# UNITED STATES TAX COURT > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/agency%3Atax-court%3A2b70547701cb5701 ## Record - **Collection:** Agency decision - **Document type:** Agency decision ## Text T.C. Memo. 1997-115 UNITED STATES TAX COURT ACM PARTNERSHIP, SOUTHAMPTON-HAMILTON COMPANY, TAX MATTERS PARTNER, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent Docket No. 10472-93. Filed March 5, 1997. In 1988, C reported a $105 million capital gain. In 1989, M, an investment banking firm, approached C with an elaborate scheme to shelter that gain from Federal income tax. Pursuant to M's advice, A, C, and M created an offshore partnership (P) in which their respective initial interests were 82.63, 17.07, and .29 percent. P served as the vehicle for a contingent installment sale transaction (CINS transaction) that would create approximately $100 million of capital losses for C, a domestic corporation, and corresponding capital gains for A, a foreign corporation that was not subject to U.S. tax. Pursuant to the scheme, P purchased securities and, approximately 3 weeks later, sold most of the securities for cash and LIBOR Notes. The value of the total consideration received, in the form of cash and LIBOR Notes, equaled the price that P had paid for the securities sold. The transactions and the returns connected thereto were the result of a - 2 carefully crafted and faithfully executed sequence of sophisticated and costly financial maneuvers that left little to chance or market opportunities. P used the contingent payment sale provisions of sec. 15a.453-1(c), Temporary Income Tax Regs., 46 Fed. Reg. 10711 (Feb. 4, 1981), to report the sale for Federal income tax purposes. In accordance therewith, P reported a large capital gain in the year of sale; most of this gain was allocated to A. In a later year, after P redeemed A's entire interest, P sold the notes and reported a corresponding capital loss, most of which was allocated to C. The loss was carried back to 1988 by C to offset its gain. Held: The Court will disregard the CINS transaction for Federal income tax purposes because it lacked economic substance. Fred T. Goldberg Jr., Albert H. Turkus, Pamela F. Olson, William L. Goldman, Christopher Kliefoth, and Joni Lupovitz, for petitioner. Jill A. Frisch, Patricia A. Donahue, Edward D. Fickess, Sheila Olaksen, Elizabeth P. Flores, Brian J. Condon, and James M. Guiry, for respondent. CONTENTS Findings of Fact 1. 2. 3. 4. 5. 6. 7. 8. 9. The Contingent Installment Sale Transaction . . . . . . . 5 Development of Colgate's Liability Management Partnership.................................. 10 The Partners . . . . . . . . . . . . . . . . . . . . . . 24 The Partnership Agreement . . . . . . . . . . . . . . . 29 Initial Stage of Colgate's Partnership Strategy . . . . . . . . . . . . . . . . . . . . . . . . 35 Tax and Financial Accounting for the Results . . . . . . 47 Final Stage of Colgate's Partnership Strategy . . . . . 54 Merrill's Collateral Swap Transactions . . . . . . . . . 59 ABN's Investment Management . . . . . . . . . . . . . . 70 - 3 Opinion 1. 2. Mechanics of a Contingent Payment Sale . . . . . . . . . 83 Economic Substance . . . . . . . . . . . . . . . . . . . 85 a. Introduction . . . . . . . . . . . . . . . . . . . . 85 b. Profit . . . . . . . . . . . . . . . . . . . . . . . 98 c. Hedging Within the Four Corners of the Partnership . . . . . . . . . . . . . . . . . 113 d. Interim Use for Idle Cash . . . . . . . . . . . . . 133 e. The Pattern of Ostensibly Market-Driven Decisions . . . . . . . . . . . . . . . . . . . . . 137 MEMORANDUM FINDINGS OF FACT AND OPINION LARO, Judge: ACM Partnership (ACM or the partnership), Southampton-Hamilton Co. (Southampton), Tax Matters Partner, petitioned the Court under section 6226 to readjust respondent's adjustments of partnership items flowing from the partnership. Respondent issued ACM a notice of final partnership administrative adjustment (FPAA) that reflects adjustments to ACM's partnership return of income for its taxable years ended November 30, 1989 (FYE 11/30/89), November 30, 1990 (FYE 11/30/90), November 30, 1991 (FYE 11/30/91), and December 31, 1991 (FYE 12/31/91). In relevant part, respondent eliminated the capital gain reported by ACM in FYE 11/30/89 as resulting from the transaction described herein, and she disallowed the corresponding capital loss reported in FYE 12/31/91. Respondent asserted a number of alternative theories in the FPAA to support the adjustments. Primarily, respondent asserted, - 4 the purchase and sale of the debt instruments at issue herein were prearranged and predetermined, devoid of economic substance, and lacking in economic reality. Alternatively, respondent asserted, ACM's activities must be disregarded under the step transaction doctrine, ACM's activities were not engaged in for profit within the meaning of section 183, and the sale of the subject debt instruments did not satisfy the formal requirements for a contingent payment sale under section 15a.453-1(c)(1), Temporary Income Tax Regs., 46 Fed. Reg. 10711 (Feb. 4, 1981). Following respondent's concession of a number of these alternative theories, the parties ask the Court to decide the following issues: (1) Whether respondent's adjustments to items of income and loss reported by ACM on the subject transactions should be sustained on the ground that the transactions lacked economic substance. (2) We hold they should. Whether, as alleged by respondent in her amendment to answer, the foreign partner should be treated as a lender for Federal income tax purposes. In view of our disposition of the first issue, we do not decide this issue. Consistent with the FPAA, as well as the manner in which ACM reported the foreign partner on its returns, we assume that the foreign partner is not a lender. (3) Whether ACM's allocation of taxable gain on the sale had substantial economic effect or was otherwise in accordance - 5 with the partners' interests in the partnership. In view of our disposition of the first issue, we need not and do not decide the validity of this allocation. Unless otherwise indicated, section references are to the Internal Revenue Code in effect for the years at issue, and Rule references are to the Tax Court Rules of Practice and Procedure. Throughout this Opinion, we use the terms "purchase", "sale", "contingent installment sale", and "contingent payment sale" solely for purposes of convenience and clarity. Our use of these terms is not meant to give legal significance to the underlying and surrounding transactions. FINDINGS OF FACT Some of the facts have been stipulated. The stipulations of fact and attached exhibits are incorporated herein by this reference. When the petition was filed, ACM's principal place of business was in Wilmington, Delaware. 1. The Contingent Installment Sale Transaction ACM is one of 11 partnerships (section 453 partnerships) formed over a 1-year period from 1989 to 1990 by the Swap Group at Merrill Lynch & Co., Inc.1 Each section 453 partnership was intended to be a vehicle for sheltering capital gains of one of its partners. 1 For purposes of this Opinion, the principal During the period at issue, Merrill Lynch & Co., Inc., was a holding company that, through subsidiaries and affiliates, provided various financial services. We use the name "Merrill" to refer generally to the affiliated group or a member thereof. - 6 transactions in which ACM engaged are collectively referred to as the contingent installment sale transaction (CINS transaction). The design of the CINS transaction appears to have originated in discussions in early 1989 between Macauley Taylor (Taylor), a managing director of Merrill's Swap Group, and James Fields (Fields), a member of his staff. From the spring of 1989 through the summer of 1990, the Swap Group and Merrill's investment bankers promoted the idea among Merrill's clients. Colgate-Palmolive Co. (Colgate) was one of Merrill's clients that Taylor and his staff approached. Colgate's treasury department regularly consulted Henry Yordan (Yordan), a managing director in Merrill's Capital Markets Group, concerning developments in the debt markets. Yordan was aware that Colgate had reported a sizeable capital gain (approximately $105 million) for its 1988 taxable year on its sale of the Kendall Co. (Kendall), and that Colgate might be receptive to the CINS transaction. Through Yordan's introduction, a meeting was held on May 15, 1989, at which Taylor and his staff described the CINS transaction to Colgate's assistant treasurer, Hans Pohlschroeder (Pohlschroeder). Merrill's representatives stated that, apart from the few elements that were essential to secure the desired tax consequences, the partnership structure could be adapted to suit a variety of investment objectives. Colgate's initial reaction to the proposal was skeptical. Pohlschroeder explained that Colgate did not have the required - 7 cash to invest in the partnership, and that the cost of borrowing to finance the investment was likely to exceed the return on a pretax basis. Pohlschroeder also was not persuaded that the partnership would serve a business purpose of Colgate. When Pohlschroeder related the proposal to Steve Belasco (Belasco), Colgate's vice president of taxation, the latter agreed: But for the tax benefits, the transaction did not accomplish anything useful for the company. Belasco also was concerned that the transaction did not have sufficient economic substance to withstand scrutiny, and that the transaction's legal, financial, and accounting complexities would require broad interdepartmental support within Colgate. Absent a connection to Colgate's business, Belasco believed, the necessary support would not be forthcoming. Merrill's proposal was not the first that Colgate considered to minimize the tax impact of the Kendall sale. During the previous summer, while the sale was pending, a cross-functional team from Colgate's treasury, accounting, and tax departments had considered at least 11 tax-saving proposals, including investing in low-income housing or property eligible for rehabilitation credits and creating a charitable foundation. All of these proposals were rejected. After the initial meeting between Colgate and Merrill, Fields, on behalf of Merrill, contacted a law firm for advice on the tax consequences of a CINS transaction. In relevant part, - 8 the firm summarized the contemplated transaction as follows: A (a foreign entity), B, and C form the ABC Partnership (ABC) on June 30, 1989, with respective cash contributions of $75, $24, and $1. Immediately thereafter, ABC invests $100 in short-term securities which it sells on December 30, 1989, to an unrelated party. The fair market value and face amount of the short-term securities at the time of the sale is still $100. In consideration for the sale, ABC receives $70 cash and an installment note that provides for six semiannual payments, commencing 6 months after the sale. Each payment equals the sum of a notional principal amount multiplied by the London Interbank Offering Rate (LIBOR) at the start of the semiannual period.2 ABC uses the $70 cash and the first payment on the installment note to liquidate A's interest in ABC and uses the subsequent interest payments to purchase long-term securities. Relying on section 15a.453-1(c), Temporary Income Tax Regs., 46 Fed. Reg. 10711 (Feb. 4, 1981), the law firm advised Fields that ABC would be entitled to report the sale of the short-term securities on the installment method, and that ABC would recover an equal portion of its basis in the short-term securities in each year in which a payment on the note could be received. The law firm advised Fields that ABC would recover $25 of its basis in each of the 4 taxable years from 1989 through 1992, and that 2 LIBOR is the primary fixed income reference rate used in Euro markets. - 9 ABC would have to recognize gain in each of these years to the extent that the year's payments exceeded $25. To the extent that the year's payments were less than $25, the law firm advised, ABC would not be allowed to recognize a loss in that year, but ABC would have to carry over that "loss" to a later year in which it would otherwise recognize enough gain on the sale to absorb all or part of the "loss". The law firm advised that any unrecognized loss on the sale would be recognized in the final year of payment. In a series of telephone calls in early July 1989, Pohlschroeder revisited Merrill's proposal with Yordan, Taylor, and Fields. Pohlschroeder communicated a number of concerns that Colgate had regarding the management of its debt. Pohlschroeder wondered whether there was a way to combine Colgate's financial objectives with Merrill's proposal. On July 18, 1989, Taylor called Pohlschroeder back with a suggestion for resolving the problem. The gist of the conversation can be reconstructed from Pohlschroeder's handwritten notes: Mac Invest. partnership Based on bus. purpose Economic profit Is this partnership profitable? Every single step to be substantiated Invest in your own debt Consolidation of effective control but not majority ownership - 10 2. Development of Colgate's Liability Management Partnership The notion that Colgate could use a partnership to acquire its own debt was the breakthrough that overcame Colgate's reservations, for it provided the opportunity to design an elaborate