# UNITED STATES TAX COURT > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/agency%3Atax-court%3A07f8379ab3c11697 ## Record - **Collection:** Agency decision - **Document type:** Agency decision ## Text 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 I. II. III. IV. V. ....................................... 13 The Ackerman Group ................................. 13 A. B. C. D. E. F. Perry Lerner ................................... Peter Ackerman ................................. Somerville S Trust ............................. Rockport Capital, Inc. ......................... Rockport Advisors, Inc. ........................ Crown Capital Group ............................ 13 14 15 16 16 16 The Credit Lyonnais Group ........................... 17 A. B. C. Credit Lyonnais ................................. Consortium de Realisation ....................... Generale Bank Nederlands ........................ 17 18 19 Metro-Goldwyn-Mayer, Inc. ........................... 19 A. B. C. D. E. F. G. H. I. J. 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 ......... 19 20 20 21 22 23 26 29 33 33 Safari Acquisition Co. .............................. 34 A. B. C. D. E. F. G. 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 ......................................... 34 35 36 38 39 40 The CDR Transaction ................................. 41 A. B. 41 43 Initial Contact with Mr. Jouannet ............... Negotiation and Drafting Process ................ 41 - 3 1. 2. 3. 4. Rockport Capital Confirms Its Interest ...... Draft Term Sheet and Letter Agreements ...... Further Negotiation and Drafting ............ Santa Monica Pictures, LLC, is Formed ....... 43 44 48 49 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 ............................. 49 49 51 53 55 55 57 57 58 58 59 Film Rights Contributed to SMHC ..................... 59 A. B. 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 ..................................... 59 61 61 62 62 Due Diligence for the CDR Transaction ............... 65 A. B. James Rhodes .................................... Troy & Gould .................................... 1. Chain-of-Title and Record Search ............ 2. Access Letters .............................. 65 67 67 69 VIII. Other Film Activities ............................... 70 IX. Relationship with TroMetro Films, LLC ............... 71 A. B. C. 71 71 72 72 74 75 75 C. D. E. 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 .............. 63 64 - 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 ........... 76 76 77 77 78 78 79 XI. Transactions with Imperial Credit Industries, Inc. .. 80 A. B. C. D. 80 81 82 84 XII. Subsequent Transactions Involving TroMetro and Troma .......................................... A. B. C. 88 89 91 92 93 93 93 94 Business Characteristics of SMP, Corona, and SMHC .. 98 A. B. C. SMP ............................................ Corona ......................................... SMHC ........................................... 98 99 99 Partnership Tax Returns ............................ 99 E. F. XIV. 84 85 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 ............................. D. 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 ........................ ..... 94 94 94 95 95 96 97 97 - 5 A. B. C. SMP ............................................ Corona ......................................... Mr. and Mrs. Ackerman .......................... 99 101 101 Notices of Final Partnership Administrative Adjustments ........................................ 103 A. B. SMP ............................................ Corona ......................................... 103 104 OPINION ................................................... 105 I. Partnership Tax Rules ............................. 108 In General ..................................... Claimed Application of Partnership Tax Rules ... 108 112 II. Burden of Proof .................................... 113 III. Economic Substance ................................. 115 A. B. C. D. 115 117 120 121 122 XV. A. B. E. 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” ............................ 125 128 128 129 130 131 131 132 134 135 145 147 147 149 150 151 152 - 6 a. Advisory Fee and Put Price ............. i. 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 .................... i. Income Projections ................ ii. Cost Projections .................. iii. Net Cashflows ..................... iv. Valuations ........................ v. Market Approach ................... b. Respondent’s Expert .................... i. Income Projections ................ ii. Cost Projections .................. iii. Net Cashflows ..................... iv. Valuations ........................ v. Market Approach ................... c. Court’s Analysis ....................... i. 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 ..................................... 153 155 157 159 167 169 171 174 177 180 180 181 183 184 184 185 186 187 189 190 191 191 192 192 193 196 203 208 215 216 217 217 219 Step Transaction Doctrine .......................... 227 A. B. C. D. Legal Principles ............................... Parties’ Arguments ............................. Court’s Analysis ............................... Conclusion ..................................... 227 229 231 236 Basis Arguments .................................... 237 A. 237 238 F. G. IV. V. 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 X. SMP’s Basis in SMHC Stock .......................... 262 XI. Accuracy-Related Penalties ......................... 264 A. B. C. 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 ................................. 265 267 275 275 279 284 Evidentiary Matters ................................ 312 A. 312 313 316 317 318 319 322 322 325 328 B. D. XII. B. 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. 1 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. 2 More precisely, the $5 million advisory fee was to be paid to one of the Credit Lyonnais group members, Credit Lyonnais International Services (CLIS). 3 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 4 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. 5 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. In 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 6 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. 7 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 8 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. 9 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. I. The Ackerman Group A. 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. 9 (...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. B. Peter Ackerman Peter Ackerman is a successful businessman. He attended Colgate University, where he received a bachelor’s degree. He 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. C. 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. E. 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. F. 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 A. 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 B. 