of the Somerville S Trust, which

was treated as a grantor trust for Federal income tax purposes.

All items of income, expense, or loss from Somerville S Trust

were reported on Mr. Ackerman and his wife’s joint Federal income

tax returns.

Somerville S Trust was the capital source for many of Mr.

Ackerman’s investments, including the transaction involving the

Credit Lyonnais group.

Mr. Lerner was the trustee of the

Somerville S Trust, and he was fully empowered to transfer or

invest its assets.

- 16 D.

Rockport Capital, Inc.

During the taxable years at issue and at all relevant times,

Mr. Ackerman conducted all his investment activities through a

wholly owned advisory company called Rockport Capital, Inc.

(Rockport Capital).

corporation.

Rockport Capital was a Delaware subchapter S

Mr. Lerner was an officer in Rockport Capital.

Rockport Advisors, Inc.

After Mr. Lerner retired from O’Melveny & Myers in 1996, Mr.

Ackerman asked Mr. Lerner to continue representing him.

Mr.

Ackerman was interested in various investment opportunities that

were coming his way, and he often asked Mr. Lerner’s legal advice

about them.

Initially, Mr. Lerner devoted about half his time to

Mr. Ackerman’s affairs.

As a product of this representation, Mr.

Lerner formed Rockport Advisors, Inc. (Rockport Advisors), which

he owned.

Rockport Capital and Rockport Advisors operated

together with respect to Mr. Ackerman’s investment activities,

including the transaction involving the Credit Lyonnais group.

Crown Capital Group

In early 1997, Mr. Lerner ceased using Rockport Advisors

with respect to Mr. Ackerman’s investments.

Instead, Mr. Lerner

created a new firm, Crown Capital Group, Inc. (Crown Capital),

located in New York, to investigate and manage Mr. Ackerman’s

investments.

Mr. Lerner owned 49 percent and Mr. Ackerman’s

nephew owned 51 percent of Crown Capital.

- 17 Crown Capital provided the due diligence and management

services for Mr. Ackerman’s investments, including SMP, a theater

exhibition company (Resort Theaters), a textile company, a small

insurance company, a business involved in manufacturing Pokemon

game cards, a company that manufactured sample wallpaper and

carpet boards, a newspaper stuffing business, a grocery business,

and a number of private equity investments.

Oftentimes, Crown

Capital would make an investment in its own name and then

transfer it into some new entity established for Mr. Ackerman.

In some cases, Crown Capital also acted on behalf of SMP or SMHC,

although there was no written agency agreement between these

companies.

II.

The Credit Lyonnais Group

Credit Lyonnais

During the early 1990s and the taxable years at issue,

Credit Lyonnais, S.A. (Credit Lyonnais), was a large European

banking and financial institution organized under the laws of

France.

Credit Lyonnais was the direct or indirect parent of

other banking and financial institutions, including Credit

Lyonnais Bank Nederland, N.V. (CLBN), a bank organized under the

laws of the Netherlands, and Credit Lyonnais International

Services (CLIS).

Credit Lyonnais acquired CLBN in the mid-1980s.

CLBN developed a large business of financing media entertainment

(e.g., film, television, etc.); it was partly responsible for

- 18 Credit Lyonnais’s indirect financing and ownership of film

companies, including MGM.10

Consortium de Realisation

In 1995, Credit Lyonnais experienced a financial crisis.

Following the intervention of the French government, Credit

Lyonnais announced a restructuring program that was intended to

shore up its balance sheet going forward.

Under the

restructuring program, Credit Lyonnais’s troubled investments and

loans, including its loans to film companies such as MGM, were

effectively transferred into a wholly owned subsidiary,

Consortium de Realisation (CDR).

CDR was set up for the purpose

of liquidating and maximizing recovery on Credit Lyonnais’s “bad

assets”.

When CDR was set up, the Credit Lyonnais employees who were

working on the troubled entertainment loans were given the option

of transferring to CDR to continue working on those loans or

taking other positions within Credit Lyonnais.

Rene-Claude

Jouannet, a longtime employee of Credit Lyonnais, transferred to

CDR, where he served as CDR’s general counsel.11

The Credit Lyonnais group’s loans to MGM and eventual

ownership of MGM are described in detail infra.

As we discuss infra, Mr. Jouannet played a significant

role in the transaction in which the Ackerman group acquired

SMHC.

- 19 C.

Generale Bank Nederland

In September 1995, CLBN was acquired by Generale Bank

Nederlands (Generale Bank).12

In this acquisition, CLBN’s “good”

and “bad” assets were transferred to Generale Bank.

Credit

Lyonnais lent Generale Bank the money to purchase the “bad

assets” of CLBN, including the debt that MGM owed to CLBN.

The

loan from Credit Lyonnais to Generale Bank was nonrecourse;

Generale Bank was not obligated to pay back the borrowed amount

except to the extent it realized anything on the bad assets.

III. Metro-Goldwyn Mayer, Inc.

History of MGM Before 1990

Metro-Goldwyn-Mayer, Inc., was established in 1924 as a

major film studio based in Los Angeles, California.

Since its

establishment, Metro-Goldwyn-Mayer, Inc., has experienced

numerous reorganizations and name changes.

For convenience, we

sometimes refer to Metro-Goldwyn-Mayer, Inc. (and its successors)

generally as “MGM”.

In 1981, MGM purchased United Artists (UA).

The combined

entity then changed its name to MGM/UA Entertainment Co.

(MGM/UA).

From 1981 through 1986, MGM/UA continued to produce

and distribute film and television products.

In 1986, Kirk

The actual name is “Generale Banque.” We follow the

parties’ convention in referring to it in Anglicized fashion as

“Generale Bank.” Sometimes, in quoted material, the reference is

to “Generale Banque” or “GB.”

- 20 Kerkorian, the majority shareholder of MGM/UA, entered into a

series of transactions with Turner Broadcasting System (TBS),

resulting in TBS’s acquisition of the pre-1986 MGM film library.

See, e.g., Turner Broad. Sys., Inc. & Subs. v. Commissioner, 111

T.C. 315 (1998).

MGM/UA Communications Co. (MGM Communications)

was formed out of the remaining assets of MGM and UA, including

the UA film library.

In 1988, MGM Communications began to

explore selling all or part of these assets.

Pathe Acquisition of MGM

In June 1990, the board of directors of MGM Communications

agreed to sell the company for approximately $1.33 billion

(excluding certain additional costs) to Pathe Communications

Corp. (Pathe), which was indirectly controlled by Giancarlo

Parretti and Florio Fiorini.13

Pursuant to this agreement, MGM-

Pathe Communications Co. (a wholly owned subsidiary of Pathe)

merged with and into MGM Communications (the 1990 merger).

The

surviving corporation was MGM-Pathe Communications Co. (MGMPathe).

As a result of the 1990 merger, Pathe owned 98.5 percent

of MGM-Pathe stock.

Sealion Corp.

In connection with Pathe’s acquisition of MGM, Credit

Lyonnais lent $150 million to Sealion Corp., N.V. (Sealion)

To finance this purchase price, Pathe Communications

Corp. relied, in part, on its available lines of credit from

CLBN.

- 21 pursuant to a credit agreement dated October 30, 1990.

Sealion

then lent the $150 million to Pathe, which in turn used the funds

to finance part of the acquisition of MGM Communications.

Sealion entered into a stock purchase agreement dated as of

November 1990, with Melia International N.V. (Melia), which owned

51.9 percent of Pathe’s outstanding common stock.

Pursuant to

the stock purchase agreement, Sealion purchased 900,000 shares of

MGM-Pathe’s common stock (constituting 1.5 percent of the common

stock of MGM-Pathe) from Melia.

Sealion in turn pledged its 1.5-

percent interest in MGM-Pathe to Credit Lyonnais as security for

the $150 million loan.

Thereafter, Sealion, Melia, and Pathe

controlled the boards of directors of Pathe and MGM-Pathe.

Cashflow Problems of MGM-Pathe

Before the Pathe acquisition, MGM relied on cashflows from

its distribution agreements to conduct its day-to-day operations

and to generate revenue.

To finance Pathe’s recent acquisition

of MGM/UA Communications, however, Mr. Parretti entered into new

distribution agreements which were then factored with financial

institutions, thereby depriving MGM of approximately 80 to 90

percent of its ordinary cashflow.

Consequently, MGM-Pathe was

soon unable to finance its day-to-day operations, including

motion picture production and release.

To fund all its operating

costs, including the payment of interest, MGM-Pathe had to rely

on external capital in the form of continuous borrowing from the

- 22 Credit Lyonnais group.

MGM-Pathe’s weak financial condition was

well-known in the entertainment industry and made it harder to

attract film talent to MGM.

Facility Agreements with CLBN

On March 22, 1991, Pathe and MGM-Pathe entered into a socalled $250 million interim revolving credit facility with CLBN

(the $250 million facility), which incorporated all of MGMPathe’s borrowing from November 1, 1990.14

All borrowing under

the $250 million facility was at the absolute discretion of CLBN

and was secured by MGM-Pathe’s assets and Pathe’s interest in

MGM-Pathe stock.

On March 29, 1991, a group of MGM-Pathe’s creditors

(excluding CLBN) filed an involuntary chapter 7 bankruptcy

petition in U.S. Bankruptcy Court.

To pay off its creditors

(other than CLBN) and allow it to emerge from bankruptcy, MGMPathe entered into a so-called $145 million facility agreement

(the $145 million facility agreement) with CLBN dated as of April

12, 1991.15

Borrowing under the $145 million facility agreement

was secured by MGM-Pathe’s assets, as well as the stock of Pathe

and MGM-Pathe.

As a result of the new financing, MGM-Pathe was

The name of this agreement did not necessarily control

the amount that was advanced under the agreement.

The name of this agreement did not necessarily control

the amount that was advanced under the agreement. Amounts

available under the $145 million facility agreement were in

addition to amounts available under the $250 million facility.

- 23 able to reach an accord with its creditors and emerge from

bankruptcy.

In connection with the $145 million facility agreement,

Pathe and certain of Melia’s stockholders and subsidiaries

entered into certain agreements in April 1991, whereby those

parties guaranteed MGM-Pathe’s obligations under the $145 million

facility agreement and pledged to CLBN all shares of Pathe, MGMPathe, and Melia owned by those parties, to secure all

indebtedness then owing by Pathe (and certain affiliates) to CLBN

(the 1991 pledge agreement).

The shares covered by these

agreements represented approximately 89.3 percent of the

outstanding common stock of Pathe and 98.5 percent of the stock

of MGM-Pathe, which shares were held in irrevocable voting trust

agreements in favor of CLBN.

As part of this process, Mr.

Parretti entered into corporate governance agreements with CLBN

wherein Mr. Parretti and Pathe ceded responsibility for the dayto-day management of MGM-Pathe to Credit Lyonnais.

On June 17,

1991, as a result of certain actions by Mr. Parretti in violation

of the corporate governance agreements between him and CLBN, CLBN

removed Mr. Parretti and certain other directors of MGM-Pathe.

Credit Lyonnais Takes Control of MGM

As of June 1991, Credit Lyonnais exercised effective control

over MGM-Pathe.

It controlled all management decisions at MGM-

Pathe and elected MGM-Pathe’s board of directors.

During this

- 24 period, Credit Lyonnais maintained a constant presence at MGMPathe’s corporate offices.

MGM-Pathe’s deepening financial problems, however, strained

its relationship with Credit Lyonnais.

For example, during the

quarter ended March 31, 1992, MGM-Pathe’s operating expenses and

financing costs exceeded its operating receipts, and its

management expected that operating expenses and financing costs

would continue to exceed operating receipts for the foreseeable

future.

MGM-Pathe’s market share was less than two percent; many

of its valuable assets had either been sold or factored to

finance Pathe’s acquisition of MGM-Pathe.

As a result, MGM-Pathe

remained entirely dependent on CLBN for additional capital to

fund its ongoing operations.

MGM-Pathe’s deepening financial

problems persisted well into 1993.

As of March 31, 1992, CLBN had lent MGM-Pathe $124,288,000

pursuant to the so-called $250 million facility agreement and

$398,223,000 pursuant to the so-called $145 million facility

agreement.

MGM-Pathe was in default on these obligations.

April 16, 1992, CLBN notified Pathe and MGM-Pathe that it was

exercising its right under the 1991 pledge agreement to foreclose

on 59.1 million shares of the common stock of MGM-Pathe

(representing 98.5 percent of the outstanding common stock of

that company).

The letter stated that the foreclosure auction

was scheduled for May 7, 1992, and that CLBN intended to bid-in,

- 25 or cause to be bid-in, at least $400 million of the secured

indebtedness.

CLBN also advised Pathe and MGM-Pathe that $400

million would be the minimum bid-in amount and that the sale of

40.2 million shares would be subject to a prior pledge in favor

of Credit Lyonnais, as assignee of Sealion.

Credit Lyonnais formed MGM Holdings Corp. (MGM Holdings) to

effect the foreclosure on the common stock of MGM-Pathe.

As of

May 1, 1992, CLBN sold to MGM Holdings approximately $483,489,000

of Pathe’s and MGM-Pathe’s indebtedness.16

Credit Lyonnais

foreclosed on the MGM-Pathe stock to recover amounts that it had

invested in MGM; it was not interested in any long-term

investment in a film business.

As a result of the foreclosure,

MGM Holdings owned 98.5 percent of MGM-Pathe’s common stock and

had the power to elect the entire board of directors of MGMPathe.

Nevertheless, the Credit Lyonnais group was working on a

5-year time clock from the date of foreclosure, because U.S.

banking laws required the Credit Lyonnais group to sell MGM

within 5 years (i.e., on or before May 7, 1997).

On May 20, 1992, MGM-Pathe changed its name to MetroGoldwyn-Mayer, Inc. (MGM).

The parties agreed to a purchase price equal to the

aggregate principal amount outstanding on the debt, together with

all interest, fees, and other amounts then due and owing.

- 26 G.

1993 Financial Restructuring

After the foreclosure, MGM was a tarnished brand.

As a

maker of motion picture products, it was minimally competitive.

MGM had effectively gotten out of the television business and had

no activities in ancillary media such as interactive and video

games.

MGM had a substantial film library, including the

considerable UA library, but it was not aggressively exploiting

it.

MGM’s financial position was precarious.

It was functioning

on a credit facility that CLBN had granted in an emergency

fashion.

Although the facility was supposed to be in the $150

million range, CLBN’s exposure had risen to half a billion

dollars.

MGM needed additional funding for its production

activities.

This funding came directly or indirectly from the

Credit Lyonnais group.

The Credit Lyonnais group meanwhile had

already invested approximately $1.6 billion in MGM-Pathe,

including amounts that it had lent to Pathe, to various entities

in connection with Pathe’s acquisition of MGM-Pathe, and to MGMPathe.

Credit Lyonnais determined that it needed to maintain MGM’s

operations to increase MGM’s value.

Because it appeared

impossible to sell MGM under satisfactory conditions, it was

necessary to rebuild it, which required both time and financial

means.

Consequently, effective April 1, 1993, CLBN provided MGM

- 27 a commitment for an additional $190 million, 3-year revolving

credit facility ($190 million facility).17

In light of Credit Lyonnais’s escalating financial exposure

and MGM’s dwindling business prospects, Credit Lyonnais

formulated a business strategy for MGM which included:

(1) completely replacing the company’s management; (2)

restructuring MGM’s finances to replenish its equity capital and

to significantly reduce the weight of its debt; and (3)

establishing a 5-year business plan intended to reposition MGM

among the film industry’s “major players” and to increase the

value of its assets, particularly through an intensive program of

new film production.18

In July 1993, MGM began a comprehensive restructuring of its

capital structure and its corporate management (the 1993

restructuring).