superstructure of liability management functions around Merrill's original tax shelter transaction. To understand the extent to which ACM was designed to serve these functions, we first review the concerns of Colgate's treasury department in this period. A number of developments during 1988 and 1989 posed special challenges for the management of Colgate's debt. In this period, Colgate radically altered the maturity profile of its debt through two actions. First, it used the proceeds from the sale of Kendall in October 1988 to retire over half a billion dollars of commercial paper constituting all of its U.S. short-term debt. Second, it established an employee stock ownership plan (ESOP) in June 1989, financed by issuing $410 million in long-term debt. The substitution of long-term debt for short-term debt caused Colgate's average debt maturity to exceed substantially the norm in its industry and increased its exposure to interest rate risk.3 3 Colgate's treasury department expected the Federal All other things being equal, the longer the maturity of a debt instrument the more sensitive its value will be to fluctuations in market interest rates. Hence, long-term debt tends to carry greater risk than short-term debt of the same issuer. - 11 Reserve to ease monetary policy, causing interest rates to fall in late 1989 or the first half of 1990. In a falling interest rate environment, Colgate would earn a lower return on its cash balances and short-term investments; yet, unlike its competitors with relatively greater amounts of short-term debt, it would be unable to cut its interest expense by refinancing. The establishment of the ESOP had the further consequence of prompting Moody's to downgrade Colgate's long-term debt from A1 to A2 on the ground that the addition of so much long-term debt reduced the company's financial flexibility. In the summer of 1989, Colgate's treasury department was exploring ways to rebalance the term structure of its debt and lower its exposure to falling interest rates. Pohlschroeder raised these issues in his discussions with Merrill's representatives in July 1989. The discussions also concerned the credit spread at which Colgate's long-term debt was trading. The market's perception of the credit worthiness of a corporation is reflected in the extent to which the yield on the corporation's bonds exceeds the yield on U.S. Treasury instruments of comparable maturity. The "spread to Treasury" of Colgate's long-term debt had exceeded the average for high and medium grade industrials throughout 1988 and, after narrowing in the early part of 1989, had widened markedly during the summer. One reason for this change was the downgrade in Colgate's credit rating in June. Colgate's treasury believed that another factor was widespread speculation that Colgate could - 12 become the target of a hostile takeover or leveraged buyout. This led to the emergence of an "event risk" premium that caused Colgate debt to trade at a discount relative to the price that would otherwise obtain. In Colgate's opinion, the market was overestimating the risks of holding Colgate's debt. Thus, Colgate's debt was undervalued, and an opportunity existed to capture subsequent improvements in its perceived credit quality by repurchasing the debt. Yet, Colgate's flexibility to respond to this arbitrage opportunity was constrained by the prospect that a significant reduction in its balance sheet liabilities would enhance its appeal to a potential acquirer. Through the collaboration of Merrill's Swap Group and Colgate's treasury department, from late July to early October 1989, the partnership gradually took shape. Merrill's first written exposition of the concept, entitled "Colgate Partnership Transaction Summary", dated July 28, 1989, states: "the primary mission of the Partnership is the acquisition and control of Colgate debt". "Colgate Sub.", "A Corp.", and "B Corp." would contribute $30 million, $169.3 million, and $0.7 million, respectively. Colgate Sub. would act as managing general partner with the authority to determine partnership investments. Over a period of several months, the partnership capital would be used to acquire long-term Colgate debt from investors. The partnership would then exchange some of the long-term debt for newly issued Colgate medium-term debt. Merrill noted that the - 13 accounting treatment of the partnership was unclear. Despite Colgate's minority interest, Merrill believed, the partnership might have to be consolidated on Colgate's financial statements if Colgate were deemed to control the partnership. Merrill thought that either result might be advantageous. By the beginning of October 1989, the design had been revised in two important respects. First, it had been determined that the partnership would be most useful if its transactions were initially kept off of Colgate's balance sheet and its consolidation with Colgate for financial accounting purposes was deferred until such time as Colgate acquired a majority interest in the partnership from the foreign partner. This would enable Colgate to conceal its activities from the market as well as choose more advantageous market conditions for retiring and reissuing the debt. Second, Merrill had devised a mechanism by which Colgate and the foreign partner could share the credit risk with respect to partnership holdings of Colgate debt in different proportions from the so-called treasury (i.e., interest rate) risk. The efficiency of "allocating to each partner the risks that it could bear" would make it possible for Colgate to receive greater benefits from the partnership at less cost. Thus, it was expected that Colgate could negotiate for the right to appropriate all the benefit of the improvement in its credit quality that it expected to occur over time, while negotiating for an option to vary the partners' relative shares of the - 14 treasury risk inherent in the debt so as to capitalize on expected changes in interest rates. A document entitled "Liability Management Partnership Executive Summary", dated October 11, 1989, purports to identify the main non-tax advantages of the contemplated partnership structure at about the time that it was approved by Colgate's senior management. The proposed Liability Management Partnership (the "Partnership") has been developed specifically for Colgate-Palmolive ("Colgate") to enable it to most efficiently manage the term structure of its liabilities, using predominantly its partners' capital. Normally an issuer's acquisition of its own debt involves three events, the acquisition of the debt, the retirement of the old issue and the issuance of substitute financing. The Partnership provides the opportunity to separate the timing of these events * * * by (i) acquiring Colgate debt in the market today, while it remains available, and (ii) placing such debt in "friendly hands," to be retired, modified or exchanged at an advantageous time in the future. * * * * * * * Despite the current opportunity to acquire its debt, Colgate does not wish to immediately retire all of such debt and issue substitute financing. This reluctance is based in part on Colgate's current rate outlook (i.e., anticipation of gradual return to a positively-sloped yield curve) and in part on Colgate's desire not to permanently restructure all of such debt immediately. * * * * * * * * * * The Partnership provides Colgate with flexibility to exchange the Colgate debt held - 15 by the partnership for newly issued Colgate debt of different maturity. Such exchanges may be effected as often and rapidly as Colgate deems appropriate. If Colgate attempted to refinance existing debt within a short time frame by repurchasing it and issuing new debt, transactions costs would rise dramatically. * * * * * * * * * * The Partnership also allows Colgate to effectively retire its debt, while leaving the debt outstanding for accounting purposes, and to take a position on rates by adjusting the relative sharing of Treasury risk by the partners. As Colgate bears a relatively greater share of the Treasury risk (i.e., losses in value of the Colgate debt attributable to interest rate increases) with respect to its debt, it has economically retired an increasing percentage of such debt and effectively changed its position with respect to interest rates. The partnership's fulfillment of the liability management purposes for which it was designed would depend on the identity of Colgate's partners. Merrill undertook to procure them. During the summer of 1989, Taylor approached Hans den Baas (den Baas), the head of the Financial Engineering Group at ABN Bank New York (ABN New York),4 concerning the possibility of ABN's participation in a partnership with Colgate. Taylor explained that the partnership would be used to acquire Colgate long-term 4 During the period at issue, ABN New York was a subsidiary of Algemene Bank Nederland, N.V., one of the Netherlands' largest financial institutions. ABN Trust Co., Curacao, N.V., was another subsidiary. For purposes of this Opinion, the name "ABN" refers to Algemene Bank Nederland, N.V., or any one of its subsidiaries, affiliates or branches. - 16 debt for liability management purposes. He also stated that a contingent payment sale was contemplated, and that ABN's participation would be limited to 2-3 years. Den Baas forwarded Taylor's inquiry to Peter de Beer (de Beer), head of the legal department of ABN Trust Co., Curacao N.V. (ABN Trust), who would be responsible for structuring the legal aspects of the participation and negotiating the agreements. ABN Trust was engaged in the business of forming and managing Netherlands Antilles' entities to facilitate financial transactions. De Beer agreed to meet Colgate representatives in Bermuda during the middle of October 1989. He learned of the liability management aspects of the proposed partnership only when actual negotiations with Colgate began. Based on prior dealings with Merrill, both den Baas and de Beer were already familiar with the CINS transaction and the defined role of the participating foreign partner. Taylor had discussed the transaction with den Baas during its development phase early in 1989. Taylor had previously approached den Baas to solicit ABN's participation in a CINS transaction on behalf of at least one other client. In that case too, den Baas had referred him to de Beer, who had represented ABN in the ensuing negotiations. For a number of reasons, ABN was well suited for the role of majority partner in Colgate's liability management partnership. An ABN affiliate created and managed the foreign partners for - 17 each of the 11 section 453 partnerships promoted by Merrill. ABN New York provided financial engineering and other services to the foreign partners in each of the partnerships. Whether or not an understanding that ABN would collaborate as a copromoter existed from the outset, ABN would have had an interest in assuring the satisfaction of Merrill's clients in order to ensure the continuity of a valuable relationship with Merrill. It is unclear whether Colgate was aware of Merrill's relationship with ABN, but Colgate already had an established relationship with ABN. Acting as Colgate's lead bank in the Netherlands, ABN had underwritten a large foreign bond issue and performed other services in connection with Colgate's foreign operations. For these reasons, ABN could be trusted to cooperate in keeping the partnership "friendly", by yielding effective control to Colgate, by protecting the confidentiality of Colgate's debt restructuring activities, and by agreeing to relinquish its partnership interest at such time as Colgate might wish to acquire it. ABN's experience and sophistication in regard to European capital markets would assist the partnership in acquiring Colgate's Eurodollar debentures. As a major international bank, ABN possessed the liquidity needed to finance the venture, and, as a major derivatives dealer, it could accommodate, at little or no cost, Colgate's desire for an option to adjust their relative shares of interest rate exposure. - 18 The third partner was to be an affiliate of Merrill. provided Colgate with further reassurance. This An equity interest would reinforce Merrill's incentive to continue to provide support and to act in a manner consistent with Colgate's interest when arranging the contemplated partnership transactions. Merrill would receive an advisory fee and transaction-based fees for initiating the partnership's asset transfers. The ultimate challenge for Merrill in designing the liability management partnership was to find a way to integrate each step of the CINS transaction convincingly so that the transaction, as a whole, would stand up for tax purposes. Swap Group devoted considerable effort to this task. The Although the basic insight was incorporated in the initial "Colgate Partnership Transaction Summary" of July 28, 1989, it was refined in subsequent revisions of this document. "XYZ Corporation: The version entitled Revised Partnership Transaction Summary", dated August 17, 1989, set forth an outline of 10 steps to be taken by the partnership summarized as follows: Step 1: The partnership is formed with contributions from XYZ Sub., A Corp. and B Corp. of $30 million, $169.3 million and $0.7 million, respectively. Step 2: The partnership invests $200 million cash in short-term, floating-rate private placement