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 10 The Credit Lyonnais group’s loans to MGM and eventual ownership of MGM are described in detail infra. 11 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. A. 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. 12 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. B. 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. C. Sealion Corp. In connection with Pathe’s acquisition of MGM, Credit Lyonnais lent $150 million to Sealion Corp., N.V. (Sealion) 13 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. D. 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. E. 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 14 The name of this agreement did not necessarily control the amount that was advanced under the agreement. 15 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. F. 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. On 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). 16 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 17 The name of this agreement did not necessarily control the amount that was advanced under the agreement. 18 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 19 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. H. 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 20 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. 21 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. J. 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. A. 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. 22 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. B. 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. D. 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 23 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. E. 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. F. 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: 24 “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”. G. 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). V. The CDR Transaction A. 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. On 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. B. 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. 1. 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. 2. 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 25 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. 3. 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 26 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. 4. 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. C. Final Agreements and Documents On December 11, 1996, the parties finalized the agreements that they had negotiated over the course of several months. 1. 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. 27 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. * * * 28 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 3. 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 50% 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 29 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 30 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. a. 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. b. 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. 31 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 0% 0 99.50 2.25 2.25 36.76% 61.27 0 0.85 0.85 $0 0 19,800,000 50,000 50,000 $1,875,000 3,125,000 0 50,000 50,000 1 The common membership interests in SMP do not add up to 100 percent. 2 The preferred membership interests in SMP do not add up to 100 percent. 32 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. 5. 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.” 6. 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. D. 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. 33 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. 34 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 A. 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 1. 2. 3. 4. 5. 6. Alley Cat Astro Zombies Auditions Avenger Banana Monster Battle of the Last Panzer 35 7. 8. 9. 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 1. 2. 3. 4. 5. 6. 7. 8. 9. 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 1. 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). 36 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. 2. 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 3. 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 37 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. 38 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. 4. 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 39 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. 5. 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, 40 The assignment, including its attached schedule, did not define the term “U.S. Video Film Rights”; it identified the films only by titles. 41 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 A. 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. B. 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. 1. 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. On 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. 42 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. 2. 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. A 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 80 8 15 5 24 33 165 2 167 $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 A. 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. B. 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. 1. 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 43 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”. 44 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.” 45 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. 3. 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. 4. 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. 46 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. X. 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. A. 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. 47 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. C. 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 48 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. 49 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 D. Troma’s Distribution of the EBD Film Library 1. 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. On March 27, 1998, Epic Productions informed Troy & Gould that SMHC’s rights had expired in “Astro Zombies”, “Banana Monster”, 50 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. 51 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. 52 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. 2. 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 53 Epic Productions informed SMHC that its rights in “Headless Eyes” had also expired. 54 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. A. 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 54 (...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. 55 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 [Text truncated at 120,000 characters. The full text is on the page linked above.] --- Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/agency%3Atax-court%3A07f8379ab3c11697. Public record. Not legal advice.