This restructuring consisted primarily of

splitting MGM into two entities.

The goal was to set up a

separate operating company which would be capitalized with $1

billion in equity and would have sufficiently reduced liabilities

to allow additional borrowing from lenders other than Credit

Lyonnais.

MGM was renamed MGM Group Holdings Corp. (MGM Group

The name of this agreement did not necessarily control

the amount that was advanced under the agreement.

Credit Lyonnais selected a 5-year business plan because

of U.S. laws requiring the bank to divest itself of MGM within 5

years of acquisition.

- 28 Holdings).

MGM Group Holdings contributed substantially all its

assets (including its film and television assets) and some

liabilities to a new subsidiary, which was later named MetroGoldwyn-Mayer, Inc. (New MGM).19

In the 1993 restructuring, MGM’s debt to CLBN was divided

between MGM Group Holdings and New MGM.

MGM Group Holdings

retained approximately $960 million of the debt, which was

restated and consolidated in an amended, restated, and

consolidated credit agreement with CLBN.

MGM Group Holdings

executed a $965,904,188.96 note dated December 30, 1993, which

was due and payable on July 15, 1997.

This $966 million debt was

unsecured by New MGM’s assets; $800 million of the principal

amount was non-interest bearing.

As of December 31, 1993, New MGM owed CLBN approximately

$618 million in principal and interest.

New MGM and CLBN entered

into an amended, restated, and consolidated credit agreement (the

New MGM credit agreement) in which the loans that New MGM assumed

in the 1993 restructuring were consolidated and converted into a

term loan with a due date of July 15, 1997 (the CLBN term loan).

In accordance with the 1993 restructuring, New MGM and

Credit Lyonnais entered into a working capital agreement dated

As part of the 1993 restructuring, MGM Group Holdings

Corp. retained its accrued tax attributes, including its accrued

net operating losses (NOLs). The 1993 restructuring included the

appointment of a new management team under Frank Mancuso as chief

executive officer.

- 29 December 30, 1993 (the working capital agreement).

The working

capital agreement provided for payment of interest on the amounts

that Credit Lyonnais had previously lent to MGM.

These amounts

became due on July 15, 1997.

New MGM executed a $490 million

note dated December 30, 1993.

In connection with the working

capital agreement and the New MGM credit agreement, MGM Group

Holdings pledged its New MGM stock, as well as New MGM’s film and

other assets, to Credit Lyonnais.

CLBN advanced $8,994,970.32 in additional funds to MGM Group

Holdings pursuant to a demand promissory note (CLBN demand note)

and an irrevocable notice of drawing, both dated October 26,

1994.

On April 26, 1995, MGM Group Holdings made an additional

drawing of $595,750.56 under the CLBN demand note.

In all, CLBN

advanced a total of $9,590,720.88 in additional funds to MGM

Group Holdings.

Carolco Pictures, Inc.

In 1993, Credit Lyonnais, using MGM as a vehicle, made an

investment in Carolco Pictures, Inc. (Carolco), and sought to

take an active role in that company’s operations.

Carolco had

been a major motion picture producer, producing some of the

highest revenue-grossing motion pictures ever made, including

“Terminator 2: Judgment Day”, “Total Recall”, “Cliffhanger”,

“Basic Instinct”, and “Rambo: First Blood Part II”.

Carolco

initially produced four to six major motion pictures a year but,

- 30 like MGM, was forced to cut production in the early 1990s due to

serious financial problems.

In 1993, Carolco underwent a financial restructuring (the

1993 Carolco restructuring) to reduce or satisfy Carolco’s

financial obligations and to provide additional capital to permit

Carolco to continue as a going concern.

As part of the 1993

Carolco restructuring, MGM, with other investors, agreed to

invest in Carolco in exchange for distribution rights to

Carolco’s films.20

On May 25, 1993, in connection with the

restructuring, MGM Holdings purchased 30,000 shares of Carolco

preferred stock for $30 million and Carolco subordinated notes

for $30 million (the Carolco securities).21

Credit Lyonnais

provided MGM Holdings the funds for investing in the Carolco

securities.

As a result of the 1993 Carolco restructuring, Carolco’s

management began preparing some of Carolco’s motion picture

projects for eventual production.

By January 1995, however, due

to the unexpectedly high cost of certain motion pictures it

became apparent that Carolco would have inadequate capital to

On May 1, 1993, Carolco and MGM entered into two

distribution agreements; a “Domestic Output Agreement”, and an

“International Output Agreement”, in which MGM was to distribute

Carolco films.

Between Jan. 15, 1994, and Oct. 15, 1995, Carolco issued

additional securities to MGM Holdings in lieu of quarterly

interest payments on the Carolco subordinated notes.

- 31 execute its business plan going forward.

During the second half

of 1994 and early 1995, Carolco sold substantially all its rights

in such motion picture projects as “Crusades”, “Showgirls”, and

“Lolita” to raise operating capital and reduce payment

obligations.

Carolco obtained certain accommodations from its

investors.

After discussions with its present investors and potential

new investors during 1994-95, it became apparent to Carolco that

the necessary additional capitalization required to continue

Carolco’s business plan was not going to be forthcoming.

Consequently, Carolco decided to sell its main film library and

certain other assets in hopes of generating cash with which it

could reduce its debt and pursue motion picture projects.

In October 1995, Twentieth Century Fox Film Corp. (Twentieth

Century Fox) offered approximately $50 million for the Carolco

film library, the projects, and the studio.

Although accepting

this offer would have doomed Carolco’s prospects as a going

concern, Carolco decided to pursue the offer and began

negotiating a sale agreement.

On November 10, 1995, Carolco and

Twentieth Century Fox executed an agreement providing for the

sale of substantially all of Carolco’s assets for approximately

$47.5 million and requiring Carolco to file a voluntary chapter

11 bankruptcy petition.

- 32 On November 10, 1995, Carolco filed a voluntary petition

under chapter 11 of the U.S. Bankruptcy Code.

On November 22,

1995, Carolco filed a motion asking the bankruptcy court to issue

an order allowing Carolco to sell its assets to Twentieth Century

Fox for $47.5 million.

On January 16, 1996, the bankruptcy court

held a hearing on Carolco’s motion, wherein Carolco announced

that Canal+ had offered $58 million for the Carolco film library

and related assets.

In an order dated March 21, 1996, the

bankruptcy court approved the sale of Carolco’s film library and

related assets to Canal+ for $58 million.

Between September 13, 1996, and March 28, 1997, the debtors’

and creditors’ committee filed various successive plans of

reorganization.

Under each of these plans of reorganization, the

holders of Carolco subordinated notes were in class 10 and the

holders of Carolco preferred stock were in class 12.

In each

case, the securities holders were to receive nothing in Carolco’s

liquidation.

In an order dated April 3, 1997, the bankruptcy court

confirmed the fourth and final amended plan of reorganization.

The bankruptcy court confirmed that SMHC (MGM Group Holdings’

successor), which then held the Carolco securities, was to

receive nothing for the Carolco securities under this plan of

reorganization because it was classified as a holder of class 10

and 12 claims.

- 33 I.

Sealion Settlement

In November 1995, Credit Lyonnais and Sealion entered into a

settlement agreement whereby: (i) Sealion assigned its 1.5percent interest in MGM Group Holdings stock to Credit Lyonnais,

and, in exchange, (ii) Credit Lyonnais accepted as repayment of

all sums that Sealion owed to it, the assignment to Credit

Lyonnais of the entire claim that Sealion held against Pathe

pursuant to its loan agreement with Pathe.

Credit Lyonnais Decides To Sell New MGM

As of 1994, MGM was not saleable; its filmed entertainment

business was still in financial disarray.

Nevertheless, after

the 1993 restructuring and after nearly 2 years under its new

management team, MGM made a fair recovery.

The management team’s

actions began bearing fruit with some successful film releases

such as “Stargate”, “Get Shorty”, and the next two “James Bond”

movies.

MGM started to resemble a real operating motion picture

company once again.

Nonetheless, Credit Lyonnais’s investment in MGM was

considerable and never ending.

As time went on, Credit Lyonnais

became very pessimistic about recovering its investment in MGM;

certainly after Credit Lyonnais transferred ownership of the MGM

stock to Consortium de Realisation (CDR) in 1995, Credit Lyonnais

had much less interest in putting money into MGM’s movies.

result, the number of movies in production at MGM diminished

As a

- 34 considerably.

Credit Lyonnais had reason to get out of its

investment in MGM as expeditiously as possible.

At some point, Credit Lyonnais decided to sell all the

assets of MGM.

Credit Lyonnais assigned to CDR’s new management

team (which included Mr. Jouannet) the task of putting together

the investment banking support and other support necessary to

sell New MGM.

This team selected Lazard Freres & Co., LLC,

(Lazard & Freres) as its investment banking firm and exclusive

financial adviser for the sale of New MGM.

In early 1996, Credit

Lyonnais, through CDR, formally put New MGM up for sale to pay

off its outstanding debts.

Credit Lyonnais and MGM management

hoped and expected to sell MGM for approximately $2 billion.

IV.

Safari Acquisition Co.

Safari Consortium

In early 1996, Mark Seiler contacted Mr. Lerner about

organizing a bid for New MGM.

Mr. Seiler was the U.S. president

of Capella Films, Inc., a motion picture company and a wholly

owned U.S. subsidiary of Deyhle Media Group, one of the largest

film distributors in Germany.22

to Mr. Ackerman.

Mr. Lerner introduced Mr. Seiler

At some point, a consortium called the Safari

At the time, the five or six “major” motion picture

companies were producing virtually all the motion pictures

exhibited in the world, and this consolidation was jeopardizing

the ability of Deyhle Media Group, and other distributors, to

acquire motion picture content for distribution. Deyhle Media

Group was interested in acquiring New MGM to assure a continuous

flow of motion picture product.

- 35 Acquisition Co. (Safari) was formed.

In an effort to secure

financing for a Safari bid, Messrs. Lerner and Ackerman met with

a Japanese company and a number of major film distributors,

including Twentieth Century Fox.

Safari Indicates Its Interest in New MGM

On April 17, 1996, Messrs. Ackerman and Seiler wrote a

letter to Mr. Peter R. Ezersky, managing director of Lazard

Freres, submitting Safari’s preliminary indication of interest in

acquiring New MGM.

The letter stated an approximate range in

which Safari might be prepared to bid ($1.95 billion to $2.5

billion) and mentioned a number of conditions to be satisfied

before any bid would be final and effective.

When this bid was

submitted, Safari had not completed its due diligence of New MGM.

In formulating its final bid, Safari hired Donaldson, Lufkin &

Jenrette Corp., as its financial adviser, and Houlihan, Lokey,

Howard, & Zukin Capital (Houlihan Lokey), as its valuation

adviser.

On April 24, 1996, Lazard Freres faxed a memorandum to

Capella Films confirming a visit to MGM on May 1 to 3, 1996, and

providing a draft list of information that was to be available

during that time in the New MGM data room.

The New MGM data room

was established in MGM’s offices in Santa Monica, and each of the

“qualified” bidders was permitted to bring in a team of advisers

to investigate MGM’s company information.

- 36 C. Investigation of MGM

Mr. Lerner was involved in investigating New MGM.

Mr.

Lerner testified that he spent nearly a week in the data room of

New MGM and talked to various members of New MGM’s corporate

management team regarding their view of the company and its

future.

In the course of this investigation, Mr. Lerner received

an MGM Corporation Information Memorandum and a confidential

memorandum that Lazard Freres had prepared in connection with the

sale of New MGM.

Safari hired Deloitte & Touche, LLP, and the

law firm of Kaye, Scholer, Fierman, Hays & Handler, LLP (Kaye

Scholer), to assist in investigating New MGM.

On May 14, 1996, Deloitte & Touche submitted its preliminary

data room due diligence observations to Safari.

This document

explained the process and procedures followed in Deloitte &

Touche’s investigation of MGM, including its review of the

information in the New MGM data room.

It also identified certain

open issues with respect to MGM.

On May 15, 1996, Kaye Scholer submitted its preliminary

memorandum to Safari summarizing its legal due diligence

investigation of New MGM.

Kaye Scholer reviewed:

(i) The

corporate organization of MGM, MGM’s principal subsidiaries, and

MGM Group Holdings; (ii) chain-of-title documentation for the

available portion of New MGM’s film library and other productrelated documents; and (iii) historical information for the MGM

- 37 and UA entities, including the more recent corporate

restructurings.

The Kaye Scholer memorandum also provided a

discussion of CDR’s tax basis in MGM Holdings stock ($605

million), MGM Holdings’s tax basis in MGM Group Holdings stock

($483 million), MGM Group Holdings’s tax basis in New MGM stock

($300 million), New MGM’s tax basis in its assets ($1.14

billion), as well as tax loss carryforwards, and net operating

loss carryforwards.

A memorandum dated May 31, 1996, from Kaye Scholer to

Capella Films, which Mr. Lerner received, describes an “MGM

Acquisition/Partnership Structure” and explains:

The proposed structure outlined herein would

increase the amount receivable by CDR over a straight

purchase. Under the proposed structure CDR would

contribute the $873 million of debt owed to it by MGM

to the capital of Holdings, which in turn would

contribute the debt to Group, which in turn would

contribute the debt to MGM. Such contributions would

increase the tax basis of the stock of each of the

companies. As a result, CDR would have a tax basis in

the stock of Holdings of approximately $1.478 billion.

CDR would then form a limited liability company (the

‘LLC’) by contributing the stock of Holdings in

exchange for a 99% interest in the LLC. An unrelated

party would receive a 1% interest in exchange for a

nominal amount. Then CDR would sell half of its

interest, or 49.5% of the LLC, to an investor who could

benefit from the use of a capital loss (“Investor”).

The LLC would not make an election under section 754

* * * to adjust the basis of its assets. Group would

then sell the stock of MGM to Capella and make an

election under section 338(h)(10) of the Code to treat

the stock sale as an asset sale. Group would use a

portion of the proceeds to repay to CDR the $970

million of debt. The remainder of the proceeds would

be held by Group, other than the amount necessary to

pay any taxes on the sale (inasmuch as MGM’s NOL’s may

- 38 not be sufficient to offset the entire gain and some of

Group’s NOLs are subject to limitations which prevent

their use to offset MGM’s income on the deemed asset

sale). After waiting for at least one year, Investor

would buy CDR’s other 49.5% interest. Again the LLC

would not make an election under section 754 of the

Code to adjust the basis of its assets. As a result of

these transactions, Investor would own 99% of the LLC,

and Group and Holdings could be liquidated into the

LLC. The capital loss on the liquidation (which would

be approximately $1.4 billion) would be allocated to

Investor.

In June 1996, Houlihan Lokey prepared a “Pro-Forma Library

Valuation” as of August 31, 1996, valuing New MGM’s film library

at $2.6 billion, an amount greatly in excess of MGM’s capital and

debt.23

Mr. Lerner testified that it was a valuation which “we

thought was fairly good, a fairly good guess at what the assets

were worth”, but that Safari wanted to prepare its bid below this

estimate in hopes of getting a discount.

Accordingly, Safari

submitted a $1.2 billion bid, which it believed was the high bid.

Kerkorian Moves in and Buys MGM

Safari was one of a number of bidders for New MGM.

New

MGM’s management was interested in finding parties who would fund

the acquisition of New MGM and retain existing management.

New

MGM’s management met with Messrs. Lerner and Ackerman to discuss

the possibility of doing a transaction with the management group.

New MGM’s management, however, decided against it; they lacked

Mr. Lerner testified that this valuation did not take

into account corporate taxes, overhead, and remake rights of

several important pictures such as the “James Bond”, “Pink

Panther”, and “Rocky” movies.