securities pending acquisition of long-term XYZ debt. The private placement notes will be issued by highly rated issuers and will provide the partnership a return greater than comparably rated commercial paper or bank deposits. Step 3: The partnership sells the private placement notes for a combination of cash, which will be used to - 19 acquire XYZ long-term debt over a period of 6 months, and LIBOR-based notes. "The purpose of the LIBOR notes will be to partly hedge the interest rate sensitivity of the long-term XYZ debt acquired by the Partnership." Depending on the maturity of the XYZ debt acquired, Merrill anticipated a ratio of 70-percent cash ($140 million) to 30-percent LIBOR Notes ($60 million). Step 4: Some long-term XYZ debt is exchanged for newly issued medium-term XYZ debt. Step 5: If a substantial amount of long-term debt was exchanged, the partnership would likely reduce its holding of the LIBOR Notes in order to rebalance its hedge. "Such a reduction would be necessary because the Medium-Term Debt, received in exchange for long-term XYZ debt, is less interest rate sensitive than the long-term XYZ debt. LIBOR Notes may either be sold directly or distributed to one or more Partners in a non-liquidating distribution." Steps 6 and 7: Partnership assets are disposed of in the event that the desired investments cannot be made. Step 8: A Corp.'s partnership interest is "possibly" redeemed at any time after 1 year following formation. Step 9: The partnership is consolidated with XYZ for financial accounting purposes. The document advises that [i]t would be most reasonable for the Partnership to sell the LIBOR Notes and any other LIBOR-based assets if A Corp. is redeemed. Since the principal asset of the Partnership, other than LIBOR Notes and LIBOR-based assets, is likely to be XYZ debt and XYZ would be a 98% partner, the hedge protection provided by the LIBOR Notes and LIBOR-based assets is no longer necessary. Step 10: B Corp. is eventually retired after a period of years. In support of its characterization of the LIBOR Notes as a risk management tool, Merrill performed a series of quantitative analyses of the effect of a given change in the level of interest - 20 rates on the value of Colgate debt and LIBOR Notes in the partnership portfolio. These analyses purport to demonstrate that the interest rate sensitivity of the interest-only LIBOR Notes greatly exceeds that of fixed rate debt instruments of equal maturity and is comparable to that of long-term fixed rate debt. Thus, a 100 to 200 basis point increase or decrease in interest rates would produce roughly equal and offsetting changes in the value of $1 of LIBOR Notes, $2.34 of 9 percent 5-year Colgate debt, and $0.88 of 9-5/8 percent 30-year Colgate debt. Pohlschroeder was impressed with Merrill's analysis. In an October 3, 1989, memorandum written for the purpose of recommending the "ABN Liability Management Partnership" to his superior, Colgate treasurer Brian Heidtke (Heidtke), Pohlschroeder explained how the composition of the partnership's portfolio would be planned to serve the purpose of "risk management within the partnership". "One aspect of importance is the interest rate exposure on the asset of the partnership which consists of Colgate debt. To minimize the exposure to ABN and Colgate, it is planned to convert a portion of the short-term notes to contingent LIBOR Notes as a hedge of the partnership's fixed rate assets." Although the hedge ratio would be determined through negotiations with ABN, he was confident that the partnership could acquire $140 million of Colgate debt, and that $60 million of LIBOR Notes would provide an appropriate level of protection. The plan was to adjust "the LIBOR note hedge" as - 21 needed in order "to achieve the ideal Colgate liability structure." Pohlschroeder envisioned "two possible situations arising in the future" which would call for the disposition of some of the LIBOR Notes. One was the exchange of long-term debt for medium- or short-term debt. "Because a shorter term instrument is less volatile, a smaller notional amount of the LIBOR Note is required for hedging purposes." A second situation was a change in the treasury risk sharing ratios. "The partnership is overhedged when Colgate decides to take more of the treasury risk and ABN reduces its share of the treasury risk. Conversely, as ABN's participation goes up, it needs more of a hedge in [the] form of the LIBOR notes." Merrill provided Colgate with estimates of the expected costs of the contemplated partnership transactions. The "Perpetual Partnership Cost Component Analysis" reproduced in modified form below was prepared based on market conditions prevailing on September 1, 1989, and evidently assumed that the partnership would remain in existence indefinitely after these transactions were completed. - 22 Perpetual Partnership Cost Component Analysis ( $ millions ) After Tax Pretax1 $25.47 --- Origination of Citicorp Notes Remarketing of LIBOR Notes Preferred returns to partners Premium on debt tender Legal expenses Advisory fee Total 1.32 1.29 0.74 0.48 0.17 1.32 5.32 $2.00 1.95 1.12 0.73 0.25 1.75 7.80 Net present value of partnership investment 20.15 --- Net present value before transaction costs & advisory fee Cost Components: 1 In its review of these costs, as part of a separate document, Colgate translated aftertax amounts into pretax amounts using a 34-percent marginal rate. The original aftertax estimate of Merrill's advisory fee ($1.32 million) would imply a pretax amount of $2 million. The discrepancy between this and the $1.75 million figure reflected in this separate document was not explained. The "origination" cost refers to the transaction cost that the partnership would incur on the exchange of private placement notes for cash and LIBOR Notes. The remarketing cost represents the transaction cost that would be incurred on the sale of the LIBOR Notes. The preferred return was an estimate of the additional allocation of income that the majority partner was expected to require. its services. The advisory fee was payable to Merrill for Colgate's management understood that most, if not all, of these costs would be borne by Colgate because all the liability management and tax benefits of the partnership - 23 transactions would enure to Colgate. They believed that the costs, though high in absolute terms, were reasonable in relation to the benefits that Colgate expected to receive from the partnership. Liability management benefits would have been difficult to quantify for purposes of this comparison. The tax benefits, however, were calculable and greatly exceeded the expected transaction costs. Although the Perpetual Partnership Cost Component Analysis does not explain the derivation of the $25.47 million net present value that appears on the top line, this figure must be attributable almost entirely to tax benefits. A succession of summaries, cash-flow projections, and flip-chart presentations that Colgate received from Merrill between August and mid-October 1989, demonstrated how the sale of $200 million private placement notes for $140 million cash and $60 million market value of LIBOR Notes would result in $107 million taxable gain for the partnership and a net taxable loss for Colgate of approximately $90 million. If the foreign partner's interest were acquired and the LIBOR Notes sold within the 2-year period remaining for carryback of capital losses to the year of the Kendall divestiture, the present value of the tax savings achieved by this transaction, discounted at prevailing interest rates of 8-1/2 to 9-1/2 percent, would be roughly $25 million. In a series of internal meetings and meetings with Merrill representatives during September and early October 1989, the - 24 liability management partnership proposal was presented to successively higher levels within Colgate's management. The vice president of taxation was now comfortable with the economic substance of the partnership. The treasurer concluded that this was a "uniquely suitable transaction for us." They, in turn, presented the tax and treasury aspects of the proposal to the chief financial officer and to the president of the company, who approved it. The decision was made to enter into negotiations with ABN. 3. The Partners ABN chose a form for its participation that would appear on its consolidated balance sheet as a loan to a third party rather than an equity investment. A Netherlands Antilles corporation named Kannex Corp., N.V. (Kannex), would be formed to borrow approximately $170 million from a bank and contribute it to the partnership. Kannex's stock would be held by two Netherlands Antilles stichtingen named Coign and Glamis. Stichtingen are foundations under Dutch law, have no owners, and conduct no commercial activities. Their sole purpose in this transaction would be to hold Kannex's stock. Control over the foundations would be exercised by their respective boards, of which de Beer would serve as chairman and other ABN Trust employees as members. The foundations would appoint ABN Trust to act as sole managing director of the corporation. - 25 Financial arrangements for Kannex's participation were initiated by den Baas at ABN New York. Based on information about the proposed partnership that den Baas had received from Taylor, ABN New York prepared a credit proposal on behalf of Kannex, dated October 3, 1989. Since the borrower's only asset would be an interest in a portfolio expected to consist largely of Colgate long-term debt, ABN New York assessed Colgate's creditworthiness. Under the terms of the proposed credit facility, the bank would loan Kannex $170 million for 1 year at an interest rate of LIBOR plus 30 basis points, corresponding to the rate that the bank would have charged Colgate or a similarly rated company for a line of credit. "client" on the credit proposal. Colgate was listed as the This was because ABN New York viewed the financing transaction as a means of fostering closer banking relations with Colgate. As the credit proposal explained: Colgate has been an important prospect for ABN New York Branch because of its strong financial condition and extensive international operations. Establishing a relationship has proven difficult because of the company's loyalty to its line banks. ABN's past involvement has been limited to facilities for Colgate subsidiaries. * * * We believe that the proposed transaction would provide an excellent entry into the parent's banking relationship. Although the interest rate on the loan would provide an acceptable return commensurate with the level of the credit risk involved, ABN New York expected that the total returns to the bank from the loan transaction would be appreciably higher. The - 26 bank would also earn sizeable profits off the bid-ask spread on swaps necessary to stabilize Kannex's return from the assets in the partnership portfolio so that it could repay the loan.5 Because of the size of the loan, approval was required at three levels within the bank: The credit committee at ABN New York, the North American Credit Committee (NACC) in Chicago, and the Risk Management Dept. (RMD) in Amsterdam. After approval by ABN New York, NACC reviewed the proposal together with a memorandum describing the partnership. On October 11, 1989, sent an advice to RMD recommending approval subject to a number of conditions, of which three are noteworthy: 1) The timing of the purchases and sales of the various securities be adhered to as proposed such that the credit risk is no greater than as outlined in partnership memo. 2) Interest rate risk is fully hedged. 3) Colgate's obligation to purchase Kannex's interest in the partnership by 11/30/89 [sic] is unconditional (will those proceeds be assigned to ABN?) RMD advised NACC and ABN New York of its decision: "We agree on the condition that Merrill again verbally states to the partners that they will buy the MTN's at par on November 29, 1989." The reference to "MTN's", or medium-term notes, evidently denotes the private placement notes in which the partnership was 5 A bid-ask spread is the spread between the price at which an instrument is bought and sold. The bid price is the price at which dealers buy the instrument, and the ask price is the price at which dealers sell the instrument. - 27 expected to invest the partners' contributions pending acquisition of Colgate debt. The earlier oral assurance to which RMD refers may have been one that Merrill made to the first section 453 partnership in which ABN collaborated, the Nieuw Willemstad Partnership. Failing to locate a buyer for the partnership's private placement notes within the time frame required by the partners, Merrill itself became the counterparty, buying the private placement notes and issuing LIBOR Notes. A second condition was that the loan to Kannex be syndicated in order to reduce the credit risk. ABN records indicate that the credit proposal was "approved per RMD". There is no record of any modification to the NACC and RMD conditions. Under ABN procedures, if credit conditions had been changed, the changes should be reflected in NACC files. Although there are cases in which a branch fails to advise NACC of changes in credit conditions or changes are made without documentation, such cases are rare. Kannex was incorporated in the Netherlands Antilles on October 25, 1989, and issued shares with a total par value of $6,000, held in equal proportions by Coign and Glamis. Kannex's financial statements reflect accounts receivable for loans to the foundations in the amount of $6,000, indicating that they borrowed from the corporation the funds they used to acquire its stock. By "Revolving Credit Agreement" dated November 2, 1989, ABN's Cayman Islands Branch (ABN Cayman Islands) agreed to make - 28 loans available to Kannex in the aggregate amount of $180 million from November 2, 1989, through August 1, 1990. The shares of Kannex stock held by Coign and Glamis were pledged to ABN as security for the loans. Kannex entered into a management agreement with ABN Trust and a financial services agreement with ABN New York, executed by den Baas, under which ABN New York agreed to provide advice on hedging strategies to reduce Kannex's interest rate exposure and to provide other services at Kannex's request. The agreement does not make provision for either the amount or calculation of ABN New York's compensation. Southampton, a wholly owned subsidiary of Colgate, was incorporated under Delaware law on October 24, 1989, for the purpose of becoming a partner in Colgate's liability management partnership. Belasco served as Southampton's president and Pohlschroeder as its vice president and treasurer. During the taxable years at issue, Southampton filed a consolidated return with Colgate. Merrill Lynch MLCS, Inc. (MLCS), was incorporated under Delaware law on October 27, 1989. MLCS is the wholly owned subsidiary of Merrill Lynch Capital Services (Merrill Capital), which operates as the swap dealer for the Merrill Lynch Group. Taylor was MLCS's president and Paul Pepe (Pepe), a member of his staff, its vice president. - 29 4. The Partnership Agreement Negotiations were conducted at two meetings held in Bermuda on October 18 through 19, and October 27, 1989. The meetings were attended by, inter alia, Heidtke, Pohlschroeder, and Belasco from Colgate; Taylor and Fields from Merrill; de Beer and den Baas from ABN. By agreement dated as of October 27, 1989 (the Partnership Agreement), ACM was formed as a general partnership under New York law with its principal place of business in Curacao, Netherlands Antilles.6 The partners' initial capital contributions were determined to be as follows: Partner Capital Contribution Kannex Southampton MLCS 1 $169,400,000 35,000,000 600,000 205,000,000 Percentage of Total 82.63 17.07 .29 1 100.00 Includes rounding error of .01 The conduct of the business and affairs of the partnership would be under the direction of a partnership committee (the Partnership Committee) composed of a representative of each of the three partners. In general, action by the Partnership Committee required the assent of partners having an aggregate capital account balance equal to at least 99 percent of the total partners' capital. 6 The affirmative concurrence of both Kannex The original name of the partnership was CAM Partnership. At the first meeting of the Partnership Committee, for reasons not disclosed in the record, the initials of Colgate and ABN (A) were reversed, and the name became ACM. - 30 and Southampton was therefore necessary for most partnership decisions. As its representative, Southampton appointed Pohlschroeder. Kannex appointed de Beer, and MLCS appointed Taylor. The Partnership Agreement provided that, in general, income, gain, expense, and loss, as reported by the partnership for Federal income tax purposes, would be allocated among the partners in proportion to their respective capital accounts. As subsequent events would demonstrate, this general sharing provision did not fully reflect the partners' original understanding of the manner in which they would share the economic costs of partnership transactions. Upon the occurrence of specified "Revaluation Events", the partnership would revalue its assets on its books, and any unrealized income, gain, expense, or loss inherent in its assets would be allocated among the partners as if realized in a sale of the assets at their fair market value. included: These Revaluation Events (i) a change in a partner's proportionate interest in partnership capital; (ii) a sale or exchange by the partnership of any Colgate debt instrument; (iii) an adjustment to the Yield Component (as defined below) with respect to Colgate debt; (iv) a contribution or distribution of partnership assets; (v) liquidation of the partnership; (vi) the last business day of each fiscal year; and (vii) after November 30, 1989, the properly executed request of any partner. - 31 To allocate gains and losses arising in connection with Colgate debt instruments in the partnership portfolio for each revaluation period, the Partnership Agreement distinguished between that portion of any change in value attributable to changes in the general level of interest rates (the Yield Component) and that portion of any change in value attributable to changes in the market's perception of risks specifically associated with Colgate's credit quality (the Quality Component). Together, the Yield Component and Quality Component would capture all of the fluctuation in market value of the Colgate debt held by the partnership. The Yield Component was initially allocated among the partners based on their respective capital interests.7 Southampton could elect, however, to change its and Kannex's relative shares of the Yield Component to any level it desired within a specified range, on 5 days notice. It could increase its own share to as much as 49.7 percent, thereby reducing Kannex's share to 51 percent, and it could reduce its own share to as little as 10 percent, causing Kannex to take 89.7 percent. The allocation of the Quality Component depended on whether Colgate's credit had improved or deteriorated during the relevant revaluation period. 7 Improvement or deterioration was measured by Kannex's share was set slightly higher (83 percent) and Southampton's slightly lower (16.7 percent) than their respective capital interests. - 32 the change in the implied spread of the Colgate debt yield over an index of the yield on U.S. Treasury securities. If Colgate's credit improved, the spread would narrow; if Colgate's credit deteriorated, the spread would widen. The Quality Component was the change in the value of the Colgate debt attributable to this change in the spread. The Partnership Agreement provided for the following Quality Component allocations: (a) For the first 50 basis point decline in value, 84.7 percent of the decline was allocated to Southampton, 15 percent to Kannex, as were subsequent increases within this 50 basis point range; (b) all declines beyond 50 basis points were allocated 99.7 percent to Southampton, and all other increases were allocated 99.7 percent to Southampton. MLCS's share of all changes was 0.3 percent. The substantial risk shifting potential of the Yield Component option, which was of substantial value to Colgate's liability management scheme, proved relatively unproblematic for ABN because of the bank's ability to hedge interest rate risks outside the partnership through routine techniques employed by financial intermediaries in the derivative markets. Indeed, in its design of this option mechanism, Merrill's Swap Group took for granted ABN's ability to make accommodations in this manner. The Quality Component provision was a bone of contention for the same reason that the Yield Component provision was not. A credit derivative that could be used by the bank to hedge the share of spread risk allocated to it under this provision was not - 33 available in the market at that time. any spread risk for Kannex. ABN was loath to accept On the advice of its tax lawyers, Colgate insisted, and the parties finally agreed, on a sharing formula that limited Kannex's exposure to 7-1/2 basis points (15 percent of a 50 basis point range). The parties agreed on one further special allocation under the Partnership Agreement. From the date of the initial capital contributions through February 28, 1992, the first $1,241,000 of partnership income and gain for each fiscal year otherwise allocable to Southampton would be allocated to Kannex. This preferred return was not cumulative and was prorated daily. For this purpose, gains otherwise allocable to Southampton did not include unrealized gains resulting from revaluations of partnership assets. ABN had insisted on a preferred return as compensation to Kannex for participating in the spread risk of the Colgate debt. ABN intended that the amount would also include a small service fee for the adjustments that the bank would have to make to accommodate Southampton's discretionary management of interest rate exposure under the Yield Component provision. As the price for these benefits and as a substitute for the covenants and other legal protections that a lender in the position of Kannex would require as a condition for investing a great deal of money in Colgate debt obligations, Colgate considered the $1.24 million preferred return to be reasonable. - 34 Southampton was required to maintain at least 2 percent of partnership capital. In the event that a substantial widening of the credit spread on Colgate debt caused Southampton's capital account to fall below the 2-percent threshold, unless prevented by insolvency, Southampton would contribute enough additional capital to continue to finance at least a certain minimum amount of the preferred return. Section 4.03 of the Partnership Agreement governed the maintenance of the partners' capital accounts. The capital accounts would be increased by the amount of the partners' contributions, adjusted for allocations of partnership income, gain, expenses, and loss, and reduced by the fair market value of distributed property. Upon the occurrence of Revaluation Events, the capital accounts would be adjusted to reflect the mark-to-market revaluation of partnership assets. Each of the partners was entitled to have its interest redeemed at fair market value upon request. Kannex could request redemption at any time after February 28, 1992. The other two partners could request redemption 1 year later. The redemption provision apparently was not the subject of negotiation. It was the intention of the parties that Kannex would be redeemed within 2 years, before its formal right under the Partnership Agreement ripened. The planned duration of Kannex's participation was dictated by the period prescribed for carryback of the capital loss to Colgate's 1988 taxable year. Colgate's plan afforded ABN - 35 the convenience of limiting the extent of Kannex's risk exposure. 5. Initial Stage of Colgate's Partnership Strategy The first meeting of the Partnership Committee (First Partnership Meeting) was held in Bermuda on October 27, 1989. The first noteworthy item of business was to appoint Merrill as qualified appraiser of partnership assets and to authorize both Merrill and ABN to make necessary arrangements for the purchase of three specified issues of Colgate debt: (1) $100 million principal amount of 8.4 percent private placement notes due in 1998 (Met Note) held by the Metropolitan Life Insurance Co. (Met Life); (2) $35 million principal amount of 9.625-percent notes due in 2017 (Long Bonds); (3) $5 million principal amount of 9.5-percent Eurodollar notes due in 1996 (Euro Notes). Next, the Partnership Committee resolved that "in order to maximize the investment return on its assets pending the acquisition of Colgate-Palmolive Bonds", the partnership authorized Merrill to arrange for the purchase, in the form of a private placement, of $205 million of 5-year floating rate notes with an investor put option exercisable after about 15 to 24 months. Finally, according to the minutes, Pohlschroeder reported that he had communicated an offer to Met Life to purchase the Met Notes at a price within a stated price range, and that Met Life undertook to consider the proposal and review it with tax and legal advisers and, if interested, would come to Bermuda on November 17 in order to complete negotiations. The - 36 Partnership Committee authorized ABN Trust to conduct "such further discussions from outside the U.S. as are necessary with Metropolitan prior to such meeting." During the proceedings in Bermuda, Taylor and Fields, on two separate occasions, presented Pohlschroeder and Belasco with revised estimates of the present value of transaction costs that were likely to be incurred in connection with the anticipated partnership transactions. According to one estimate, the total amounted to $6.95 million before tax, including $1.31 million origination cost on the sale of the private placement securities and issuance of the LIBOR Notes and $1.0 million for remarketing of the LIBOR Notes. The other estimate was higher: A total of $7.91 million before tax, including origination and remarketing costs of $2.0 million and $1.1 million, respectively. Colgate and Merrill did not discuss the costs of alternative short-term investments for the partnership's cash balances pending acquisition of Colgate debt. On November 2, 1989, the partners' cash contributions in the amount of $205 million were deposited in the partnership bank account at ABN New York paying interest at a rate of 8.75 percent annually. day. The funds were withdrawn, at no cost, on the following By Private Placement Note Purchase Agreement between ACM and Citicorp, dated