- 39 confidence in Messrs. Lerner’s and Ackerman’s capital sources and

were not comfortable that their proposed financing from Japan was

going to materialize.

Unbeknownst to Safari, New MGM’s management had the right,

after all the final bids were in, to find another buyer within a

certain number of hours.

After all bids were submitted, New

MGM’s management approached Kirk Kerkorian who, through his

company, P&F Acquisition Corp. (P&F Acquisition), successfully

bid $1.3 billion for New MGM.

Safari was not given an

opportunity to rebid; it lost out on its attempt to buy New MGM.

On July 16, 1996, P&F Acquisition entered into a stock

purchase agreement (the stock purchase agreement) with CDR, MGM

Holdings, MGM Group Holdings, and New MGM.

The stock purchase

agreement provided that all of New MGM’s and its subsidiaries’

indebtedness would be repaid in full upon the consummation of the

sale and that any New MGM indebtedness remaining unpaid would be

satisfied, canceled, or extinguished at or before the closing on

the sale.

The closing date was set as of October 10, 1996.

Debt Release and Assumption Agreement

As of October 9, 1996, New MGM owed Credit Lyonnais

$378,748,588.93 under the working capital agreement.

The $1.3

billion purchase price that P&F Acquisition paid for New MGM

sufficed to pay off all of New MGM’s creditors except Credit

- 40 Lyonnais.24

Because the debt that New MGM owed Credit Lyonnais

($378,748,588.93) exceeded the New MGM sale proceeds that Credit

Lyonnais was to receive ($298,835,633.58), New MGM still owed

Credit Lyonnais $79,912,955.34.

On October 9, 1996, Credit

Lyonnais, MGM Group Holdings, and New MGM executed a debt release

and assumption agreement releasing New MGM from its obligations

on the remaining $79,912,955.34 of principal owed to Credit

Lyonnais under the working capital agreement and providing that

MGM Group Holdings assumed this remaining $79,912,955.34 of

indebtedness (the $79 million receivable).

MGM Group Holdings

(and its successor SMHC) never executed a note for the

$79,912,955.34 of indebtedness referred to in the debt release

and assumption agreement.

Subparticipation Agreement

On September 25, 1996, CDR and Credit Lyonnais entered into

a subparticipation agreement concerning the working capital

agreement.

Under this agreement, CDR agreed to take a 100-

percent subparticipation in the working capital agreement,

assuming all risks connected to that loan.

On October 11, 1996, Credit Lyonnais sent a letter to CDR

referencing the $79,912,955.34 excess debt from the New MGM sale

and stating:

“Pursuant to your agreement of October 1, 1996, we

Generale Bank (CLBN’s successor) was to be paid

$611,064,366.42 (which included accrued interest) for the amounts

that New MGM owed under the CLBN term loan.

- 41 have resolved and settled this insufficient payment by utilizing

your subparticipation to meet the amount owed.”

On December 13,

1996, CDR assigned the $79 million receivable to CLIS, effective

as of that date, pursuant to a document entitled “Cession de

Creance”.

Dissolution of MGM Holdings and Formation of SMHC

On or about September 28, 1996, MGM Holdings contributed its

Carolco preferred stock and Carolco subordinated notes to MGM

Group Holdings.

On October 8, 1996, MGM Holdings was dissolved;

its assets were distributed to CLIS, MGM Holdings’s sole

shareholder.

On October 15, 1996, MGM Group Holdings changed its

corporate name to Santa Monica Holdings Corp. (SMHC).

The CDR Transaction

Initial Contact With Mr. Jouannet

After agreement was reached on the sale of New MGM, one of

Mr. Jouannet’s continuing jobs at CDR was to see what, if

anything, he could realize on the stock of MGM Group Holdings.

CDR and Mr. Jouannet were interested in “monetizing”

MGM Group

Holdings as soon as possible.

Sometime before September 11, 1996, Mr. Lerner, on behalf of

Rockport Capital, and Mr. Jouannet, on behalf of CDR, discussed a

possible transaction involving MGM Holdings and MGM Group

Holdings.

The Ackerman group hired a French firm (unnamed in the

record) and the law firm of Shearman & Sterling, LLP (Shearman &

- 42 Sterling), in New York City, to assist in the proposed

transaction with CDR.

Mr. Lerner testified that “When our conversation began with

Rene Claude [Jouannet] about acquiring MGM Holdings, I already

knew from the due diligence exercise before that there were, I

would say, complex tax issues arising from the acquisition of

that company”, including tax basis and NOL issues.

He testified

that he asked Shearman & Sterling to give him “an analysis of the

ways in which a transaction could be organized involving MGM

Holdings so that any tax attributes that might have existed could

be preserved.”

Shearman & Sterling prepared two memoranda

summarizing the anticipated U.S. tax consequences of certain

hypothetical transactions involving MGM Holdings.

On November 1, 1996, Alvin D. Knott of Shearman & Sterling

sent a letter to William Wofford, an associate at White & Case,

requesting documentation of obligations that MGM Group Holdings

owed; balance sheets and income statements of MGM Group Holdings,

MGM, and Generale Bank; documentation of the loans from CLBN to

Pathe; documentation of the transactions in which MGM Group

Holdings acquired Sealion’s 1.5-percent interest in MGM Group

Holdings; and documentation of the liquidation of MGM Holdings.

On November 6 and 8, 1996, Mr. Wofford sent two letters to Mr.

Knott providing the requested information and documentation.

December 3, 1996, Mr. Knott sent a letter to Mr. Lerner enclosing

- 43 these letters and summarizing the information and documentation

received.

On December 6, 1996, Mr. Wofford faxed to Mr. Lerner’s

representative, James M. Rhodes:

(i) The debt release and

assumption agreement dated as of October 9, 1996, by and among

MGM Group Holdings, MGM, and Credit Lyonnais; and (ii) the

certificate of amendment of MGM Group Holdings, changing its name

to SMHC.

Negotiation and Drafting Process

At some point, Mr. Lerner, on behalf of Rockport Capital,

and Mr. Jouannet, on behalf of CDR, decided to move forward with

a transaction involving MGM Group Holdings.

Negotiations

concerning this proposed transaction continued throughout October

and November 1996.

The law firm of White & Case, LLP,

represented the interests of CDR during the course of the

negotiation, drafting, and agreement process with the Ackerman

group.

Sean Geary was the lead attorney in White & Case’s

representation of CDR.

Rockport Capital Confirms Its Interest

On September 11, 1996, Mr. Lerner sent a letter to Mr.

Geary, as counsel for CDR, confirming “the interest of Rockport

Capital * * * in MGM Holdings, Inc. * * * and the U.S. tax

attributes which may relate to the direct and indirect

investments by Credit Lyonnais, S.A., and * * * [CDR] in Metro-

- 44 Goldwyn-Mayer, Inc.”

The letter agreement did not mention any

films or film business.

Draft Term Sheet and Letter Agreements

On October 16, 1996, at Mr. Lerner’s request, Shearman &

Sterling sent Mr. Geary a “Draft Term Sheet” proposing a

transaction with Generale Bank concerning MGM Group Holdings.

The draft term sheet contained a section entitled “Initial

Transactions”, providing:

Generale Banque acquires all the stock of MGM Group

Holdings (“Group”) and subsequently contributes

obligations owed to it by Group in the approximate

amount of $1.050 billion (collectively, the “Note”) to

the capital of Group.

The draft term sheet proposed an alternative transaction whereby:

if CLIS’s current basis in Group stock is significant,

in lieu of the transactions described in the term

sheet: (a) CLIS will contribute all of the stock of

Group to Newco in exchange for Preferred Interests, (b)

Generale Banque will contribute the Note to Newco in

exchange for Preferred Interests, and (c) Newco will

contribute the Note to Group.

The draft term sheet also contained a section entitled

“Transaction Structure”, providing:

Step 1: Rockport Capital, Inc., and its associates

(the “Initial Members”) form a Delaware limited

liability company (“Newco”), and contribute assets

(cash and securities) to Newco in an agreed amount to

enhance and monetize the value of the Preferred

Interests to be issued in Step 2.

Step 2: Generale Banque contributes all of the stock

of Group to Newco in exchange for preferred membership

interests in Newco (“Preferred Interests”).

- 45 The draft term sheet contained a section called “Terms of

Preferred Interests”, which provided:

The Preferred Interests will have a liquidation value

equal to $

million, will have a 6% per annum

dividend preference, and will be convertible after 5

years into 51% of Newco’s common membership interests,

provided that if the conversion right is exercised,

Newco may redeem all of the Preferred Interests at

their liquidation value plus accrued and unpaid

dividends. The conversion right will be accelerated in

the event Newco fails to make a dividend payment when

due on the Preferred Interests, and in other pertinent

circumstances.

In addition to these items, the draft term sheet contained a

section entitled “Conditions”, which, among other things,

required Generale Bank to give satisfactory representations and

warranties to Newco and Rockport Capital as to the original

amount of the loans evidenced by its “Note”, the amount

outstanding under those loans at the time of the contribution of

the note to Newco, and the fact that MGM Group Holdings and

Generale Bank continuously recorded the note as debt from the

date of its creation through the date of contribution.

It also

provided that Rockport Capital (and its associates) would decide

whether Newco should be structured as a partnership or a

corporation for Federal income tax purposes.

The draft term

sheet did not mention any films or film business.

On October 21, 1996, at the request of Mr. Lerner, Shearman

& Sterling sent Mr. Geary a memorandum entitled “Draft Letter

Agreement” discussing the alternative transaction alluded to in

- 46 the draft term sheet and refining the terms and provisions in the

draft term sheet.

The memorandum stated that the letter

agreement “would require Generale Bank and CLIS simply to

transfer their respective assets to a Newco in exchange for

preferred interests which will be monetized.”25

Rockport Capital

would form a Delaware limited liability company (“Newco”) and

contribute assets (cash and securities) to Newco in an amount

mutually agreed by Rockport, CLIS, and Generale Bank, in exchange

for all the common interests in Newco; CLIS would contribute all

the stock of MGM Group Holdings to Newco in exchange for

preferred membership interests in Newco; and Generale Bank would

contribute to Newco, in exchange for preferred membership

interests, some $1.050 billion of obligations that MGM Group

Holdings owed to Generale Bank.

Regarding documentation, the

first draft letter agreement provided:

3. Documentation. The Transactions will be

documented in the form of an Exchange and Contribution

Agreement * * * among Newco, CLIS and * * * [Generale

Bank] which will contain customary representations,

warranties and indemnification provisions, including,

without limitation, (i) representations and warranties

by CLIS concerning Group’s assets and the absence of

any undisclosed liabilities, (ii) representations and

warranties by CLIS as to its basis in the stock of

Group, (iii) representations and warranties by * * *

[Generale Bank] as to the original amount of the loans

Mr. Geary explained that “by this time [the time of the

draft letter agreement] clearly there was going to be a second

letter, a put letter. That’s what I understood to be monetized.

There was a put available. We didn’t have to wait, you know, for

the time of the deal.”

- 47 evidenced by the Note [MGM Group Holdings’ debt

obligations of $1.05 billion], the amount outstanding

under such loans at the time of the contribution of the

Note to Newco, and the fact that * * * [Generale Bank]

and Group continuously recorded the Note as debt from

the date of creation through the date of contribution,

and (iv) provisions providing for the indemnification

by CLIS and * * * [Generale Bank] of Newco, the Initial

Members and their affiliates and agents against

breaches of any of the foregoing representations or

warranties.

At some point, White & Case took control of drafting the

letter agreement.

Mr. Geary tried to produce something that

reflected his discussions with Mr. Jouannet.

Mr. Geary

incorporated into the drafting process a side letter agreement

giving Generale Bank and CLIS the right to put their preferred

interests in Newco (later SMP) to Rockport Advisors (or its

affiliate).

The put could be exercised “no earlier than December

31, 1996 and no later than December 31, 1997 upon two days

written notice from a Seller to Purchaser directing that the Put

be effected.”

The side letter agreement proposed a $6 million

purchase price for the preferred interests and an advisory fee

consisting of $4 million plus an amount (not to exceed $2

million) equal to three-quarters of 1 percent of the tax losses,

if any, in excess of $1 billion that would have been allocated to

all members of Newco (other than Generale Bank, CLIS, Rockport

Advisors, CDR, or their affiliates) upon consummation of the

various transactions.

The $6 million purchase price and the

advisory fee were to be deposited in a blocked account with a

- 48 bank designated by CDR.26

On November 21, 1996, after exchanging

numerous drafts of the letter agreement and the side letter

agreement, the parties reached a basic agreement.

No draft of

the letter agreement or side letter agreement mentioned any films

or film business.

Further Negotiation and Drafting

Although the parties had reached basic agreement on the

terms of the proposed transaction, including the put in favor of

Generale Bank and CLIS, the transaction did not close at this

point.

The parties proposed supplementary terms to the letter

agreement and to the side letter agreement, as well as several

revisions to the terms of the side letter agreement.

These

proposals primarily concerned the Carolco securities--CDR wanted

to retain the benefit of whatever value might be realized on

those securities.

To this end, the parties added a contingent

amount to the put price that would be tied to any recovery on the

Carolco securities and also provided certain preferred

distribution rights tied to any proceeds realized on a

liquidation of Carolco.

In addition, the parties agreed that

Rockport Capital (instead of Rockport Advisors) and Mr. Lerner

would be the initial members of a limited liability company (that

would later become SMP), which would be structured as a

Over the course of the drafting process, the parties

agreed to a $5 million put price and a $5 million advisory fee.

- 49 partnership for Federal tax purposes and would be formed with an

aggregate contribution of $20 million.

After further

negotiations on the terms of the transaction, the attorneys for

both sides began distilling those terms into an exchange and

contribution agreement, a limited liability company agreement, a

deposit account agreement, and an advisory fee agreement.

Santa Monica Pictures, LLC, Is Formed

On December 6, 1996, SMP filed its certificate of limited

liability company.

On or about December 10, 1996, SMP applied

for registration with the State of California for the purpose of

registering to transact intrastate business in California.

Final Agreements and Documents

On December 11, 1996, the parties finalized the agreements

that they had negotiated over the course of several months.

Side Letter Agreement

On December 11, 1996, Rockport Capital, CDR, Generale Bank,

and CLIS executed a side letter agreement pursuant to which

Rockport Capital irrevocably agreed to purchase, upon written or

facsimile notice, all the preferred interests of Generale Bank

and CLIS in SMP for a specified purchase price.

Under the side

letter agreement, CLIS and Generale Bank could exercise the put

by giving written or facsimile notice during the period

- 50 commencing on December 31, 1996, and ending December 31, 1997.27

The purchase price for the preferred interests consisted of

a “Cash Purchase Price” and a “Contingent Amount”.

The Cash

Purchase Price was defined as the amount of CLIS’s and Generale

Bank’s initial preferred capital accounts in SMP ($5 million)

plus interest as of the purchase date.

defined as:

The Contingent Amount was

(i) The lesser of $7 million or the amount recovered

on the Carolco subordinated notes; plus (ii) the lesser of $3

million or the amount recovered on the Carolco preferred stock.

By its terms, the side letter agreement was not effective

until:

(i) Each of the parties signed a counterpart of the side

letter agreement and received a full set of signed counterparts;

and (ii) Rockport deposited $5 million (i.e., the sum of the

preferred capital accounts of CLIS and Generale Bank on the

closing date of the exchange and contribution agreement) in an

account maintained at Chase Manhattan Bank.

The side letter

agreement also provided that CLIS and Generale Bank had no

obligation to make the contributions provided for in the exchange

and contribution agreement unless and until the side letter

agreement became effective.