November 3, 1989, ACM acquired from Citicorp at par $205 million principal amount of floating rate notes due October 19, 1994 (Citicorp Notes or the Notes). The Citicorp - 37 Notes paid interest at the commercial paper rate plus 15 basis points, paid and reset monthly. The initial coupon was set at 8.78 percent and the first reset date was November 15. were rated AA by Standard & Poors. The Notes The holder had the option of tendering the Citicorp Notes for repayment on October 16, 1991, at 100 percent of the principal amount. The Citicorp Notes were not registered under the Securities Act, 15 U.S.C. sec. 77a (1933) and were not traded on an established securities market. At the time of purchase, it was contemplated that the Citicorp Notes would be sold at the end of the month. Indeed, arrangements to sell the notes were already well underway. In several meetings beginning in late October, Pepe and other Merrill representatives discussed a proposed structure for the sale with the Capital Markets Group of the Bank of Tokyo's (BOT) New York Agency. Parallel discussions were held with the New York Branch of Banque Francaise du Commerce Exterieure (BFCE). During the first week of November, Merrill disclosed the specific terms of its proposal to each bank. The banks would purchase $175 million of the Citicorp Notes, paying 80 percent of the price ($140 million) in cash and the remainder with an installment purchase note providing for a 5-year LIBOR cash flow having a present value of $35 million. In addition, the banks would enter into collateral swaps with Merrill Capital that provided the banks with risk protection and an attractive return. Merrill had already prepared the legal documentation for the - 38 transactions. By facsimile dated November 9, BOT Capital Markets Group sent an urgent request for credit approval to the head office in Tokyo, attaching "all details of the transaction". Merrill required that the agreements be executed within a few days and any delay was likely to result in loss of the deal. On November 10, Merrill informed the banks that, at the asset seller's request, the transaction would be divided between them: BOT would purchase $125 million of the Citicorp Notes and BFCE would purchase $50 million. If the amount and timing of the partnership's cash needs were so clearly foreseen at the beginning of November, it was in large part because by this time preparations for the acquisition of Colgate debt were also well advanced. The Met Note, Long Bonds, and Euro Notes that the Partnership Committee directed Merrill and ABN to acquire had been targeted for acquisition months earlier. Merrill's first "Partnership Transaction Summary", prepared in July, had contemplated that the partnership would purchase these three issues, using approximately $140 million cash from the sale of the private placement notes. During the summer, Pohlschroeder had told Fields that he knew that Met Life would be willing to sell the Met Note and could probably be induced to sell it immediately. He had arrived at the conclusion as a result of recent unsuccessful attempts by the insurance company to renegotiate the loan agreement. Both the Long Bonds and Euro Notes were identified as good candidates - 39 because substantial amounts of these public issues were held by institutions. Based upon his own study of market activities and consultation with traders during the first 6 to 9 months of 1989, Pohlschroeder was able to estimate how much of the Long Bonds and Euro Notes were available. Colgate's treasury department had Yordan perform further research on availability and price. By the beginning of October, Pohlschroeder felt confident that the partnership would meet Colgate's debt purchase target of approximately $140 million. The only genuine question in regard to the Met Note was price. In late September, Pohlschroeder contacted Met Life to indicate a possible interest in purchasing the Met Note. On October 23, a few days before he returned to Bermuda to conclude the Partnership Agreement, Pohlschroeder prepared himself for negotiations with Met Life by conferring with Yordan. His notes from that conversation conclude with a reference to the date November 17, which is circled. As the minutes of the First Partnership Meeting reflect, Pohlschroeder contacted Met Life again from Bermuda to invite a representative of the insurance company to negotiate a sale of the note in Bermuda on November 17. The statement in the minutes that Pohlschroeder had communicated an offer on specific terms appears to have no basis in fact, however. It is clear that Pohlschroeder refused to enter into any discussion of terms on that occasion. During the 3 weeks prior to the meeting scheduled for November 16 and 17, - 40 Pohlschroeder received a telephone message from Met Life stating the insurance company's asking price. call. He did not return the There were no negotiations prior to the scheduled meeting, either by Colgate within the United States, or by ABN Trust, the partnership's authorized representative for this purpose, outside the United States. Yordan attended the meeting of the Partnership Committee in Bermuda on October 27 in order to advise the partnership concerning availability and prices of Colgate's Long Bonds and Euro Notes. At this time, Pohlschroeder prepared notes regarding standing orders that ACM intended to issue to Merrill for the purchase of the Long Bonds and Euronotes. The notes apparently reflect a decision as to the timing of these transactions: "Peter de Beer, Curacao will give instructions from C to M.L. after Citi's purchase". The second partnership meeting was held in Bermuda on November 17, 1989. A representative from Met Life came to Bermuda at this time to negotiate the sale of the Met Note. The negotiation was not lengthy; price was the only issue, and the parties split the difference between their respective offers. By Note Purchase Agreement dated November 17, 1989, and effective December 4, 1989, ACM purchased $100 million principal amount of the Met Note for the aggregate purchase price of $99,291,000 plus accrued interest. - 41 Pohlschroeder reported the successful conclusion of the agreement to the Partnership Committee. According to the minutes, he pointed out that the partnership would now require cash in order to perform its obligations under the Note Purchase Agreement with Met Life. In addition, this investment "would create a risk to the Partnership in the event that interest rates increased because the Met Bonds had a fixed rate of interest." Pohlschroeder recommended "that the Partnership hedge its risk by purchasing notional principal contracts with a floating rate of interest." By resolution of the Partnership Committee, Merrill was authorized to arrange the sale of $175 million principal amount of the Citicorp Notes to one or more of BOT, BFCE, and Mitsubishi Bank "for cash and other LIBOR-based consideration, upon substantially the terms of a draft Installment Purchase Agreement presented to the meeting". One other significant item of business at the second partnership meeting was the adoption of the "Investment Policy Guidelines" (Investment Guidelines). Weeks before the formation of the Partnership, Pohlschroeder had reported to Heidtke that Colgate would ensure in the Partnership Agreement that the company's own cash management policies would be used as guidance to maintain "liquidity * * * required to facilitate the buyback of long-term debt". As it turned out, the partners were not yet ready to adopt such policies at the time the Partnership Agreement was executed. The primary objective of the belated - 42 Investment Guidelines was "to preserve principal". To this end, temporary cash balances were to be invested in a portfolio of short-term money market instruments selected so as to achieve both a high degree of liquidity and diversification. Upon the liquidation of most of its investment in unregistered 5-year notes of a single issuer, the partnership would be in a position to implement its Investment Guidelines. On November 27, 1989, ACM sold $175 million principal amount of the Citicorp Notes to BOT ($125 million) and BFCE ($50 million). The aggregate consideration consisted of cash in the amount of $140 million and eight notes requiring quarterly payments of 3-month LIBOR for 20 quarters commencing March 1, 1990, on a notional principal amount of $97.76 million (LIBOR notes).8 The LIBOR notes were not registered under the Securities Act of 1933 and were not readily tradable on an established securities market. At the time of the transaction, Standard & Poors rated the senior debt of BOT AA and that of BFCE AAA. The aggregate amount of the consideration paid by the banks included the discount, or origination cost, that Merrill determined it would need to charge for its role in the arrangement and intermediation of the transaction. 8 The discount The term "notional principal amount" means that the principal amount is not actually exchanged; rather, parties agree to exchange payments based on the notional amount. - 43 was 5/8 percent of the par value of the Citicorp Notes, or $1,093,750. The banks issued the LIBOR Notes at a price equal to the aggregate consideration less the cash. The notional principal amount of the Notes was the amount that was required at current market swap rates to give the expected LIBOR cash flows a present value equal to this price. The following table summarizes the various costs associated with the Citicorp Notes and LIBOR Notes: Citicorp Notes aggregate par amount Transaction price Transaction value Accrued interest (12 days @ 8.65 percent) Total consideration Citicorp Notes par value Accrued interest Cash payment Cost of LIBOR Notes Origination cost Issue price/present value of LIBOR Notes Notional principal of LIBOR Notes $175,000,000 99.375% 173,906,250 504,564 174,410,814 BOT BFCE TOTAL $125,000,000 360,403 (100,000,000) 25,360,403 (781,250) $50,000,000 144,161 (40,000,000) 10,144,161 (312,500) $175,000,000 504,564 (140,000,000) 35,504,564 (1,093,750) 24,579,153 9,831,661 34,410,814 69,850,000 27,910,000 97,760,000 On the same day that the partnership acquired the LIBOR Notes for the stated purpose of hedging the partners' exposure to interest rate risk associated with the Colgate debt, Southampton served notice of an adjustment to the Yield Component sharing ratio. Desiring greater exposure, Southampton increased its share of the Yield Component from 16.7 percent to 29.7 percent. ACM invested the $140 million cash received in the sale in several commercial paper issues (time deposits and certificates - 44 of deposit (CD's)) maturing December 4, 1989, and bearing interest at 8.15 to 8.20 percent. Upon maturity, these funds became available at no transaction cost to finance the following purchases of Colgate debt between December 4 and 8: $100 million principal amount of the Met Note for $99,291,000 plus accrued interest; $1 million principal amount of Euro Notes for $1,025,500 plus accrued interest; $4 million principal amount of Euro Notes for $4,102,000 plus accrued interest; $31 million principal amount of Long Bonds for $31,493,396 plus accrued interest. During November, the groundwork was being laid for the disposition of some of the LIBOR Notes that ACM would acquire in the sale. A memorandum that Merrill prepared for Colgate entitled "Analysis of Partnership Hedging Activity," dated November 13, 1989, purports to demonstrate quantitatively how either an increase in Southampton's share of the interest rate volatility of the Colgate debt from 30 percent to 50 percent or an exchange of the Long Bonds for a new issue of 5-year Colgate debt would warrant a reduction in the amount of the LIBOR Note hedge in the partnership portfolio by approximately $10 million. Merrill reasoned that, in either case, ABN's interest rate exposure would fall by about 30 percent, and a 30-percent reduction in the size of the partnership's hedge would leave the bank's net exposure unchanged. Sometime in November, Pepe approached Neil Schickner (Schickner), head of the Capital - 45 Markets Desk at the New York Branch of Sparekassen SDS (Sparekassen).9 Pepe proposed a transaction involving the purchase of the BFCE LIBOR Notes by Sparekassen and collateral swaps that provided Sparekassen with risk protection and an attractive return. Schickner was already familiar with the transaction structure; at about the same time, Pepe offered him one or two similar deals in connection with other section 453 partnerships. On December 5, in order to conclude the deal, Schickner notified the bank's headquarters in Copenhagen that he was reserving a credit line in the amount of $10 million. The third partnership meeting took place on December 12, 1989, in Curacao. On behalf of Southampton, Pohlschroeder served notice of an adjustment in the Yield Component, whereby Southampton elected to increase its share of interest rate exposure to 39.7 percent. Next, the Committee voted to accede to a Colgate proposal to exchange $4.7 million aggregate principal amount of the Long Bonds plus $4,165 cash payment for $5 million aggregate principal amount of new 3-1/2 year fixed rate debt. Macauley Taylor next stated that the debt exchange contemplated by the foregoing resolutions would reduce the Partnership's exposure to the risk of interest rate fluctuations and recommended that the Partnership reduce its position in the variable rate instruments purchased to hedge against such exposure. He reported that a reduction of approximately 30 percent in the 9 During 1989, Sparekassen was the largest savings bank in Denmark. Later, in the same year, it merged with the two other banks to form Unibank. We refer to the bank at all times as Sparekassen. - 46 hedging provided by the Installment Purchase Agreements executed by the Partnership on November 27, 1989 would be economically advisable. He noted that this reduction would not adversely affect Kannex because of the adjustment of sharing of Yield Component effected by the notice dated December 12, 1989, from Southampton to the Partnership Committee. It was decided that the BFCE Notes would be distributed to Southampton as a partial return of capital. ACM assigned the BFCE Notes to Southampton as of December 13. By Assignment Agreements dated December 22, 1989, Southampton agreed to assign the notes to Sparekassen for aggregate consideration of $9,406,180. The discrepancy between the issue price at which the Notes had been acquired ($9,831,661) and the price that Southampton received on their sale ($9,406,180) was largely attributable to a bid-ask spread of $390,000. The bid-ask spread reflected the margins above and below mid-market value that Merrill deemed necessary in order to originate and sell the Notes. Estimating cash flows under the Notes from ask-side swap rates and discounting at a spread below LIBOR in its valuation of the Notes at issuance, Merrill was able to create an attractively priced liability for BFCE. Estimating cash flows under the Notes from bid-side swap rates and discounting at a spread above LIBOR in its valuation of the Notes for purposes of the assignment transaction, Merrill was able to create an attractively priced asset for Sparekassen. The remaining portion of the discrepancy, $35,481, was due to a decline in market interest rates over the - 47 3-week period since the issuance of the LIBOR Notes, which caused them to lose value. 6. Tax and Financial Accounting for the Results For Federal income tax purposes, ACM treated the sale of the Citicorp Notes as a contingent payment sale, governed by section 15a.453-1(c)(3), Temporary Income Tax Regs., 46 Fed. Reg. 10714 (Feb. 4, 1981). As there was no stated maximum selling price and all payments on the LIBOR Notes would be received over a fixed period of 6 taxable years, ACM recovered its basis in the Citicorp Notes ratably over 6 years. On Form 1065, U.S. Partnership Return of Income, for FYE 11/30/89, the partnership reported capital gain of $110,749,239.10 The gain was allocated among the partners in proportion to their capital accounts as shown on the November 30, 1989, revaluation worksheet: $91,516,689 to Kannex, $18,908,407 to Southampton, and $324,144 to MLCS. The parties to this proceeding have agreed that the partnership's tax basis in the LIBOR Notes immediately after the sale was $146,253,803, an amount that exceeded the cost of the Notes by the gain recognized on the sale. 10 ACM computed the gain as follows: Payments received in FYE 11/30/89 $140,000,000 Basis recovered in FYE 11/30/89 Citicorp Note basis plus accrued interest 175,504,564 Portion allocable to FYE 11/30/89 (1/6) (29,250,761) Capital gain 110,749,239 - 48 Kannex paid neither U.S. nor foreign tax on its 82.63 percent distributive share of the partnership capital gain. On its consolidated Federal income tax return for 1989, Colgate reported a net capital loss attributable to Southampton in the amount of $13,521,432, representing the difference between Southampton's distributive share of the partnership capital gain ($18,908,407) and the capital loss that Southampton recognized on the sale of the BFCE Notes to Sparekassen ($32,429,839).11 During the years at issue, Colgate retained Arthur Andersen & Co., as its accountants. In connection with the audit of Colgate's consolidated financial statement for 1989, the audit engagement team and Arthur Andersen's tax team discussed with Colgate's treasury, financial, and tax department personnel how to report the partnership and its activities for financial accounting purposes. present. 11 Representatives of Merrill were also An outline was presented of the planned sequence of Colgate computed the loss as follows: Cash proceeds Imputed interest on contingent payments Amount realized Citicorp Note basis plus accrued interest Basis allocable to LIBOR Notes (5/6) Section 1274 interest accrued by ACM Adjusted basis allocable to LIBOR Notes Capital loss $9,406,180 (48,693) 9,357,487 50,144,161 41,786,801 525 41,787,326 32,429,839 - 49 steps by which the partnership would borrow to redeem ABN's interest in October 1991 and recognize the remainder of the total $100 million capital loss. The auditors were concerned that recognition of the large tax loss without a corresponding book loss would leave Colgate with an outside basis considerably lower than the value of the partnership assets.12 The deferred tax liability associated with this built-in gain would have to be recognized for financial accounting purposes, unless the company could demonstrate an "exit tax strategy". With Merrill's assistance, Colgate explained how the low outside basis and deferred tax liability would be eliminated through a series of contemplated tax-free asset and stock transfers among Colgate affiliates some time after 1992. The auditors were of the opinion that until it became clear that they would be sustainable, for the most part the tax benefits of the transaction should not be recognized for financial accounting purposes. They understood from Colgate's account of the partnership, however, that sizable transaction costs would be incurred in connection with its activities. Colgate explained that only a minor amount of these costs would be shared with the other partners. Colgate would bear approximately $5 million, including all of Merrill's advisory fee of $1.7 million as well as approximately $2 million to originate and remarket the LIBOR 12 "Outside basis" refers to a partner's basis in its partnership interest. - 50 Notes. The auditors agreed with Colgate that tax benefits from the partnership could be recognized to the extent of the net-of-tax amount of these transaction costs. On the issue of consolidation, the auditors endorsed Colgate's position. Consolidation would not be required until ABN's retirement, chiefly because the Colgate debt was not effectively retired to the extent that ABN was sharing changes in its market value. In the meantime, since Colgate was using its position in the partnership essentially as a hedge of its liabilities, and would otherwise have used swaps or other conventional hedging operations to accomplish the same purposes, its investment in ACM should be treated in the same manner for financial accounting purposes as a swap. This would entail the recognition of mark-to-market changes in the value of its equity interest on its financial statements. The Curacao office of Arthur Andersen served as accountants for ACM. In the course of their review of the results for FYE 11/30/89, the auditors noted two problems with the partnership's financial statements. The first problem was that the $1,093,750 discount on the sale of the Citicorp Notes was not reflected in the income statement. The second problem was that the partnership had included this discount in the book value of the LIBOR Notes, contrary to provisions of the Partnership Agreement that required partnership assets to be restated at fair market value on the last day of the fiscal year. Following - 51 consultations with the New York office of Arthur Andersen and with Colgate, in February 1990, the audit engagement manager briefed his colleague on the status of the problem: Colgate does not want the cost to sell of US $1,093,750 * * * in the November 30, 1989 income statement of ACM. The reasons are mainly tax driven, as inclusion might set the IRS on top of the reasons why the partnership was constructed in the first place and thus the planned tax losses may be denied by the IRS. We, in cooperation with Steve Rossi of our New York office, were requested to think with Colgate in order to keep the cost to sell out of the balance sheet. [Emphasis added.] One proposal under consideration was as follows: Leave the LIBOR notes on the balance sheet as they are and reason that one third of the notes will be distributed to Colgate by 1990 and that the remainder of the notes is eventually for the account of Colgate too. This would require a side letter to the partnership agreement stating that the LIBOR notes are the one exception to the valuation rules which now state valuation at market and would state valuation at market and would then state valuation at market increased by the cost to sell the original Citicorp notes. The partnership followed this approach. Pursuant to the "Summary of Financial Accounting Policies" (Accounting Policies), adopted 2 weeks later at the fourth partnership meeting, the LIBOR Notes would be: carried on the books of the Partnership at cost, and adjusted * * * (I) for amortization of principal on a straight-line basis; and (ii) for movements in interest rates upon the following events: (a) distribution of any * * * [LIBOR] notes; (b) redemption of any Partner; and liquidation of the Partnership. - 52 Thus, the LIBOR Notes were initially booked at a cost that included the $1,093,750 transaction costs incurred on their origination. The cost would be amortized over the life of the investment. This amortization would constitute a charge against income, offset by accrued payments on the Notes. If any of the LIBOR Notes were distributed or a partner was redeemed, the amortized balance would be adjusted for changes in value due to interest rate movements and increased by the previously amortized portion of the origination cost. This convention had the effect of ensuring that the origination cost would be borne solely by the partner(s) that held an interest in the Notes, directly or indirectly, at the time they matured or were sold. The Accounting Policies do not specify the methodology to be used in revaluing the LIBOR Notes to reflect changes in interest rates. The methodology would differ depending on whether the book value was meant to reflect the minimum price at which the Notes could be purchased in the market (ask value), the maximum price at which they could be sold in the market (bid value), or the midpoint between the two (mid-market value). The understanding among the partners on this issue is revealed by the partnership's actual accounting practice. In pricing the LIBOR Notes at issuance, Merrill used an ask-side valuation methodology. The Notes were originally booked at a value based on this price; the bid value of the Notes at that time, as determined by Merrill, was about $1.3 million lower. Thereafter, - 53 book value was consistently adjusted to reflect the current ask price. This convention had the effect of ensuring that the bid-ask spread would be borne solely by the partner(s) that held an interest in the Notes, directly or indirectly, at the time they matured or were sold. Finally, unlike the policies governing the revaluation of Colgate debt, there is no provision in any agreement for adjusting the book value of the LIBOR Notes to reflect changes in the credit quality of the issuers. As a result, any credit risk would be borne only upon the sale of the Notes to a third party. As a corollary to the Accounting Policies described above, the partners agreed that in the event that any of the LIBOR Notes were distributed to a partner before maturity, they would be distributed at book value. As a result, the distributee partner's capital accounts and outside basis would be reduced. This reduction would result in the distributee in effect paying the full origination cost and bid-ask spread attributable to the distributed LIBOR Notes. In connection with the distribution of the BFCE Notes to Southampton, as of December 13, the partnership's assets were revalued. The book value of the BFCE Notes was adjusted to $10,133,540. For financial and tax accounting purposes, Southampton's capital account was reduced by this amount, resulting in a decrease in its ownership percentage from 16.89 percent to 12.60 percent. - 54 7. Final Stage of Colgate's Partnership Strategy ACM made additional purchases of Colgate debt from the marketplace as follows: Issue Acquired Euro Notes Long Bonds Euro Notes Long Bonds Euro Notes Date Principal Amount Aggregate Purchase Price 6/1/90 9/6/90 9/11/90 9/12/90 10/23/90 $5,000,000 4,000,000 1,750,000 6,000,000 2,000,000 $5,154,861 3,864,622 1,859,132 5,852,290 2,159,389 There were also exchanges between ACM and Colgate of the Met Note and approximately one-third of the Long Bonds. In January 1990, ACM exchanged the Met Note for a new Colgate Note with substantially identical terms. This new note was, in turn, exchanged on July 26, 1990, for the purpose of rescheduling certain payments. ACM made two exchanges of the Long Bonds, which totaled $10 million. On December 13, 1989, ACM exchanged $4.7 million principal amount of Long Bonds for $5 million principal amount of Colgate 8.72-percent notes due June 13, 1993. On March 1, 1991, the partnership exchanged $4.85 million principal amount of Long Bonds for $5 million principal amount of Colgate Notes due in 1994. The