Any written or facsimile notice was required to have an

attached instrument of assignment, a copy of which was attached

as “Exhibit A” to the put agreement. Exhibit A provided that any

assignment and transfer of the preferred interests to Rockport

Capital was to be effective upon payment to the seller of the

cash purchase price provided in the put agreement.

- 51 2.

Exchange and Contribution Agreement

On December 11, 1996, SMP, CDR, CLIS, Generale Bank, and

Rockport Capital entered into an exchange and contribution

agreement (the exchange and contribution).

Under this agreement,

CLIS and Generale Bank agreed to contribute assets to SMP in

exchange for preferred membership interests in SMP.

According to

the exchange and contribution agreement, CLIS was to contribute

its SMHC stock and the $79 million receivable.28

Generale Bank

was to contribute $974 million in receivables.

Schedule 1 of the

exchange and contribution agreement described the $79 million

receivable and the $974 million in receivables as follows:

Holdings-CLIS Debt

$79,912,955.34 principal amount of indebtedness,

outstanding under the MGM Working Capital Credit

Agreement dated as of December 30, 1993 between MetroGoldwyn-Mayer Inc. (“MGM”) and Credit Lyonnais SA.

originally owing by MGM and assumed by Santa Monica

Holdings Corporation (then known as MGM Group Holdings

Corporation and herein “Holdings”) on October 9, 1996,

together with all accrued interest thereon.

Holdings-GB Debt

Indebtedness owing by Holdings to Generale Bank

Nederland (formerly known as Credit Lyonnais Bank

Netherlands) for borrowed money aggregating no less

than $974,296,600.85, together with all accrued

interests thereon, including that indebtedness

evidenced by a promissory note dated December 30, 1993

in the principal amount of $965,904,188.96 and by a

promissory note dated October 26, 1994. * * *

As previously noted, on Oct. 15, 1996, MGM Group Holdings

had changed its name to Santa Monica Holdings Corp. (SMHC).

- 52 CDR and CLIS represented and warranted:

(1) SMHC had an

authorized capitalization consisting of 200 million shares of

capital stock, of which 60 million shares of common stock, par

value $1.00 per share, were issued and outstanding; (2) the

aggregate amount of capital CLIS contributed to MGM Holdings from

the date of the creation thereof to the date of MGM Holdings’s

liquidation equaled approximately $605 million; and (3) CLIS had

received no payment of principal on the $79 million receivable

and had not written down any of the debt for accounting or tax

purposes.

Generale Bank also represented and warranted that it

had received no payment of principal on the $974 million in

receivables and had not written down the loans for accounting or

tax purposes.

CDR retained control of SMHC’s tax return filing

obligations for all taxable years or other taxable periods ending

on or before December 31, 1996.

On December 12, 1996, White & Case faxed to Mr. Lerner and

his associates Schedules 1.6(b) and (c) to the exchange and

contribution agreement and a revised deposit account agreement.

Schedule 1.6(b) lists the “U.S. Video Film Rights” to 65 films

(identified by title only), the rights to 26 development

projects, and the rights to the Carolco preferred stock and

- 53 $33,111,856.98 aggregate principal amount of the Carolco

subordinated notes.29

SMP LLC Agreement

On December 10, 1996, Rockport Capital and Mr. Lerner formed

SMP pursuant to a limited liability company agreement (the SMP

LLC agreement).

The SMP LLC agreement indicated that among the

purposes for which SMP was formed was “to produce and distribute

filmed entertainment products and to own interests in entities

engaged in such activities”.

The SMP LLC agreement provided that the members of SMP would

have the following membership interests:

Rockport

Lerner

Common

interest

Preferred

interest

Common

capital

account

Preferred

capital

account

50%

$50,000

50,000

$50,000

50,000

The agreement provided for 3 types of interests--Common I, Common

II, and Preferred.

Members holding Common I interests had

exclusive voting rights in SMP.

Members holding preferred

interests had no voting rights; however, they had the right to

convert all their preferred interests into Common II interests on

The exchange and contribution agreement (including its

attached schedules) did not define the term “U.S. Video Film

Rights”.

- 54 or after December 10, 2001.30

Members holding Common II

interests also had no voting rights in SMP.

Under the SMP LLC agreement, if the members holding

preferred interests exercised their conversion rights, SMP had

the right to redeem all the preferred interests at a price equal

to the sum of the preferred capital accounts for all holders of

preferred interests.

SMP also had the option to convert the

preferred interests into debt of SMP beginning on December 31,

1997, and on conversion, the debt would have a principal amount

equal to $5 million for a term of 5 years at an interest rate of

8 percent per annum.

Mr. Lerner was appointed SMP’s manager.

The SMP LLC

agreement provided that no member could sell, assign, transfer or

dispose of, directly or indirectly, by operation of law or

otherwise (including by merger, consolidation, dividend, or

distribution) any membership interest, without the prior written

consent of SMP’s manager.

It also provided that no member could

retire or withdraw from SMP without SMP’s manager’s written

consent except in certain defined circumstances.

Pursuant to the SMP LLC agreement, with certain exceptions,

each SMP member (including any additional members) agreed that it

Members holding preferred interests could immediately

convert their preferred interests to Common II interests if

certain required annual distributions of excess cashflow were not

made.

- 55 would not, and would not cause any of its affiliates to, at any

time, reveal to any other person or use in any way detrimental to

SMP any nonpublic, confidential, or proprietary information

relating to the business and affairs of SMP that was acquired or

otherwise received by such person in connection with the

transactions contemplated in the LLC agreement.

Amendment No. 1

Mr. Lerner and Rockport Capital executed an amendment

(“Amendment No. 1”) to the SMP LLC agreement dated as of December

11, 1996, which admitted CLIS and Generale Bank as new members of

SMP.

Amendment No. 1 recited that CLIS would contribute its SMHC

stock and the $79 million receivable to SMP, and Generale Bank

would contribute $974,296,600.85 of principal indebtedness owing

by SMHC, in exchange for preferred interests in SMP.31

CLIS and

Generale Bank executed ratification certificates agreeing to all

the terms of the SMP LLC agreement as amended by Amendment No. 1.

Amendment No. 2

Mr. Lerner, as manager of SMP and as a director of Rockport

Capital, executed a second amendment (“Amendment No. 2”) to the

SMP LLC agreement dated as of December 11, 1996, admitting

Somerville S Trust as a member of SMP.

Amendment No. 2 required

From this point forward, the documents in the record

(including the relevant tax returns) refer to $974,296,600.85 in

indebtedness owing by SMHC. Previous documents alluded to a

principal debt of $975,494,909.84. For our purposes, we refer to

the $974 million in receivables from Generale Bank.

- 56 Somerville S Trust to contribute $19.8 million in cash to SMP in

exchange for a 99.5-percent common interest in SMP (to be held as

a Common I interest).

Mr. Lerner, as trustee of Somerville S Trust, executed a

document entitled “Assignment” dated December 10, 1996, in which

Somerville S Trust contributed $19.8 million in cash and

marketable securities to SMP.32

The members of SMP had the following membership interests in

SMP after December 11, 1996:

CLIS

Generale Bank

Somerville

Rockport

Lerner

Common

interest1

Preferred

interest2

Common

capital

account

Preferred

capital

account

99.50

2.25

36.76%

61.27

0.85

19,800,000

50,000

$1,875,000

3,125,000

50,000

The common membership interests in SMP do not add up to

100 percent.

The preferred membership interests in SMP do not add up to

100 percent.

Amendment No. 2 indicated that the $19.8 million in cash

and marketable securities would be held by Somerville S Trust

“for the sole and exclusive benefit of the LLC and that said

amount shall heretofore be deemed assigned to and owned by the

LLC.” It also indicated that on or before Dec. 31, 1997, this

amount plus interest would be paid to an account established in

the name of SMP.

- 57 4.

Deposit Account Agreement

On December 11, 1996, Rockport, CDR, and Chase Manhattan

Bank entered into a deposit account agreement (the deposit

account agreement) pursuant to which Rockport agreed to place $5

million in a blocked account to be paid to Generale Bank and CLIS

upon the exercise of the put under the side letter agreement.

Pursuant to the deposit agreement, upon notice from CDR directing

a distribution to be made, Chase Manhattan Bank was irrevocably

directed to distribute the amount specified in the notice.

Rockport Capital irrevocably agreed that no amount on deposit in

the deposit account could be distributed at the direction of

Rockport Capital.

The deposit agreement provided that on January

2, 1998, the bank would withdraw and pay to Rockport Capital all

funds then on deposit, if no withdrawal had been made by then.

Advisory Fee Agreement

On December 11, 1996, Rockport Capital executed a letter

(the advisory fee agreement) agreeing to pay CLIS an advisory fee

of $5 million and an additional advisory fee equal to threequarters of 1 percent of the tax losses, if any, in excess of $1

billion that would be allocated to all members of SMP other than

Generale Bank, CLIS, Rockport, or their affiliates as of the

exchange and contribution agreement closing date.

In the

advisory fee agreement, Rockport agreed that “notwithstanding any

provision of the * * * [letter agreement] to the contrary, the

- 58 Effective Date will not occur unless Rockport has made the

payment, if any, required by the preceding paragraph.”

Consent

Prior to becoming members of SMP, CLIS and Generale Bank

required Mr. Lerner, as manager of SMP, to execute a document

(the consent) to provide advance consent to transfer CLIS’s and

Generale Bank’s preferred interests and to withdraw from SMP.33

White & Case drafted the consent on behalf of CLIS and Generale

Bank and dated it “___________, 1996”.34

Prior to CLIS’s and Generale Bank’s becoming members of

SMP, Mr. Lerner, as manager of SMP, signed the consent agreeing

to CLIS’s and Generale Bank’s transfer of preferred interests in

SMP and withdrawal as members of SMP.

Assignment to Santa Monica Finance, B.V.

On December 23, 1996, Mr. Geary sent Mr. Lerner:

(i) A

facsimile of an instrument assigning Generale Bank’s 61.27percent preferred interest in SMP to Santa Monica Finance, B.V.;

and (ii) an executed ratification certificate from the latter

entity.

CLIS and Generale Bank planned to transfer the preferred

interests to a CDR affiliate, Santa Monica Finance B.V., before

the put under the side letter agreement was exercised.

Mr. Lerner executed two other consents for the transfer

of preferred interests and the withdrawal of an unnamed “Member”

of SMP. These consents were also predated “

, 1996”.

- 59 E.

Exercise of the Put

On December 26, 1996, Mr. Geary, pursuant to the

instructions of Mr. Jouannet, sent facsimiles to William Ponce,

Gary Mazzola, and Celia Murphy at Chase Manhattan Bank, and to

Mr. Lerner, transmitting notices from CLIS and Santa Monica

Finance, B.V., exercising their rights under the side letter

agreement and the deposit account agreement.35

The $5 million

that Somerville S Trust had deposited with Chase Manhattan Bank

was duly paid to CLIS and Generale Bank.

Per an informal

agreement between Rockport Capital and Somerville S Trust,

Somerville S Trust became the purchaser and owner of the

preferred interests.

VI.

Film Rights Contributed to SMHC

Film Titles and Development Projects

The following film titles and development projects were

listed in Schedule 1.6(b) of the exchange and contribution

agreement as assets of SMHC:

U.S. Video Film Rights

Alley Cat

Astro Zombies

Auditions

Avenger

Banana Monster

Battle of the Last Panzer

10.

11.

12.

Battle of the Valiant

Beast, The

Blood Brothers

Blood Castle

Cardiac Arrest

Carthage in Flames

Mr. Geary exercised Generale Bank’s and CLIS’s rights

under the side letter agreement and deposit account agreement on

Dec. 26, 1996; however, the put period did not commence until

Dec. 31, 1996.

- 60 13.

14.

15.

16.

17.

18.

19.

20.

21.

22.

23.

24.

25.

26.

27.

28.

29.

30.

31.

32.

33.

34.

35.

36.

37.

38.

39.

40.

Cold Steel for Tortuga

Conqueror and the Empress

Crimson

Demoniac

Duel of Champions

Equinox

Erotkill

Escape from Hell

Escape from Venice

Fear

Fist of Fear, Touch of

Death

Fraulein Devil

Headless Eyes

Invincible Gladiators

Invisible Dead

Jungle Master

Oasis of Zombies

Return of the Conqueror

Return of the Zombies

SS Camp 5

SS Experimental Love Camp

The Sword & The Cross

Throne of Vengeance

Tiger of the Seven Seas

Tormentor

White Slave

Zombie

Mother & Daughter: Loving

War

41.

42.

43.

44.

45.

46.

47.

48.

49.

50.

51.

52.

53.

54.

55.

56.

57.

58.

59.

60.

61.

62.

63.

64.

65.

Octavia

Platypus Cove

Summer Camp Nightmare

Bombay Talkie

Courtesans of Bombay

Hullabaloo over Georgia

Shakespeare Wallah

Nasty Hero

To Love Again

Sticks and Stones

This Time I’ll Make You

Rich

Danger Zone

Hunter’s Blood

Sidewinder One

Firefight

House of Terror

Ninja Hunt

Ninja Showdown

Ninja Squad

Outlaw Force

Plutonium Baby

Terror on Alcatraz

The Visitants

War Cat

White Ghost

14.

15.

16.

17.

18.

19.

20.

21.

22.

23.

24.

25.

26.

Karma Sutra

“M”

Marriage License

Nobody’s Boy

Pied Piper

Price of Passion

Prince and the Pauper

Princess and the Pea

Scorched Season

Snow Queen

Strike on Babylon

Tom Sawyer

Treasure Island

Development Projects

10.

11.

12.

13.

Atlantis

Captain’s Daughter

Child Prostitution

Detroit Boogie

Deadly Vision

Dubrovsky

Shining City

$1.98 Man

Ballhouse Jam

Cinderella

Golden Goose

Goldilocks & 3 Bears

Jack & the Bean Stalk

- 61 B.

History of the EBD Film Library

Epic Productions

In the late 1980s, through some intermediate steps of

ownership, Credit Lyonnais created Epic Pictures Enterprises

(Epic Pictures) and Epic Productions, Inc. (Epic Productions).

Epic Pictures was created in 1987 or 1988 to take possession of

and manage certain motion picture assets.

Epic Productions took

possession of the stock of Epic Pictures and managed that company

after it was created.

In 1992, Credit Lyonnais lost confidence

in the existing management of Epic Productions and hired John

Peters to replace that management and serve as its CEO.36

Mr.

Peters worked as Epic Productions’ CEO from 1992 until July 1998.

In late 1993 or early 1994, Credit Lyonnais began acquiring

other entertainment assets, particularly film libraries, from

companies to which Credit Lyonnais had lent money.

(When loans

from Credit Lyonnais became distressed, Credit Lyonnais would

acquire the film assets in workouts, bankruptcies, or other

proceedings.)

To take possession of, or title to, these film

assets, Credit Lyonnais created approximately six companies,

including Alpha Library Co., Inc. (Alpha) and Epsilon Library

Co., Inc. (Epsilon).

After Credit Lyonnais acquired these film

As chief executive officer (CEO) at Epic Productions,

John Peters had frequent contact with individuals associated with

Credit Lyonnais, including Hank de Kaiser in Rotterdam, Mr.

Jouannet and Michelle la Brund in Paris, and Bruno Hurstel, who

was a director on Epic Productions’ board.

- 62 assets, it turned them over to Epic Productions to manage.

As a

result, Epic Productions eventually was managing over 1,000 films

(the CDR library).

Credit Lyonnais’s overall goal was to liquidate the film

assets that it acquired rather than to simply consolidate these

assets and pursue business in the entertainment realm.