exchanges of the Long Bonds had the effect of reducing Colgate's original average debt maturity of 13 years by only 2 months (or 1 percent). - 55 At the end of August 1990, Colgate's treasury concluded that a significant change had occurred in the interest rate environment. Inflationary expectations and the prospect of war in the Persian Gulf were causing a rise in long-term interest rates and a steepening of the yield curve. Under these conditions, the value of Colgate debt held by the partnership would fall. Reversing its policy over the past 10 months of accepting substantially greater interest rate exposure than its pro rata share, Colgate caused Southampton to reduce its share of the Yield Component to 10 percent, effective September 6. Thereafter, Southampton adjusted the Yield Component Sharing ratio on two more occasions, maintaining its exposure between 10 and 20 percent. Contrary to the expectations of Colgate's management, long-term interest rates declined. By the spring of 1991 Colgate's treasury department identified a constellation of factors favoring consolidation of the partnership and retirement of its Colgate debt holdings in the near future. Not only were general interest rates lower, but the credit spreads on Colgate debt had narrowed appreciably, reflecting stronger prices for the company's stock and diminished takeover risk. Moreover, efforts - 56 to locate Colgate debt available for purchase were no longer successful. By Partnership Interest Purchase Agreements dated June 25, 1991, Colgate acquired a 38.31-percent interest in ACM from Kannex for $85,897,203, and Southampton acquired a 6.69-percent interest in ACM from Kannex for $15 million. As a result of these transactions, Kannex's ownership percentage declined to 43.04 percent. The shift in ownership was accompanied by a revaluation of partnership assets. Changes in asset values were allocated among the partners' respective capital accounts and the purchase price was determined based upon the balance of Kannex's account. In this process, the book value of the BOT LIBOR Notes was adjusted to reflect their current market value increased by $781,250, the full amount of the origination cost attributable to the notes, and 88 percent of the adjustment was allocated to Kannex's capital account. Although not specifically provided for by the partnership's Accounting Policies, a revaluation of the LIBOR Notes under these circumstances was evidently consistent with the agreement among the partners that Kannex would bear none of the origination cost. By agreement dated November 27, 1991, ACM redeemed the remainder of Kannex's partnership interest for $100,775,915. redemption was financed in part with cash and in part with the The proceeds of a loan from Citibank secured by the partnership's holdings of Colgate debt. In accordance with the Accounting - 57 Policies, partnership assets were revalued and unrealized income, gains, and losses were allocated among the partners. For this purpose, a value of $13,974,304 was assigned to the BOT LIBOR Notes, reflecting their current market value increased by the $781,250 origination cost attributable to them. The liquidating distribution that Kannex received was equal to the resulting balance in its capital account. At the twelfth partnership meeting, held on December 5, 1991, it was observed that as Colgate and a subsidiary, Southampton, owned 99.4% of the Partnership, the principal Partners' net economic exposure to the risk of interest rate fluctuations in the value of the Colgate debt was effectively minimal, and the Partnership need not maintain its position in the instruments purchased to hedge against such exposure. Moreover, the LIBOR Notes "were a highly volatile investment and * * * without the need to hedge interest rate risk, it was unwise for the Partnership to hold them." "[Short-term interest rates had declined steadily in recent months, thereby reducing the value of the instruments." It was resolved that the partnership would sell the LIBOR Notes. The final substantive comment of the meeting was delivered by Belasco, representing Colgate, who noted that "the Partnership had achieved substantially all of its objectives in connection with the acquisition of Colgate bonds and related debt management." - 58 On December 17, 1991, shortly before the close of Colgate's 1991 taxable year, ACM sold the BOT LIBOR Notes to BFCE for $10,961,581. The notes had fallen considerably in value owing to the decline in market interest rates. Eight and one-half percent at the time the first payment on the notes had been determined, 3-month LIBOR was below 5.7 percent when the last payment was determined. The price at which the BOT LIBOR Notes were sold also reflected a remarketing cost corresponding to the bid-ask spread, equal to $440,000. The economic loss incurred on the sale of the LIBOR Notes was more than compensated for by the tax loss. On its Form 1065 for FYE 12/31/91, ACM reported a capital loss in the amount of $84,997,111. Colgate claimed $84,537,479 as its own and Southampton's combined distributive shares of this loss on its consolidated corporation tax return for the 1991 taxable year. By amended return, Colgate carried this loss back to 1988. The total net tax loss that Colgate achieved through the CINS transaction exceeded $98 million. As a result of the consolidation of ACM on Colgate's financial statements for 1991, Colgate's reported outstanding long-term indebtedness declined by $124.1 million,13 13 This figure represents the aggregate face amount of Colgate long-term debt held by the partnership ($136.6 million) minus the decline that would have occurred in any case during (continued...) - 59 approximately one-half of the overall decline in long-term debt during this year. As of December 31, 1991, the value of Southampton's and Colgate's capital accounts plus the proceeds that had been received from sale of BFCE LIBOR Notes exceeded the costs of their combined investment in the partnership by approximately $5.42 million, representing a pre-tax internal rate of return of 4.7 percent. More than 2 percentage points of this return was attributable to the appreciation of the partnership's Colgate debt caused by further declines in interest rates in the month following Kannex's redemption. 8. Merrill's Collateral Swap Transactions The origination and remarketing costs of nearly $2 million that Colgate incurred through its partnership strategy represented the costs of a highly complex structure of collateral swaps arranged and executed by Merrill for the purpose of accommodating the investment in and divestment of assets qualifying for contingent payment sale treatment. This section outlines the transactions that Merrill entered into with BOT, BFCE, and Sparekassen between the issuance of the LIBOR Notes in November 1989 and the partnership's sale of the BOT LIBOR Notes in December 1991. 13 (...continued) 1991 owing to a scheduled principal payment ($12.5 million). - 60 To secure the participation of BOT and BFCE in the contingent payment sale desired by ACM, Merrill's Swap Group offered each of the banks a "structured transaction."14 The structured transaction consisted of two swaps to be executed in conjunction with the contingent payment sale, a basis swap related to the asset that the banks would be purchasing and a hedge swap related to the liability that they would be issuing to finance the purchase. Merrill Capital. The banks' counterparty in these swaps was Both sets of swaps were entered into on November 27, 1989. Under the basis swaps, BOT and BFCE were obligated to make monthly payments to Merrill Capital at the 1-month commercial paper rate plus 15 basis points on notional amounts of $125 million and $50 million, respectively. These payments were equivalent to the interest that the banks received on the Citicorp Notes. In exchange, Merrill Capital was required to make monthly payments to the banks at a rate of 1-month LIBOR plus 25 basis points on identical notional amounts. After 3 months the spread over LIBOR that Merrill Capital was required to pay increased to 40 basis points and in the case of BOT, to 50 basis points after another month, unless on any payment date 14 In financial terminology, a "structured transaction" is one that combines two or more financial instruments or derivatives. Most structured transactions, like those in this case, include at least one derivative. - 61 Merrill Capital elected to terminate the basis swaps and purchase the Citicorp Notes from the banks at par. The basis swaps served a risk management function for the banks. The net cash flows resulting from the combination of the Citicorp Notes with the basis swaps were tied to LIBOR, the index in terms of which BOT and BFCE, like international banks generally, conducted most of their business. The step-up provisions were negotiated at the request of the banks and were designed to give Merrill Capital a financial incentive to make arrangements for resale of the notes as quickly as possible. Merrill Capital would forgo the exercise of its call option only in the event of a substantial decline in Citicorp's credit that caused the value of the Citicorp Notes to fall by more than the cost of paying the premium. Under the hedge swaps, Merrill Capital was obligated to make quarterly payments over 5 years equivalent to the LIBOR Note payments that the banks were required to make to ACM. In return, BOT agreed to pay the sum of $25 million in 20 equal quarterly installments plus interest on the unpaid balance at a rate of LIBOR minus 18.75 basis points. BFCE agreed to pay the sum of $9,831,661 in 20 equal quarterly installments plus interest on the unpaid balance at a rate of LIBOR minus 25 basis points. addition, there were two upfront payments: In Merrill Capital paid $35,000 to BOT, and BFCE paid $168,339 to Merrill Capital. Like - 62 the basis swaps, the hedge swaps served a risk management function for the banks. They were designed to replicate the portfolio effects of partly financing the purchase of the Citicorp Notes with a conventional amortizing loan, whose value would not be affected by changes in LIBOR, rather than with the highly volatile LIBOR Notes.15 The structured transactions were designed to be remunerative for the dealer, Merrill Capital. Under the basis and hedge swaps, the present value of the banks' payment obligations exceeded the present value of Merrill Capital's obligations. In this way, the swaps were expected to result in the transfer from the banks to Merrill Capital of the 5/8 discount incurred by ACM on the contingent payment sale. To the extent that the basis swap continued beyond 3 months, Merrill Capital would return some or all of the discount to the banks through the stepped up LIBOR payments. BOT and BFCE would not have participated in the hedge swaps if they did not also perceive an opportunity to profit. Internal bank documents confirm that those who negotiated the structured 15 The banks did not actually pay Merrill Capital the full amount of the interest coupons they received from Citicorp, nor did Merrill Capital pay them the full amounts payable to ACM under the LIBOR notes. On each payment date amounts owed by each counterparty to a swap were offset, and only the net payments were made. The netting of payments is standard practice in the swap market and was provided for in all of the swap agreements discussed hereafter. - 63 transactions with Merrill believed that they offered "very attractive", "extremely favorable" terms. According to calculations performed by petitioner's expert Tanya Beder (Beder),16 the transactions effectively provided both banks with funding at a cost 39 basis points lower than that available in the direct interbank market. The 39 basis points in savings represents each bank's net present value gain from the structured transaction expressed in relation to the amount of the financing involved. Beder's valuation analysis is useful for identifying how the banks expected to gain overall while losing money on both the basis and hedge swaps. Valuation of the Positions of BOT and BFCE as of 11/27/89 ( $ millions = mm ) LIBOR Notes Price rec'd from ACM Mid-market value Citicorp Notes Price paid to ACM PV of expected sale proceeds rec'd by banks Hedge Swap Liability leg Asset leg Basis Swap Asset leg Liability leg Merrill's cancellation option 16 BOT BFCE $24.58 mm (24.05)mm $9.83 mm (9.61)mm (124.58)mm (49.83)mm 125.39 mm 50.15 mm (24.88)mm 24.08 mm (9.77)mm 9.62 mm 18.77 mm (18.22)mm (0.89)mm 7.43 mm (7.29)mm (0.29)mm Beder is affiliated with the New York consulting firm of Capital Market Risk Advisors, and serves on the faculty of the Yale School of Management. - 64 Up-front payment Net Present Value Implied Funding Spread Under LIBOR 0.04 mm 222,586 (0.17)mm 88,323 1 1 0.39% 0.39% 1 The approximate calculations are: $222,586 savings divided by $25 million in principal, spread over 2.3 year duration of principal payments; $88,323 savings divided by $9,831,661 in principal, spread over 2.3 year duration of principal payments. This analysis indicates that the source of the banks' expected gains was Merrill's pricing of the Citicorp Notes and LIBOR Notes for purposes of the contingent payment sale. These prices reflect sizeable bid-side and ask-side spreads. Transaction spreads generally tend to be wider for structured transactions than for direct