By late

1995, Credit Lyonnais instructed Epic Productions to begin

planning the liquidation of the CDR library; this became the

focus of Epic Productions’ business operations.

EBD (Rotterdam) Finance, B.V.

On December 18, 1995, CDR incorporated EBD (Rotterdam)

Finance, B.V. (EBD), as a special-purpose entity to take over the

so-called EBD film-related portfolio which was excluded from the

sale of CLBN to Generale Bank.37

Selection of Film Titles for CDR

In 1996, during Epic Productions’ efforts to sell the CDR

library, someone at either Credit Lyonnais or EBD contacted Mr.

Peters and instructed him to find some low-value films and

development projects within the CDR library.38

Mr. Peters

The record is unclear on the precise role that EBD played

vis-a-vis Epic Productions, although it appears that EBD was in

some respect higher on the Credit Lyonnais/CDR chain than Epic

Productions.

Mr. Peters testified that the individual who contacted

him from Credit Lyonnais or EBD was likely Hank de Kaiser, Mr.

Jouannet, Bruno Hurstel, or Michelle la Brund.

- 63 selected the “U.S. Video Film Rights” to the 65 film titles and

the rights to the 26 development projects that were listed in

Schedule 1.6(b) of the exchange and contribution agreement.

Assignments Before the Contributions to SMHC

As described below, a number of documents were executed

providing for transfers and assignments of the 65 film titles and

26 development projects that Mr. Peters had selected.

According to a document entitled “Assignment” dated as of

December 10, 1996, Alpha assigned and transferred to CLIS:

(i) The “U.S. Video Film Rights” to 15 film titles; and (ii)

eight development projects for “$0.25 and other good and valuable

consideration.”39

According to this document, Alpha made no

express or implied warranties or representations with respect to

these assets.

According to a second document entitled “Assignment” dated

as of December 10, 1996, Epsilon assigned and transferred to CLIS

18 development projects for “$0.25 and other good and valuable

consideration.”

According to this document, Epsilon made no

express or implied warranties or representations with respect to

these assets.

According to a third document entitled “Assignment” dated as

of December 10, 1996, EBD assigned and transferred to CLIS the

The assignment, including its attached schedule, did not

define the term “U.S. Video Film Rights”; it identified the films

only by titles.

- 64 “U.S. Video Film Rights” to 50 film titles for “$0.50 and other

good and valuable consideration.”40

According to this document,

EBD made no express or implied warranties or representations with

respect to these assets.

According to a fourth document entitled “Assignment”, dated

as of December 10, 1996, EBD, on behalf of itself and its

subsidiaries, Alpha, Epsilon, and Epic Pictures (collectively

“the EBD group”), assigned and transferred to CLIS the “U.S.

Video Film Rights” to 65 film titles (the EBD film rights) and 26

development projects (collectively “the EBD film library”) for

“$1 and other good and valuable consideration”.41

According to a fifth document entitled “Resolutions of

Credit Lyonnais International Services”, effective December 10,

1996, CLIS assigned, transferred, and contributed all its rights

and interests in the EBD film library to the capital of SMHC.

Storage Conditions of the EBD Film Library

In 1996, many of the films in the EBD film library were

stored at “the Epic warehouse”, which Epic Productions owned.

The Epic warehouse was a metal shell building, about 30,000

square feet, located near the airport in Burbank, California,

The assignment, including its attached schedule, did not

define the term “U.S. Video Film Rights”; it identified the films

only by titles.

The assignment, including its attached schedule, did not

define the term “U.S. Video Film Rights”; it identified the films

only by titles.

- 65 about 5 or 6 miles from Epic Productions’ offices.

At this

location, film materials were stored on metal racks along with

other materials, including reels of film, posters, publicity

materials, cardboard cassette boxes, cassette inventory, old

files, an ambulance, and an old Cadillac convertible.

Unlike

regular film laboratories and facilities, the Epic warehouse was

not a temperature- and humidity-controlled facility; it was not

bonded; and it did not have good inventory control.

At one time, Epic Productions had a full-time employee who

supervised and provided security at the Epic warehouse; however,

as of sometime before 1996, Epic Productions had no supervision

or security at the Epic warehouse.

For this and other reasons,

Epic Productions stored no film materials in the Epic warehouse

that it regarded as highly valuable or irreplaceable.

If Epic

Productions had master film material for valuable films, it

stored them in secure laboratories with temperature and humidity

controls.

VII. Due Diligence for the CDR Transaction

James Rhodes

Sometime in 1996, Mr. Lerner hired an attorney, James

Rhodes, to assist with some of the due diligence on the

“corporate side” for the transaction between Rockport Capital and

CDR.

Mr. Rhodes continued his work into 1997, tying up loose

- 66 ends and following up with White & Case and Mr. Jouannet to

complete the Ackerman group’s files.

On December 11, 1996, Mr. Rhodes faxed to Mr. Wofford at

White & Case a revised draft of a “Basis Chronology”, which

contained an analysis of the bases of all the assets involved in

the transaction between Rockport Capital and CDR.

The basis

chronology included a section analyzing the basis of the MGM

Group Holdings stock, and it listed three transactions affecting

the basis of MGM Group Holdings’ stock:

(i) MGM Holdings’s

purchase of 98.5 percent of MGM Group Holdings stock in the 1992

foreclosure sale for $483,489,000; (ii) Credit Lyonnais’s

acquisition of Sealion’s 1.5-percent stock interest in MGM Group

Holdings that had been pledged to Credit Lyonnais as security for

a $150 million loan to Sealion; and (iii) MGM Holdings’s

contribution of Carolco securities in the face amount of $60

million to MGM Group Holdings on September 28, 1996.

On May 12, 1997, Mr. Wofford sent a facsimile cover sheet to

Mr. Rhodes which stated:

This letter is to confirm that, to our knowledge,

none of Credit Lyonnais International Services

(“CLIS”), Generale Bank Nederland (“GB”), or any

affiliate of Credit Lyonnais S.A. or Consortium de

Realisation (“CDR”) derived any U.S. tax benefit from

the contribution of the stock of Santa Monica Holdings

Corporation or the Holdings - CLIS Debt (as defined in

the Exchange and Contribution Agreement (the

“Agreement”) by and among Santa Monica Pictures, L.L.C.

(the “Company”), CDR, CLIS, GB and Rockport Capital

Incorporated, dated as of December 11, 1996) pursuant

- 67 to the Agreement or the subsequent disposition by CLIS

and GB of interests in the Company.

Troy & Gould

In June 1997, Mr. Lerner engaged the law firm of Troy &

Gould, P.C., in Los Angeles, California, to perform due diligence

on the EBD film library.

Two highly regarded entertainment

lawyers at Troy & Gould, Gary Concoff and Jonathan Handel,

conducted the due diligence.

Before engaging Troy & Gould, Mr.

Lerner received no documentation tracing the chain of title for

the EBD film rights.

Chain-of-Title and Record Search

Troy & Gould contacted individuals at certain law firms and

at various entities (principally Epic Productions) that were

believed to have held interests in the EBD film library.

December 9, 1997, Mr. Handel sent Mr. Lerner a memorandum

containing Troy & Gould’s conclusions regarding the nature of the

rights that SMHC acquired in the EBD film library.

The

memorandum summarizes its conclusions as follows:

The documentation is too fragmentary to draw

conclusions with any semblance of confidence. As a

matter of general characterization, it would seem that

Santa Monica Holdings is intended to have acquired

domestic video rights for a term of years to the

subject pictures and all rights to the subject

development projects. The domestic rights appear to

include Canada as to some but not all pictures. The

term of the rights varies from picture to picture.

Again, the foregoing characterization is subject to the

caveat that we have no documentation whatsoever on most

of the subject pictures and projects, and the

- 68 documentation we do have is incomplete. In addition,

there are outright gaps in the chain of title as to

groups of pictures; that is, certain documents relating

to transfers of libraries are missing.

For the foregoing reasons, it is not possible to

determine what rights have effectively been acquired.

It also is unclear who possesses the rights other than

domestic video in the various pictures, and who

possesses the reversion rights in domestic video.

The memorandum related that Epic Productions provided chain-oftitle documentation for only 15 of the 65 film titles (and 22 of

26 development projects), and that many of the 15 film titles for

which Troy & Gould received documentation appeared to be the

subject of domestic video rights licenses to Embassy and

Concorde, but that some of those licenses expired in May 1997.42

Troy & Gould stated that rights to completed pictures in the

EBD film library were apparently acquired by three entities,

Epic, Sultan (or its predecessor, Nelson), and Trans World

Entertainment; however, Troy & Gould could not determine how

these entities acquired rights from other entities appearing in

the chain of title, e.g., Embassy.

Troy & Gould concluded that

this failure represented a significant gap in the chain of title.

From its examination of these film titles, Troy & Gould

determined that the licenses were for a term of years, in most

cases 10 years from delivery, and that it appeared for the most

part that the licenses had recently expired or would soon expire.

Troy & Gould concluded that “as to pictures for which the video

license to Embassy or Concorde has expired, it would appear that

* * * [SMHC] has no rights whatsoever, unless there are other

assignments (for which we have no documentation) into our chain

of title from the producers or other rights holders.”

- 69 Troy & Gould pointed out:

“There is no evidence * * * that

the Epic entities actually transferred their rights in the

subject pictures to EBD, despite the fact that EBD subsequently

purported to transfer rights in the pictures”; and “The

documentation of the chain of title thus appears unsatisfactory

as to the Epic pictures.”

Troy & Gould characterized the various assignments of film

assets from Alpha, Epsilon, and EBD to CLIS as “quitclaim

assignments; that is, the transferors disclaimed all warranties

and representations as to the assets.”

Moreover, although the

assignments referred to all right, title, and interest in the

film assets, the attached schedules referred only to “‘U.S. Video

Film Rights’”.

Troy & Gould also indicated that it had no

documentation confirming CLIS’s assignment of the EBD film

library to SMHC; it characterized this lack of documentation as

“another significant gap in the chain of title.”

Troy & Gould

expressed further concerns that the term “U.S. Video Film Rights”

in Schedule 1.6(b) of the exchange and contribution agreement was

not defined and that the exchange and contribution agreement

contained no explicit statement that SMHC owned those rights.

Access Letters

While Troy & Gould was conducting its due diligence on the

EBD film library, it was also attempting to obtain laboratory and

facility access letters to the physical materials of certain film

- 70 titles in order to enter the laboratories and facilities and

examine those physical materials.

VIII. Other Film Activities

In 1997, 1998, and 1999, SMHC (largely through the efforts

of Mr. Lerner, sometimes working with Michael Herz, the vice

president of Troma Entertainment, Inc.) investigated and acquired

a number of film titles and film libraries in addition to the

film library acquired in connection with the CDR transaction.

June 16, 1999, memo that Mr. Lerner sent to Mr. Ackerman reported

on the film libraries that SMHC had acquired, summarizing the

“initial library and acquisitions”, the number of titles, and

their “Cost” as follows:

Library

MGM (original)

Wisdom

City Lights

Five Stones

Vista Street

Moving Picture Factory

Total

New Production Total

Total

Number of Titles

Cost

165

167

$5,000,000

120,000

115,000

75,000

470,000

320,000

$615,000

$6,715,000

The “Wisdom” library, which Crown Capital purchased in

November 1997 from Wisdom Entertainment, Ltd., contained eight

karate films.

The “City Lights” library, purchased by Crown

Capital in September 1997 from Nevada Media Partners, Inc.,

contained 15 full-length feature films.

The “Five Stones”

library, purchased by SMHC in October 1998 from Five Stones,

- 71 Inc., contained five film titles.

The “Vista Street” library,

purchased by SMHC in March 1999 from Marketing Media Corp. d/b/a

Vista Street Entertainment, contained 24 film titles.

The

“Moving Picture Factory” library, purchased by SMHC in October

1998 from The Moving Picture Co., Inc., contained 34 film titles.

SMHC also investigated a number of film titles and film

libraries that, for one reason or another, it did not acquire.

IX.

Relationship With TroMetro Films, LLC

John H. van Merkensteijn

John H. van Merkensteijn was Mr. Lerner’s longtime friend,

client, and business associate.

In the 1970s, Mr. Lerner had

represented Mr. van Merkensteijn in some transactions.

Since

then, they have stayed in contact and have been friends.

Mr. van

Merkensteijn participated in transactions with Mr. Lerner both

before and after 1996.

TroMetro Films, LLC

On December 15, 1997, Mr. van Merkensteijn formed TroMetro

Films, LLC (TroMetro), to be part of a distribution relationship

with SMHC and Troma and to purchase receivables from SMP.

Mr.

van Merkensteijn had no office of his own for TroMetro; instead,

he had items sent to Crown Capital’s office.

- 72 C.

TroMetro’s Purchases of SMP’s Receivables

In 1997 and again in 1998, TroMetro purchased from SMP

portions of the $974 million in receivables that Generale Bank

had contributed to SMP in 1996.

First Note Purchase Agreement

As of December 19, 1997, TroMetro and SMP entered into a

note purchase agreement (the first note purchase agreement) in

which TroMetro agreed to purchase “SMP’s right, title and

interest in and to the $150,000,000 Note” (the $150 million

receivable).

was:

The consideration for the $150 million receivable

(i) A certified check of $230,000; and (ii) a promissory

note that TroMetro executed in an unspecified amount.

SMP agreed

to deliver to TroMetro, at the closing of the transaction, a $150

million note endorsed by SMP and payable to the order of

TroMetro.

As of December 19, 1997, Mr. van Merkensteijn, as manager of

TroMetro, executed an “Unsecured Promissory Note” payable to SMP

in the amount of $2,284,000 (the $2,284,000 Trometro note) in

connection with TroMetro’s purchase of the $150 million

receivable.

The terms of this note provided that interest would

accrue at 7 percent per annum, that interest and principal would

be fully amortized over 5 years, and that interest and principal

payments would be due and payable in five equal annual

installments beginning December 19, 1998.

- 73 In connection with the sale of the $150 million receivable

at the end of 1997, Mr. Lerner executed a $150 million note (the

$150 million note) representing a portion of the $974 million in

receivables that Generale Bank had contributed to SMP.

stated that MGM Group Holdings owed CLBN $150 million.43

The note

Mr.

Lerner backdated the note as of December 30, 1993, and signed it

as president of MGM Group Holdings; however, Mr. Lerner was not

the president, or an officer, of MGM Group Holdings on that date.

As a result of the sale of the $150 million receivable, SMP

reported the following information on its 1997 Form 1065, U.S.

Partnership Return of Income, with respect to the $150 million

receivable:

Date acquired

Date sold

Sales price

Cost or other basis

Gain or (Loss) for entire year

12/30/93

12/19/97

$2,514,000

$150,000,000

($147,486,000)

The $147,486,000 loss flowed through to Somerville S Trust.44

The note purchase agreement restated that “SMP is the

holder of two Promissory Notes issued by * * * [SMHC] in the

respective principal amounts of $815,904,188.96 and

$150,000,000”.

On Dec. 29, 1997, Somerville S Trust contributed all its

outstanding member interests in Somerville, LLC to SMP. This

contribution was reflected on SMP’s 1997 partnership tax return

as a $145,236,168 increase in Somerville S Trust’s capital

account in SMP.

- 74 2.

Second Note Purchase Agreement

As of December 10, 1998, TroMetro and SMP entered into a

second note purchase agreement (the second note purchase

agreement) in which TroMetro agreed to purchase “10% of SMP’s

right, title and interest in and to the Note, representing a

$81,590,418 share of the face amount of the Note” (the $81

million receivable).45

receivable was:

The consideration for the $81 million

(i) A $150,000 certified check; and (ii) a $1.25

million promissory note from TroMetro.

As of December 10, 1998, Mr. van Merkensteijn, as manager of

TroMetro, executed an “Unsecured Promissory Note” payable to SMP

in the amount of $1.25 million (the $1.25 million TroMetro note)

in connection with TroMetro’s purchase of the $81 million

receivable.

The terms of this note provided that interest would

accrue at 7 percent per annum, that interest and principal would

be fully amortized over 5 years, and that interest and principal

payments would be due and payable in five equal annual

installments beginning December 10, 1999.

As of December 10, 1998, Mr. Lerner, as manager of SMP, and

Mr. van Merkensteijn, as manager of TroMetro, signed a document

entitled “Assignment.”

Pursuant to this document, SMP assigned

The second note purchase agreement stated that SMP was

the holder of an $815,904,188.96 promissory note that SMHC had

issued.

- 75 to TroMetro, and TroMetro purchased and assumed from SMP, SMP’s

right, title, and interest in the $81 million receivable.

As a result of the sale of the $81 million receivable, SMP

reported the following information on its 1998 Form 1065 with

respect to the $81 million receivable:

Date acquired

Date sold

Sales price

Cost or other basis

Gain or (Loss) for entire year

12/30/93

12/10/98

$1,400,000

$81,590,418

($80,190,418)

The $80,190,418 loss flowed through to Somerville S Trust.

Purchase Price Determinations

Mr. van Merkensteijn testified that the purchase price for

the $150 million receivable and the $81 million receivable was

determined as percentages of the total value of SMHC’s assets,

after applying a discount.

He testified that the total value of

the assets in this calculation was based on an appraisal that Mr.

Lerner had obtained from Sage Entertainment.46

Mr. van

Merkensteijn did not obtain his own appraisal of SMHC’s assets.

Payments on the TroMetro Notes

On December 21, 1998, TroMetro made a $557,046.35 payment to

SMP on the $2,284,000 TroMetro note.

This payment consisted of

$397,166 principal and $159,880.35 interest.

It was the only

At some point, Mr. Lerner had asked Sage Entertainment

for an opinion valuing the EBD film library. He had obtained an

opinion from Steve Kutner of that company valuing the library at

approximately $29 million.

- 76 cash payment TroMetro ever made on the $2,284,000 TroMetro note.

On December 21, 1998, TroMetro paid SMP $150,000 pursuant to the

second note purchase agreement.

TroMetro never made any

additional cash payments on the $1.25 million TroMetro note.

Distribution Agreements

In 1997, SMHC entered into a distribution agreement with

TroMetro which, in turn, entered into a distribution agreement

with Troma.

The distribution agreements covered a portion of the

EBD film library and several of SMHC’s acquired libraries.

The TroMetro Distribution Agreement

As of December 23, 1997, SMHC and TroMetro entered into a

distribution agreement (the TroMetro distribution agreement).

Pursuant to this agreement, SMHC gave TroMetro a license to

distribute 33 of the 65 film titles within the EBD film library,

as well as the “Wisdom” library and the “City Lights” library.47

TroMetro never paid any royalties to SMHC pursuant to the

TroMetro distribution agreement.

The 33 film titles from the EBD film library were:

“Astro Zombies”, “Auditions”, “Avenger”, “Banana Monster”,

“Battle of the Last Panzer”, “Battle of the Valiant”, “The

Beast”, “Blood Brothers”, “Blood Castle”, “Carthage in Flames”,

“Cold Steel for Tortuga”, “Dual of Champions”, “Escape From

Hell”, “Fear”, “Fist of Fear, Touch of Death”, “Headless Eyes”,

“Invincible Gladiators”, “Return of the Conqueror”, “Return of

the Zombies”, “SS Experimental Love Camp”, “The Sword and the

Cross”, “Tiger of the Seven Seas”, “Tormentor”, “White Slave”,

“Octavia”, “Platypus Cove”, “Hullabaloo Over Georgia”, “To Love

Again”, “This Time I’ll Make You Rich”, “Danger Zone”,

“Sidewinder One”, “Ninja Showdown”, and “Ninja Squad”.

- 77 B.

The Troma Distribution Agreement

As of December 23, 1997, TroMetro and Troma Entertainment,

Inc. (Troma), an independent production and distribution company

in New York City, entered into a distribution agreement (the

Troma distribution agreement), covering the same film titles as

the TroMetro distribution agreement.48

Troma never paid any

royalties to TroMetro pursuant to the Troma distribution

agreement.

Troma Entertainment, Inc.

Michael Herz and Lloyd Kaufman started Troma while they were

students at New York University Law School in 1974.49

Troma is

owned by Messrs. Herz and Kaufman, a private company called QIC

controlled by Alan Quasha, and Foster Partnership.

In the early 1980s, Troma began distributing its films with

a film called “Squeeze Play.”

Troma eventually produced 25 to 30

films and acquired a number of films through purchases and

distribution deals.

Troma currently has 800 to 850 film

On Nov. 2, 1998, TroMetro and Troma entered into an

addendum, to which SMHC acknowledged and consented, amending the

Troma distribution agreement. Pursuant to this addendum, the

“Moving Pictures” library and the “Five Stones” library were

added to the Troma distribution agreement. No addendum was made

to the TroMetro distribution agreement.

Mr. Lerner was introduced to Mr. Herz by Mr. van

Merkensteijn.

- 78 titles.50

All of Troma’s film titles are available on its

website, and there are distribution materials such as advertising

slicks for them.

Not all of Troma’s films, however, are in

current distribution.51

Troma’s Distribution of the EBD Film Library

Distribution History

SMHC and SMP distributed no films prior to forming their

relationship with Troma.

films.

Troma was the only distributor of SMHC

Of the 65 film titles in the EBD film library, Troma

ultimately distributed six films:

“Astro Zombies”, “Banana

Monster”, “Battle of the Last Panzer”, “Escape from Hell”, “Fist

of Fear, Touch of Death”, and “Plutonium Baby”.52

Several of these distributions ran into legal troubles.

March 27, 1998, Epic Productions informed Troy & Gould that

SMHC’s rights had expired in “Astro Zombies”, “Banana Monster”,

There are several stars in Troma’s films, including Billy

Bob Thornton and Kevin Costner. The character “Toxic Avenger” is

Troma’s ‘Mickey Mouse’, having been featured in four action

movies and a children’s cartoon that Troma distributed.

About 200 to 220 of Troma’s film titles have actually

been authored and digitized and are out in U.S. distribution on

DVD. The remaining film titles are not in distribution because

the process of preparing them for distribution is costly, and

because Troma needs to be sure that the market can absorb the

number of films that it presents for distribution on a monthly

basis.

Troma created distribution materials for the eight film

titles in the “Wisdom” library.

- 79 and “Fist of Fear, Touch of Death”.53

Moreover, on June 23,

1999, a representative of Gazotskie Films, Inc., informed Troma

Entertainment that SMHC “does not have, nor has it ever had, any

rights” relating to “Banana Monster” (a.k.a. “Schlock”), and

requested that Troma cease and desist its distribution of that

film title.

Also, on October 23, 1999, Jack H. Harris, the

president of Worldwide Entertainment Corp., informed Troma that

SMHC’s rights in the film title “Astro Zombies” had actually

expired in 1987, and requested that Troma cease and desist its

distribution of that film.

Distribution Revenue and Expenses

In the course of distributing SMHC films, Troma incurred

expenses (e.g., for advertising slicks and media costs) which

SMHC either advanced or reimbursed pursuant to the TroMetro and

Troma distribution agreements.

Periodically, Troma sent Crown

Capital (on behalf of SMHC) statements of revenue and expenses

and invoices regarding these expenses and the distribution of

SMHC films.54

Epic Productions informed SMHC that its rights in

“Headless Eyes” had also expired.

For example, Troma sent Crown Capital (on behalf of SMHC)

a statement of revenue and expenses as of June 30, 1998, showing

no revenues, $234,000 in expenses, and an advance payment of

$230,000. Troma also sent Crown Capital an invoice for creation

of distribution materials (including production of press and

media) for the “Wisdom” library for the period June 1 to 30,

1998, showing expenses of $44,000. Troma sent to “TroMetro-Santa

(continued...)

- 80 Mr. Herz testified that the agreement with TroMetro and SMHC

had always been for Troma to retain any net revenue from its

distribution activities to fund additional distribution expenses

rather than to remit royalties.55

SMHC reported and received no

income from licensing video rights to film titles or film

financing during 1997 and 1998.

XI.

Transactions With Imperial Credit Industries, Inc.

In 1997, the Ackerman group engaged in discussions with

Imperial Credit Industries, Inc., culminating in the formation of

Corona Film Finance Fund, LLC.

Imperial Credit Industries, Inc.

Before 1992, Imperial Bank acquired or started six different

operating businesses.

In 1991, Imperial Bank decided to take two

of those six businesses public, including a residential mortgage

business and thrift and loan.

In 1992, Imperial Bank

(...continued)

Monica” a statement of revenue and expense as of Dec. 31, 1998,

for films that Troma distributed on behalf of TroMetro and SMHC.

This statement shows $23,250 in revenue, $6,907.91 in

distribution expenses, and a $16,342.09 amount due TroMetro. On

Nov. 4, 1998, Troma sent Crown Capital another invoice for

$103,025 on the release of video and DVD for “Banana Monster”,

“Fist of Fear, Touch of Death”, “Astro Zombies”, “Battle of Last

Panzer”, and “Escape from Hell”. This invoice requested a

$50,000 advance payment.

In at least one case, the statement to “TroMetro-Santa

Monica” as of Dec. 31, 1998, states “Check Enclosed” for the

amount of revenues exceeding distribution expenses. Mr. Herz

testified that he did not think a check was in fact sent to

TroMetro or SMHC, given the agreement to retain net revenue.

- 81 successfully combined those businesses and took them public as

Imperial Credit Industries, Inc. (Imperial).56

During 1996 and 1997, Imperial was a diversified financial

services company.

It was involved in franchise lending,

residential lending, income property lending, asset-based

lending, and warehouse lines for mortgage bankers.

Imperial’s

investments included, among other things, an equipment leasing

company, a boutique investment bank, and an auto financing

company.

In 1996, Imperial had 10 operating divisions.

Film

finance was not one of Imperial’s operating divisions.

Shopping for Tax Deals

At some point in 1997, Imperial sold its interests in

Franchise Mortgage Acceptance Corp. (FMAC) and Southern Pacific

Funding Corp. (SPFC), resulting in capital gains to Imperial-approximately $300 million from FMAC and $150 million from SPFC.

In the planning stage of these transactions, Kevin Villani, as

Imperial’s CFO, was asked to develop a plan with favorable

offsetting tax implications.

On August 27, 1997, at a meeting of Imperial’s board of

directors, Wayne Snavely, who was Imperial’s CEO and chairman,

and Mr. Villani reported that Imperial had significant taxable

capital gains to be realized from securities sales in 1997.

Mr.

At one point, Imperial Bank owned 100 percent of

Imperial; after spinning Imperial out, however, Imperial Bank’s

ownership interest fell to 40 percent.

- 82 Villani was requested to develop a plan for presentation to the

Board that would include potential investments with favorable

offsetting tax implications.

Proposed Transaction With SMP

Mr. Lerner was on Imperial’s board of directors during 1996,

1997, and 1998.

Mr. Lerner was aware that Imperial was actively

looking for a transaction that would generate large capital

losses to offset its capital gains.

On October 7, 1997, Mr. Lerner sent Mr. Villani a memorandum

discussing a proposal whereby Imperial would purchase a 25percent interest in SMP for $5 million.

Mr. Lerner represented

that SMP had “assets totaling $49 million (with zero liabilities)

including:

$29 million in film library assets (appraised value)

and $20 million in cash[.]

ICII’s 25% share of the assets would

equal approximately $12.25 million, a multiple of the proposed

investment”.

The memorandum stated:

“Rockport intends to use

* * * [SMP] as a platform to finance and build a film library of

significant size that should enable * * * [SMP] to capitalize on

a changing dynamic that is occurring in the film industry.”

memorandum also stated:

Tax Attributes. In addition to the foregoing, the

Company may realize income tax benefits on the disposal

of its assets in the form of capital losses. Based on

a 25% ownership interest, * * * [Imperial’s] share of

such losses would be approximately $400 million. We

anticipate that the parties would enter into a tax

sharing agreement providing for a sharing of the

benefits attributable to this loss[.]

The

- 83 Imperial received and considered this memorandum.

On October 24, 1997, Mr. Lerner sent Mr. Villani an email

stating:

I am preparing a short term sheet for the film

partnership investment we discussed last week. I

haven’t heard any more from KPMG and I assume that they

have no more comments. The two issues we need to tie

down are the size of the investment and the

compensation formula. A quarter of the partnership

would give * * * [Imperial] a loss of about $430

million. The board should approve the deal in broad

outlines and we should then work out the details as

quickly as possible since time is running out on the

year and you have a lot of things to do. * * *

On October 27, 1997, Mr. Lerner faxed Mr. Villani a

confidential letter outlining the proposed transaction between

SMP and Imperial:

1. * * * [Imperial] will acquire 25 percent of

SMP for $5.0 million (25 percent of SMP’s cash assets),

payable in cash at the Closing. * * * [Imperial] may

also have the option to increase its interest in SMP on

agreed terms.

2. Any tax benefits derived by * * * [Imperial]

or its affiliates associated with an ownership interest

in SMP, including the sale or disposition of any of its

assets, will be shared with SMP’s current partners on a

50-50 basis. Amounts received by SMP’s partners as a

result of the sharing of tax benefits will be available

for investments with * * * [Imperial] on a deal by deal

basis. We anticipate that * * * [Imperial’s] share of

SMP’s potential tax losses will exceed $430 million.

On October 29, 1997, at a second meeting of Imperial’s board

of directors, Mr. Lerner proposed that Imperial invest in SMP.

Mr. Snavely testified that the proposed investment in SMP was

supposed to result in favorable tax treatment.

- 84 On November 19, 1997, at a third meeting of Imperial’s board

of directors, Mr. Lerner formally offered Imperial a 25-percent

equity interest in SMP in exchange for a $5 million cash

investment.

At this meeting, Mr. Lerner distributed a handout

that described SMP.

He discussed SMP’s assets (including its

film rights), and he explained SMP’s securitization and other

financing plans.

Mr. Lerner also discussed “the potential market

for securitization of film libraries and the due diligence

performed to date by * * * [Imperial’s] external accountants.”

After discussing this proposal, Imperial’s board resolved to

invest in SMP.57

Proposed Transaction With Corona

Formation of Corona Film Finance Fund, LLC

As of November 5, 1997, Mr. Lerner, on behalf of himself,

Peridon Corp. (Peridon), and SMP, executed an “Operating

Agreement” for the creation of Corona Film Finance Fund, LLC

(Corona) as a limited liability company (the Corona LLC

agreement).

The initial members of Corona were Mr. Lerner,

Peridon, and SMP.

Mr. Lerner contributed $5,000 cash, Peridon

Regarding this proposal, Mr. Snavely testified:

There was discussions [sic] about an opportunity

for us to invest in this business, and we did have some

expertise in securitization, and there were discussions

about acquiring film libraries, all of which was

interesting, but we were also interested in making sure

that it fit our tax strategies.

- 85 contributed $10,000 cash, and SMP contributed $250,000 cash and

the $79 million receivable.

As of November 5, 1997, Corona’s

capital accounts and percentage interests were as follows:

Imperial

SMP

Mr. Lerner

Peridon

Total

Capital Account

Percentage Interest

1,550,000

5,000

10,000

$1,565,000

0.00%

99.00

0.33

0.67

100.00

The Corona LLC agreement recited that the purposes for

Corona’s formation were “to finance the production and

exploitation of filmed entertainment products and to own

interests in entities engaged in such activities” and “to make

investments in connection with the foregoing activities and

otherwise.”

The Corona LLC agreement appointed Mr. Lerner as its

manager and authorized him to act on behalf of Corona to appoint

employees, officers, or additional managers, and to bind the

company in dealings with third parties.58

The Corona Transaction

On December 11, 1997, Mr. Lerner sent an email to Irv

Gubman, Imperial’s general counsel, proposing that the previously

discussed transaction be done through Corona rather than SMP.

The email states:

On Dec. 16, 1997, the secretary of state of Delaware

certified: “Corona Film Finance Fund LLC is duly formed under

the laws of the State of Delaware and is in good standing and has

a legal existence so far as the records of this Office show as of

the sixteenth day of December, A.D. 1997.”

- 86 Dear Irv. I have thought about our conversation last

night and the risk at this point in time. I suggest

the following: Lets just do the transaction for a loss

of 70 mil (the amount you need, or perhaps a little

more or less) through, as we discussed, a new

partnership. This reduces the risk related to size. I

like this structure much better as it solves your

problem today. We can take next year as it comes.

Thus, the plan would be as follows: We will create a

new partnership [Corona] into which we will transfer

high basis debt. * * * [Imperial] will buy a part of

our partnership interest for a price related to the

value of the partnership’s assets. This will be much

less than the amount we originally discussed, probably

around $500,000. On the pricing, my partner wants to

keep the pricing the same, which we should discuss. In

any event, think about this and let me know. We can

get this done quickly as I have the entities set up.

Thanks, Perry.

Mr. Lerner testified that he was uncomfortable with the large

size of the capital loss resulting from the proposed transaction

with SMP; he suggested a smaller capital loss.

He testified that

he purposely told Imperial that it would be very expensive for

them because he felt that SMP should profit from Imperial’s

capital loss.

On December 12, 1997, Mr. Lerner sent a second email to Irv

Gubman concerning the proposed transaction with Corona.

In this

email, Mr. Lerner recommended that Imperial purchase part of

SMP’s partnership interest for an amount

“sufficient to give it

a share of the basis equal to around 60-65 million dollars.

This

loss will be triggered if the * * * [$79 million receivable] is

sold. * * * (I think that most of this should be claimed in 1997

- 87 as we have a buyer for it by the end of the year.)”

The email

further states:

5. * * * [Imperial] will need to put capital in for

the tax sharing, above and some debt to increase basis.

* * * Paul [Lasiter] understands this point. I want to

use paart [sic] of the cash to invest with The Lew

Horowitz organization to finance movie production.

This will come out of our share of the tax sharing

payment. * * *

On or about December 12, 1997, drafts were prepared of a

purchase agreement and an amendment and restatement of the Corona

LLC agreement.

In the purchase agreement, SMP agreed to sell and

Imperial agreed to purchase 80 percent of SMP’s interest in

Corona.

Mr. Gubman reviewed these drafts and made a handwritten

notation on the draft amendment and restatement of Corona’s LLC

agreement which proposed that “if Imperial’s Allocated Losses are

disallowed, then upon liquidation of the Company [Corona] all

moneys contributed to the Company by Imperial shall be returned

to Imperial and accrued interest shall be paid thereon at the

Treasury (IRS) rate.”59

On December 17, 1997, at a fourth meeting of Imperial’s

board of directors, Mr. Snavely announced that Mr. Lerner had

submitted a revised proposal under which Imperial could invest in

Corona rather than SMP.

the revised proposal.

Imperial’s board reviewed and approved

Mr. Snavely testified that tax losses were

This notation was the only significant comment that Mr.

Gubman made on the draft amendment and restatement of the Corona

LLC agreement.

- 88 driving the Corona transaction and were the primary reason in

1997 for Imperial’s investing in the Corona transaction.

Initial Purchase of SMP’s Interest in Corona

SMP and Imperial executed a purchase agreement (the purchase

agreement), as of December 15, 1997, providing for Imperial’s

purchase from SMP of a 79.2-percent membership interest in

Corona.

According to the purchase agreement, Imperial was to pay

$1,252,000 for the membership interest, of which $212,000 was to

be paid in cash and the $1.04 million balance was to be paid with

a note.

In connection with the purchase agreement, Imperial

executed a $1.04 million promissory note (the $1.04 million note)

dated December 15, 1997, payable to SMP.

Imperial paid $212,000 to SMP.

On December 18, 1997,

No payments of principal or

interest were ever made on the $1.04 million note.60

In an amendment and restatement dated as of December 15,

1997, Corona’s LLC agreement was amended and restated to reflect

the admission of Imperial as a new member of Corona.

This

document reflected Imperial’s agreement to pay SMP a fee of 20

percent of the tax losses received from Corona.

This fee was to

be structured as a contribution by Imperial to Corona and a

Pursuant to the $1.04 million note, interest was to

accrue at a rate of 8 percent per annum and was payable

semiannually on June 15 and December 15 of each year. Imperial

agreed to pay the outstanding principal amount of the $1.04

million note together with accrued and unpaid interest thereon on

Dec. 15, 2002.

- 89 distribution from Corona to SMP.

As a result of Imperial’s

purchase of SMP’s membership interest in Corona, Corona’s capital

accounts and percentage interests were restated as follows:

Capital Account

Percentage Interest

$1,240,000

310,000

5,000

10,000

$1,565,000

79.20%

19.80

0.33

0.67

100.00

Imperial

SMP

Mr. Lerner

Peridon Corp.

Total

On its November 5 to December 15, 1997, partnership tax

return, Corona reported Imperial’s initial purchase of SMP’s

interest as a $64,130,364 capital reduction by SMP and a

$64,130,364 capital contribution by Imperial.

Corona reported

these amounts at tax values, not accounting book values.

On its

tax return for the taxable year ended December 31, 1997, SMP

reported the sale of its interest in Corona to Imperial as

follows:

$1,252,000 Sales price

63,489,061 Basis

(62,237,061) Long-term capital loss

The $62,237,061 loss that SMP reported flowed through to

Somerville S Trust and then through to Mr. Ackerman, who claimed

it on his tax return.

Additional Purchase of SMP’s Interest in Corona

On December 23, 1997, Imperial purchased from SMP an

additional 14.65-percent interest in Corona pursuant to an

amendment to purchase agreement.

With this purchase, Imperial

- 90 had acquired a total interest in Corona of 93.85 percent.

Imperial paid $36,700 in cash for the additional interest and

increased the amount of its promissory note to SMP by $180,050

for a total note payable of $1,220,050 (the $1,220,050 note).

Imperial made no payments of principal or interest on this

note.61

On December 23, 1997, the members of Corona executed an

amendment to the amended and restated Corona LLC agreement,

providing for Imperial’s purchase of the 14.65-percent additional

interest in Corona.

According to this amendment, Corona’s

capital accounts were restated as follows:

Capital account

Imperial

SMP

Mr. Lerner

Peridon Corp.

Total

$1,469,000

81,000

5,000

10,000

$1,565,000

Percentage interest

93.85

5.15

0.33

0.67

100.00

On its partnership tax return for the period December 16 to

31, 1997, Corona reported Imperial’s additional purchase as an

$11,864,117 capital reduction by SMP and an $11,864,117 capital

contribution by Imperial.

Pursuant to the $1,220,050 note, interest was to accrue

at a rate of 8 percent per annum and was payable semiannually on

June 15 and December 15 of each year. Imperial agreed to pay the

outstanding principal amount of the $1,220,050 note together with

accrued and unpaid interest thereon on Dec. 15, 2002.

- 91 On its partnership tax return for the taxable year ended

December 31, 1997, SMP reported the sale of the additional 14.65percent interest in Corona to Imperial as follows:

$216,750 Sales price

11,864,117 Basis

(11,647,367) Short-term capital loss

This $11,647,367 loss flowed through to the Somerville S Trust

and then through to Mr. Ackerman, who claimed it on his tax

return.

Sale of the $79 Million Receivable

On December 29, 1997, Mr. Lerner, on behalf of Corona, and

Mr. van Merkensteijn, on behalf of TroMetro, executed a note

purchase agreement providing for Corona’s sale of the $79 million

receivable to TroMetro.

According to this agreement, the

purchase price to be paid by TroMetro was $1,144,000, to consist

of $120,000 cash and a $1,024,000 promissory note payable by

TroMetro to Corona.62

On December 29, 1997, the $120,000 cash amount was paid by

wire transfer.

Mr. van Merkensteijn, on behalf of TroMetro,

executed a $1,024,000 promissory note dated December 29, 1997

In arriving at a purchase price for the $79 million

receivable, Mr. van Merkensteijn testified that he used the same

pricing formula as in TroMetro’s purchases of the $150 million

and $81 million receivables, and he similarly relied on the Sage

Entertainment appraisal of SMHC’s film assets.

- 92 (the $1,024,000 TroMetro note).63

On December 10, 1998, TroMetro

paid $205,191 principal and $82,600 interest on the $1,024,000

TroMetro note.

No other cash payments were made on the

$1,024,000 Trometro note.

On its partnership tax return for the period December 16 to

31, 1997, Corona reported a $78,768,955 long-term capital loss on

the sale of the $79 million receivable.

In computing this loss,

Corona reported a $1,144,000 sale price and $79,912,955 basis for

the $79 million receivable.

The loss flowed through to Imperial

in the amount of $74,671,378 and to SMP in the amount of

$4,097,577.

SMP’s $4,097,577 loss then flowed through to

Somerville S Trust and finally through to Mr. Ackerman.

Schedules K-1 attached to its return, Corona reported the sale of

the $79 million receivable as a $74,671,378 decrease in

Imperial’s capital account and a $4,097,577 decrease in SMP’s

capital account.

Imperial’s Capital Contribution

On January 15, 1998, Corona’s members executed a second

amendment to the amended and restated Corona LLC agreement,

providing that “At the end of any year in which there are

At some point, Mr. van Merkensteijn, on behalf of

TroMetro, executed a second promissory note also dated Dec. 29,

1997, in the amount of $1.180 million (the $1.180 million

TroMetro note). Mr. van Merkensteijn testified that the first

note was corrected to reflect a different amount. The $1,024,000

TroMetro note in the record has the handwritten notation

“Cancelled” on its first and last pages.

- 93 Allocated Losses to Imperial, Imperial shall promptly contribute

cash in an amount equal to 20.0% of such Allocated Loss.”

During

taxable year 1998, Imperial made a $14,595,652 capital

contribution in cash to Corona.

This contribution was made in

connection with the 20-percent fee that Imperial had agreed to

pay SMP for the tax losses that it received from the Corona

transaction.

SMP later received this $14,595,652 fee.

Treasury Bills

In 1997, Imperial had insufficient basis in Corona to

recognize the tax losses that were going to flow through from

Corona.

Consequently, Imperial and Corona devised a scheme,

starting in 1997, in which Imperial would purchase U.S. Treasury

bills each yearend and simultaneously enter into a repurchase

agreement to sell those Treasury bills back at the beginning of

the next year.

At each yearend, in order to increase its tax

basis in Corona, Imperial temporarily assigned the Treasury bills

and repurchase agreement to Corona.

Imperial repeated the

Treasury bill transactions for its 1998 through 2001 taxable

years.

XII. Subsequent Transactions Involving TroMetro and Troma

Capital Contribution Agreement

As of March 1, 1999, SMHC and TroMetro entered into a

capital contribution agreement.

Pursuant to this agreement,

TroMetro contributed, assigned, transferred, and conveyed to SMHC

- 94 all the interests that TroMetro owned and held in the $81 million

receivable, the $150 million receivable, and the $79 million

receivable.

In exchange, TroMetro received a right to receive 20

percent of all classes of stock of SMHC (or its successor),

exercisable by TroMetro any time after March 1, 2001 (the

TroMetro stock option).

Assumption Agreement

As of September 1, 1999, SMP, SMHC, and TroMetro entered

into an assumption agreement.

Pursuant to this agreement, SMP

assumed SMHC’s obligation under the TroMetro stock option.

Transfer and Assignment of the Carolco Securities

On September 1, 1999, SMHC transferred and assigned to SMP

the Carolco preferred stock ($30 million face amount) and the

Carolco subordinated notes ($30 million face amount).

SMHC and Troma Merger

SMHC Merges Into Troma

As of September 1, 1999, Troma’s stockholders and board of

directors approved actions in connection with the issuance of

common and preferred stock to SMHC.

As of September 2, 1999,

SMHC and Troma entered into a purchase agreement.

Pursuant to

this agreement, SMHC purchased 1,070.6 shares of Troma common

stock and 400 shares of Troma Series B convertible preferred

stock in exchange for all the assets listed on Schedule 3.3 of

the agreement and $2.22 million in cash (the SMHC and Troma

- 95 merger).

The assets listed on Schedule 3.3 were the EBD film

rights, the EBD development projects, the “City Lights” library

(except for 1 specific film), the “Wisdom” library, the “Moving

Pictures” library (except for 4 specified films), the “Five

Stones” library, and the “Vista Street” library.64

SMHC’s Dissolution

On December 10, 1999, SMHC was dissolved.

SMP thereafter

became the owner of 1,070.6 shares of Troma common stock and 400

shares of Troma Series B convertible preferred stock.65

Tax Return Treatment of the Transaction

On its amended 1999 corporate income tax return, SMHC

reported that on December 10, 1999, a “C” reorganization took

place between SMHC and Troma whereby Troma acquired all of SMHC’s

assets solely in exchange for Troma voting stock (the C

reorganization).66

SMHC also reported that “Immediately prior to

the ‘C’ reorganization

* * * [SMP], the sole shareholder made a

Schedule 3.3 included the film title “Mommy’s Epitaph”,

which was not a part of any of SMHC’s film libraries. It also

included a 22-film library that SMHC was to acquire for $485,000;

however, SMHC did not acquire this library. As a result, on

Sept. 2, 1999, SMHC and Troma amended the asset purchase

agreement with SMHC agreeing to contribute an additional $630,000

to Troma’s capital in lieu of the 22-film library.

Apparently, the stock certificates previously issued to

SMHC were marked “Void,” and new stock certificates were issued

to SMP.

On its amended 1999 partnership return, SMP reported that

the C reorganization between SMHC and Troma occurred on Sept. 2,

1999.

- 96 capital contribution consisting of obligations of the company

having a face value and adjusted basis of $738,307,459.”

SMHC

reported that “Subsequent to the asset transfer, * * * [SMHC]

liquidated and distributed the Troma Entertainment, Inc. stock

(which it received in exchange for its assets) to its sole

shareholder * * * [SMP].”

On its amended 1999 partnership return, SMP reported its

total basis in the Troma stock as $1,409,759,123.

Termination of the Distribution Agreements

On June 21, 2001, in connection with the SMHC and Troma

merger, TroMetro sent to Mr. Herz of Troma and Mr. Lerner of SMP

a letter confirming for SMP’s and Troma’s records:

(1) The

consideration that was due and payable by TroMetro to SMHC

pursuant to the TroMetro distribution agreement for the period

December 23, 1997, to September 2, 1999, was waived; and (2) the

consideration receivable by TroMetro from Troma pursuant to the

Troma distribution agreement for the period December 23, 1997, to

September 2, 1999, was waived.

In this letter, TroMetro asked

SMP and Troma to confirm for TroMetro’s records that:

(1) The

agreement to the termination of the TroMetro and Troma

distribution agreements; and (2) the agreement to waive any

consideration due under those distribution agreements.67

Mr. Lerner signed this letter on June 21, 2001; Mr. Herz

signed it but did not date it.

- 97 At some point thereafter, the TroMetro distribution

agreement and the Troma distribution agreement were terminated.

Both TroMetro and SMHC waived any rights under those agreements

to all royalties that had accrued between December 23, 1997, and

September 2, 1999.

Letter Agreement With TroMetro

On March 29, 2001, Mr. van Merkensteijn, on behalf of

TroMetro, and Mr. Lerner, on behalf of SMP, entered into a letter

agreement.

Pursuant to this letter agreement, TroMetro deferred

its right to exercise the TroMetro stock option for no more than

6 months.

Troma Finance, LLC

As of December 12, 2001, Troma Finance, LLC (Troma Finance),

SMP, and TroMetro entered into an “Operating Agreement of Troma

Finance LLC”.

Pursuant to this agreement, Troma Finance was

formed and TroMetro was designated as its manager.68

As of December 12, 2001, Troma Finance and TroMetro executed

a document entitled “Capital Contribution and Assignment and

Mr. Lerner testified that Troma Finance was formed with a

view of consolidating all the ownership interests in Troma into

one entity for purposes of making a sale of the company.

According to Mr. Lerner, Mr. van Merkensteijn was negotiating

with a certain party for the sale of Troma, and “he wanted to

make sure that all of the ownership interests were in one entity

so he wouldn’t have to keep going back around”.

- 98 Assumption Agreement” between Troma Finance, SMP, and TroMetro.69

Pursuant to this agreement, SMP agreed to contribute to Troma

Finance:

(i) $3.4 million in cash, (ii) the $2,284,000 TroMetro

note, (iii) the $1.25 million TroMetro note, (iv) 1,070.6 shares

of Troma common stock, and (v) 400 shares of Troma Series B

convertible preferred stock.70

Troma Finance:

TroMetro agreed to contribute to

(i) The TroMetro stock option, and (ii) its 75-

percent interest in the Action Entertainment Co. (a New York

general partnership).

obligations under:

Troma Finance assumed TroMetro’s

(i) A $150,000 note issued by TroMetro to IFG

Film Fund, LLC, (ii) the $1,024,000 TroMetro note, (iii) the

$2,284,000 TroMetro note, and (iv) the $1.25 million TroMetro

note.

XIII. Business Characteristics of SMP, Corona, and SMHC

SMP

SMP has never had any employees.

had no bank account.

Until December 1997, SMP

During the taxable years ended December 31,

1997 and 1998, SMP had no separate office of its own; it used the

same business address as Crown Capital.

SMP did not execute this document.

In lieu of a cash contribution, Mr. Lerner, as manager of

SMP, executed a $3.4 million promissory note dated Dec. 12, 2001.

- 99 SMP neither received nor reported any income from film

financing, film library licensing, or video rights licensing

during its taxable years ended 1997 and 1998.

Corona

Corona has never had any employees.

During the taxable

years ended December 31, 1997 and 1998, Corona had no separate

office of its own; it used the same business address as Crown

Capital.

Corona received no income from film financing, film library

licensing, or video rights licensing during its taxable years

ended December 31, 1997 and 1998.

SMHC

SMHC had no employees from December 11, 1996, until it was

dissolved in 1999.

All its work was done by Crown Capital.

SMHC

had no bank account from December 11, 1996 until December 1998.

During the taxable years ended December 31, 1997 and 1998, SMHC

did not have a separate office of its own; it used the same

business address as Crown Capital.

XIV. Partnership Tax Returns

SMP

Following an extension to October 15, 1998, SMP filed its

1997 partnership tax return, which it dated October 14, 1998.

Following an extension to October 15, 1999, SMP filed its 1998

partnership tax return, which it dated October 14, 1999.

SMP

- 100 thereafter filed an amended 1998 partnership tax return, which it

dated October 22, 1999.

During the taxable years at issue, SMP

reported Mr. Lerner, Rockport Capital, Somerville S Trust,

Generale Bank, and CLIS as having varying interests in SMP’s

profits, losses, and ownership of capital.

On its 1997 tax return, SMP reported that the adjusted basis

of the $974 million in receivables from Generale Bank was

$974,296,601; that the adjusted basis of the $79 million

receivable was $79,912,955; and that the adjusted basis of the

SMHC stock was $665 million.

On its 1998 return, SMP reported

that the adjusted basis of one portion of the $974 million in

receivables was $81,590,418; that the adjusted basis of the

remaining portion was $512,793,227; and that the adjusted basis

of the SMHC stock was $665 million.

On Schedule D, Capital Gains and Losses, of its 1997

partnership tax return, SMP reported its sales of the $150

million (face value) notes receivable to TroMetro, and its sales

to Imperial of 14.8 and 79.2-percent interests in Corona.

described in more detail supra, SMP reported a long-term capital

loss of $147,486,000 on its sale of the receivable; a short-term

capital loss of $11,647,367 with respect to the sale of the 14.8percent Corona interest; and a long-term capital loss of

$62,237,061 with respect to the sale of the 79.2-percent Corona

interest.

- 101 On Schedule D of its 1998 partnership tax return, SMP

reported its sale of $81,590,418 (face value) notes receivable.

As described in more detail supra, SMP reported a long-term

capital loss of $80,190,418 on this sale.

Corona

Following an extension to October 15, 1998, Corona filed its

1997 partnership tax return (for the period December 16, 1997, to

December 31, 1997), which it dated October 14, 1998.

Corona

reported Mr. Lerner, Peridon, SMP, and Imperial as having varying

interests in Corona’s profits, losses, and ownership of capital.

Corona reported Mr. Lerner as its tax matters partner.

Corona reported a $79,912,955 basis in the $79 million

receivable.

As described in more detail supra, on Schedule D of

its 1997 partnership tax return Corona reported selling this

receivable for a long-term capital loss of $78,768,955.

Mr. and Mrs. Ackerman

Peter and Joanne Ackerman filed joint Federal income tax

returns for 1997 and 1998.

On their 1997 return, the Ackermans

reported a net long-term capital loss from SMP of $213,715,813

and a net short term capital loss from SMP of $11,545,023.

Among other gains and losses, the $213,715,813 net long-term

capital loss included these items:

a $147,486,000 loss that

flowed through from SMP to Somerville S Trust to the Ackermans

when SMP sold the $150 million receivable in 1997; a $62,237,061

- 102 loss that flowed through from SMP to Somerville S Trust to the

Ackermans when SMP sold 79.2 percent of its interest in Corona in

1997; and a $4,097,577 loss that flowed through from Corona to

SMP to Somerville S Trust to the Ackermans when Corona sold the

$79 million receivable in 1997.71

The $11,545,023 net short-term capital loss flowed through

from SMP to the Ackermans when SMP sold 14.65 percent of its

interest in Corona to Imperial in 1997.72

On their 1998 return, the Ackermans reported a net long-term

capital loss from SMP of $80,190,418, which flowed through from

SMP to Somerville S Trust to the Ackermans when SMP sold the $81

million receivable to TroMetro in 1998.73

On its 1997 return, SMP reported a net long-term capital

loss of $213,715,689 on Schedule D, Capital Gains and Losses.

From this amount, SMP passed through net long-term capital gains

of $62 to Mr. Lerner and $62 to Rockport Capital, and a net longterm capital loss of $213,715,813 to Somerville S Trust.

The sale of the 14.8-percent interest in Corona resulted

in a $11,647,367 loss on SMP’s 1997 tax return. SMP reported a

net short-term capital loss of $11,544,902. From this amount,

SMP passed net short-term capital gains of $60 to Mr. Lerner and

$61 to Rockport Capital and a short-term capital loss of

$11,545,023 to Somerville S Trust.

On Schedule D of its 1998 return, SMP reported a net

long-term capital loss of $79,979,011; however, it passed through

a net long-term capital loss of $80,190,418; i.e., the entire

amount of the loss that it reported on the sale of the $81

million receivable. SMP reported $211,407 as its share of net

long-term capital gain from other partnerships, estates, and

trusts. SMP failed to pass this amount through to its members

via Sch. K, Partners Share of Income, Credits, Deductions, etc.

- 103 XV.

Notices of Final Partnership Administrative Adjustment

SMP

On January 24, 2003, respondent issued Notices of Final

Partnership Administrative Adjustment (FPAAs) to SMP for its

taxable years ended December 31, 1997 and 1998.

For 1997, respondent disallowed SMP’s claimed long-term

capital loss of $147,486,000 on the 1997 sale of the $150 million

receivable.

Respondent also disallowed SMP’s claimed short-term

capital loss of $11,647,367 and long-term capital loss of

$62,237,061 on the sales of its interests in Corona.

Respondent

determined instead that SMP recognized long-term capital gain of

$2,514,000 on the sale of the receivable, and short-term capital

gain of $198,941 and long-term capital gain of $1,034,809 on the

sales of its interests in Corona.74

Respondent determined that, pursuant to section 6662(h), the

40-percent accuracy-related penalty for gross valuation

Respondent computed SMP’s short-term capital gain (STCG)

and long-term capital gain (LTCG) from the sales of its interests

in Corona as follows:

STCG

Amount realized ($248,700 cash +

$1,220,050 note)

$236,763

Adjusted basis (($250,000 cash +

$0 basis in note)

(94-percent interest))

37,822

Gain on sale of Corona interest

198,941

LTCG

Total

$1,231,987

$1,468,750

197,178

1,034,809

235,000

1,233,750

- 104 misstatements applies to all of SMP’s partnership adjustments for

1997.

Alternatively, respondent determined that, pursuant to

section 6662(a), the 20-percent accuracy-related penalty applies

on the grounds of negligence or disregard of rules and

regulations, a substantial understatement of income tax, or a

substantial valuation misstatement.

For 1998, respondent disallowed SMP’s claimed long-term

capital loss of $80,190,418 on the 1998 sale of the $81 million

receivable.

Respondent determined instead that SMP recognized

long-term capital gain of $1.4 million on this sale.75

Respondent determined that, pursuant to section 6662(h), the 40percent accuracy-related penalty for gross valuation

misstatements applies to all of SMP’s partnership adjustments for

1998 (except for the aforementioned long-term capital gain

adjustment of $211,407).

Alternatively, respondent determined

that, pursuant to section 6662(a), the 20-percent accuracyrelated penalty applies on the grounds of negligence or disregard

of rules and regulations, a substantial understatement of income

tax, or a substantial valuation misstatement.

Corona

On January 24, 2003, respondent issued an FPAA to Corona for

its taxable year ended December 31, 1997.

Respondent disallowed

Respondent also determined that $211,407 of pass-through

gain that SMP reported on Sch. D of its partnership tax return

for 1998 should have been passed through to its members.

-105Corona’s claimed long-term capital loss of $78,768,955 on the

sale of the $79 million receivable.

Respondent determined

instead that Corona recognized a long-term capital gain of

$1,144,000 on this sale.

Respondent determined that, pursuant to

section 6662(h), the 40-percent accuracy-related penalty for

gross valuation misstatements applies to all of Corona’s

partnership adjustments for 1997.

Alternatively, respondent

determined that, pursuant to section 6662(a), the 20-percent

accuracy-related penalty applies on the grounds of negligence or

disregard of rules and regulations, a substantial understatement

of income tax, or a substantial valuation misstatement.

OPINION

As becomes apparent from the foregoing findings, the facts

in these cases are a virtual labyrinth.

At the heart of the

labyrinth, where one might expect to find, if not a Minotaur,

then at least an old movie lion, we find high-basis, low-value

assets (said to have spawned startling losses) and some B-grade

films.

To help thread the labyrinth, we briefly recap some

salient facts.

In 1996, Mr. Lerner was involved with the Safari

consortium’s failed bid to acquire MGM.

Subsequently, Mr. Lerner

was contacted by CDR’s representative, Rene Claude Jouannet, who

had been assigned the task of selling the assets in MGM’s parent

company, MGM Group Holdings (later renamed SMHC).

Messrs. Lerner

-106and Jouannet struck a deal:

Rockport Capital, Mr. Lerner,

Generale Bank, and CLIS would join together as purported members

of a limited liability company, SMP, which elected to be treated

as a partnership for Federal tax purposes.

In exchange for

common interests in SMP, Rockport Capital and Mr. Lerner would

contribute $20 million cash or marketable securities.

exchange for preferred interests in SMP, Generale Bank would

contribute its $974 million in receivables from SMHC, and CLIS

would contribute its $79 million receivable and SMHC stock.

the time of these contributions, the receivables and SMHC stock

had purported bases totaling over $1.7 billion.

These

properties, however, had little, if any, value.

As part of the transaction between CDR and the Ackerman

group, CDR negotiated a side letter agreement in which Rockport

Capital agreed to purchase Generale Bank’s and CLIS’s (sometimes,

collectively, the banks) preferred interests in SMP upon written

notice from those entities (put rights).

The banks’ put rights

were exercisable during a 1-year period beginning December 31,

1996.

The deal closed on December 11, 1996.

Less than 3 weeks

later, on December 31, 1996 (the first day of the 1-year put

period), the banks exercised their put rights.

Somerville S

Trust (standing in the shoes of Rockport Capital) purchased the

banks’ preferred interests in SMP.

-107In 1997 and again in 1998, SMP sold to TroMetro portions of

the $974 million in receivables that Generale Bank had

contributed.

SMP reported a $147,486,000 loss on the sale of the

$150 million receivable in 1997 and a $80,190,418 loss on the

sale of the $81 million receivable in 1998.76

These losses

flowed through to Somerville S Trust under the partnership tax

rules.

Also in 1997, Mr. Lerner negotiated a deal with Imperial,

wherein SMP contributed the $79 million receivable to a new

limited liability company, Corona, which also elected partnership

tax treatment, and SMP then sold 79.2- and 14.65-percent

membership interests in Corona to Imperial.77

The transactions

produced losses for SMP of $62,237,061, and $11,647,367,

respectively, which flowed through to Somerville S Trust.

1997, Corona sold the $79 million receivable to TroMetro,

generating a $78,768,955 loss, $74,671,378 of which flowed

TroMetro paid $230,000 and gave a $2,284,000 note in

exchange for the $150 million receivable. TroMetro paid $150,000

and gave a $1.25 million note in exchange for the $81 million

receivable. TroMetro paid $397,166 principal and $159,880.35

interest on the $2,284,000 note. No additional amounts were paid

on these notes.

Imperial paid $212,000 cash and gave a $1.04 million note

for the 79.2-percent membership interest and paid $36,700 cash

and increased its note to $1,220,050 for the 14.65-percent

membership interest.

-108through to Imperial and $4,097,577 of which flowed through to SMP

and then to Somerville S Trust.78

The core issue is whether respondent has properly

disallowed these claimed losses.

Petitioner’s claims to the

losses rest on the partnership tax rules, which are contained in

subchapter K (secs. 701 to 777) of the Code.

Although the

operation of these rules is not directly in dispute, the effects

of these rules permeate the transactions in question and inform

our analysis.

We start with an overview of these rules.

Partnership Tax Rules

In General

A partnership is not subject to Federal income tax at the

partnership level; instead, persons carrying on business as

partners are liable for income tax only in their separate or

individual capacities.

Sec. 701; see secs. 702, 704 (providing

rules for determining partners’ distributive shares), sec. 703

(providing rules for computing taxable income of a partnership).

A partner must take into account his or her distributive share of

each item of partnership income, gain, loss, deduction, and

Mr. van Merkensteijn paid $120,000 and gave a $1,024,000

note (revised to $1.180 million) in exchange for the $79 million

receivable. Mr. van Merkensteijn paid $205,191 principal and

$82,600 interest on this note. He paid no additional amounts.

Imperial paid $14,595,652 as a fee for the tax losses that it

received from the Corona transaction.

-109credit.79

Sec. 702(a); Vecchio v. Commissioner, 103 T.C. 170,

185 (1994).

A partner’s distributive sha

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