market transactions because structured transactions are customized to meet the needs of the end users and often incorporate a premium to the dealer for innovations that competitors are unable to replicate. The spreads implied in Merrill's pricing of the Citicorp Notes and LIBOR Notes represented the costs of the financial engineering that the contingent payment sale required. charged to ACM. Accordingly, the costs were The banks acquired the Citicorp Notes at the bid price and issued the LIBOR Notes at the ask price. The spreads on these two instruments could have been expected, at the time of the contingent payment sale, to result in the transfer of a total of about $1.8 to $1.9 million in value from ACM to the banks. - 65 The banks could have expected to retain approximately $300,000 of this value. See diagram 1 infra p. 67.17 It was the understanding of BFCE that Merrill would arrange for the resale of the Citicorp Notes after only 1 month, well in advance of the date that the step-up in Merrill's payments took effect. The written agreement contained no such provision, but Merrill found a buyer, and BFCE sold its $50 million principal amount of Citicorp Notes on December 22, 1989. At the same time, the basis swap between Merrill Capital and BFCE was canceled. In January 1990, the basis swap with BOT was terminated, and the remaining $125 million principal amount of Citicorp Notes was resold. Merrill arranged another structured transaction to facilitate Southampton's sale of the BFCE LIBOR Notes to Sparekassen on December 22, 1989. Under the hedge swap between Merrill Capital and Sparekassen, Sparekassen was obligated to make quarterly payments equivalent to those it was entitled to receive from BFCE under the LIBOR Notes. In return, Merrill Capital was required to pay $9,406,180, an amount that corresponded to the purchase price of the notes, in 20 equal 17 As will be seen hereafter, Merrill Capital did not retain all of the remaining $1.5 to $1.6 million of value extracted from the partnership. Some of this value was transferred back to ABNs and Kannex through a separate set of swaps relating to the LIBOR notes. - 66 quarterly installments, together with interest on the unpaid balance at a rate of LIBOR plus 35 basis points. The spread over LIBOR increased to 85 basis points after March 1, 1990, if Merrill did not first exercise its right to call the notes at a price equal to the unpaid principal balance and terminate the swap. From Sparekassen's perspective, the structured transaction was similar to investing in an amortizing loan that paid a margin over LIBOR, rather than in volatile LIBOR Notes. From Merrill Capital's perspective, the transaction provided an asset whose volatility matched and offset the volatility of its liability under the hedge swap with BFCE or BOT. The step-up in Merrill Capital's payment obligations provided it a financial incentive to exercise its call right and cancel the swap. Petitioner's expert, Beder, concluded that as of the time of its acquisition of the BFCE Notes, Sparekassen could have expected a net present value benefit of $7,208, equivalent to a return on its investment of 41 basis points more than that available in the direct interbank market. - 67 Flow of Benefits in 11/17/89 Structured Transaction Diagram 1 Purchase Citicorp Notes at the Bid < ACM Expected benefit to Bank = $$ BoT/BFCE Issue Contingent LIBOR Notes at the ask = Expected benefit to Bank = $ AMerrill Capital puts the bank (BoT or BFCE) into the Postion of a dealer Swaps Expected benefit to Merrill = $$$ ABank expects to benefit by executing transactions at ? Dealer prices (benefit shown as $ + $$) AThrough swaps, most of the expected benefit of dealer Pricing is transferred back to Merrill (shown as $$$) ABank is left with sub-LIBOR funding, but has taken Incremental credit risk Merrill Capital Flow of Benefits in 12/22/89 Structured Transaction Diagram 2 Purchase Contingent LIBOR Notes at the Bid Southampton Hamilton < Sparekassen Benefit to Bank = $$ AMerrill Capital puts the bank (Sparekassen)into the Position of a dealer Hedge Swap Benefit to Merrill = $ ABank benefits by executing transacation at a dealer's Price (benefit shown as $$) ? AThrough Hedge Swap, most of the benefit of dealer Pricing is transferred back to Merrill (shown as $) ABank is left with above-market asset, but has taken Incremental credit risk Merrill Capital - 68 - Flow of Benefits in 12/17/91 Structured Transaction Diagram 3 Purchase Contingent LIBOR Notes at the Bid < ACM BFCE Benefit to Bank = $$ AMerrrill Capital puts the bank (BFCE) into the Position of a dealer ABank benefits by executing transaction at a dealer's Price (Benefit shown as $$) Hedge Swap Benefit to Merrill = $ ? AThrough Hedge Swap, most of the benefit of dealer Pricing is transferred back to Merrill (shown as $) ABank is left with above-market asset, but has taken Incremental credit risk Merrill Capital Valuation of Sparekassen's Position on 12/22/89 ( $ millions = mm ) LIBOR Notes Price paid to Southampton Mid-market value Hedge Swap Asset leg Liability leg Merrill's cancellation option Net Present Value Implied Return Over LIBOR 1 (9.41)mm 9.63 mm 9.58 mm (9.63)mm (0.17)mm 7,208 1 0.41% The approximate calculation is: $7,208 gain divided by $9,406,180 invested, spread over 0.189 year duration of payments. The calculation assumes that Merrill Capital will cancel the swap - 69 on March 1, 1990, when the opportunity to do so first arises: At the inception of the swap, the prospect of a decline in BFCE's credit sufficient to warrant retention of the option at the large cost that this would impose was highly unlikely. As in the structured transaction that Merrill designed for the other two banks, Sparekassen could expect to lose money on the swap; the source of its gain is the bid-side spread implied in Merrill's pricing of the LIBOR Notes. The transaction pricing resulted in the transfer from Southampton to the bank of more than $200,000 in value, most of which would ultimately enure to See diagram 2 supra p. 67. the benefit of Merrill Capital. By agreements among BFCE, Sparekassen and Merrill Capital, the BFCE LIBOR Notes and the two hedge swaps related to them were terminated during 1990. Merrill arranged another hedge swap for BFCE in conjunction with the bank's purchase of the BOT LIBOR Notes from ACM for $10,961,581 on December 17, 1991. The structure and function of this swap were for the most part identical with those of the hedge swap between Merrill Capital and Sparekassen. BFCE agreed to pay Merrill Capital amounts equal to the flows it was entitled to receive under the BOT Notes. Merrill Capital agreed to make 12 equal quarterly payments aggregating $10,961,581, together with interest on the unpaid balance at LIBOR plus 35 basis points. The interest rate was stepped up after the first year unless Merrill elected to terminate the swap and acquire the - 70 notes at a price equal to the unpaid principal balance remaining on the amortizing leg. For BFCE, the hedge swap effectively created a synthetic asset paying an attractive margin over LIBOR, and, for Merrill Capital, a hedge for its payment obligations under the outstanding swap with BOT. According to Beder's calculations, the midmarket value of the BOT LIBOR Notes at the time of their sale to BFCE was $11.18 million. The bid-side spread of $220,000 implicit in the purchase price that BFCE paid ACM for the notes financed the gains shared by Merrill and the bank from the transaction. diagram 3 supra p. 68. See Ultimately, the cost of engineering this structured transaction, like the two before it, was borne almost entirely by Colgate. 9. ABN's Investment Management In conformity with the requirements for approval of Kannex's loan, den Baas and his colleagues at ABN New York took steps to protect the bank from the risks of Kannex's participation in ACM and to ensure the bank an adequate return. ABN New York had the authority to implement a comprehensive financial management program for Kannex by virtue of ABN New York's financial services agreement. First, Kannex's exposure to the intrinsic interest rate risk of partnership assets would be "fully hedged". Den Baas never considered relying on the partnership's LIBOR Notes for this purpose. He made no attempt to evaluate their hedging - 71 effect within the partnership portfolio. It was clear to him that effect would not be adequate, and hedging instruments of greater precision and reliability were available. Accordingly, ABN New York arranged to neutralize the effect of the LIBOR Notes on Kannex's interest. The structure that it employed for this purpose consisted of back-to-back swap transactions with Kannex on the one hand and Merrill Capital on the other. ABN New York assumed the role of intermediary on the assumption that neither Merrill Capital nor any other third party would accept Kannex's credit risk. By swap confirmations effective November 27, 1989, the issue date of the LIBOR Notes, ABN New York entered into a hedge swap agreement with Merrill Capital. Under the swap, ABN New York was required to make to Merrill Capital quarterly payments of 3-month LIBOR over 5 years equivalent to Kannex's 82.63 percent pro rata share of the payments owed to ACM under the LIBOR Notes. Merrill Capital was required to pay to ABN New York the sum of $28,433,655 in 20 equal quarterly installments together with interest on the unpaid balance at a rate of LIBOR minus 25 basis points. This amortizing principal amount was equal to 82.63 percent of $34,410,814, Kannex's pro rata share of the issue price of the LIBOR Notes. ABN New York entered into a matching hedge swap with Kannex under which Kannex's rights and obligations vis-a-vis ABN New York corresponded to those of ABN - 72 New York vis-a-vis Merrill Capital. When Kannex's indirect interest in the LIBOR Notes held by the partnership changed significantly as a result of the distribution of the BFCE Notes to Southampton on December 13, 1989, the partial purchase of Kannex's partnership interest on June 27, 1991, and the redemption of its remaining interest on November 27, 1991, both legs of the hedge swaps were adjusted proportionately. At these times, the portion of the swap that was to be terminated would be marked to market, and the counterparty that would otherwise have benefitted from the change in market interest rates would receive a compensatory termination payment. satisfied complementary needs. The back-to-back hedge swaps Kannex was able to stabilize its return on $28 million of its partnership investment. Likewise, Merrill Capital was able partly to offset the interest rate exposure that it incurred in connection with its hedge swaps with BOT and BFCE. The back-to-back hedge swaps relating to the LIBOR Notes also served an additional function that can be understood only by reference to the terms of the structured transactions in which the LIBOR Notes were issued. According to the analysis of petitioner's expert, the transaction spreads implied in Merrill's pricing of the Citicorp Notes and LIBOR Notes for purposes of the contingent payment sale could be expected to result in the transfer of between $1.8 and $1.9 million of value from ACM to - 73 the foreign banks. The banks could have expected to retain only about $300,000 of this value, because their basis and hedge swaps with Merrill Capital were structured in such a way that the present value of the swap payments they were entitled to receive from Merrill Capital was less than the present value of the swap payments they were obligated to pay to Merrill Capital. Thus, the value of BFCE's right to quarterly payments of 3-month LIBOR Notes over 5 years on a notional principal amount of $27.91 million was $9.62 million, while the value of its obligation to pay $9,831,661 in equal quarterly installments over 5 years together with interest on the unpaid balance at LIBOR minus 25 basis points was $9.77 million. As a result of the discrepancy in the value of these two legs of the hedge swap, Merrill Capital could have expected to realize a net gain, and BFCE a net loss, of $150,000. The hedge swap between Merrill Capital and ABN was structured in a manner similar to the hedge swap between BFCE and Merrill Capital. only two respects. The ABN swap differed from the BFCE swap in First, the payment obligations on both sides of the ABN swap were proportionately larger. In the BFCE swap, the notional principal amount of the fixed notional leg was set at an amount ($27.91 million) equal to 50/175, or 28.5 percent, of the combined total notional principal amount of the BOT and BFCE Notes ($97.76 million); in the ABN swap, it was set at an - 74 amount ($80,779,000), equal to Kannex's 82.63 percent share of the combined total notional principal amount of the BOT and BFCE Notes. Likewise, in the BFCE swap, the principal amount of the amortizing leg ($9,831,661) was equal to 50/175, or 28.5 percent of the combined total issue price of the BOT and BFCE Notes ($34,410,814); in the ABN swap, the principal amount of the corresponding leg was $28,433,655, an amount approximately equal to Kannex's 82.63 percent share of the combined total issue price of the BOT and BFCE Notes. If, as Beder concluded, the amortizing leg was worth more than then fixed notional leg in the BFCE swap, that asymmetry in value would necessarily have been magnified in the larger, but structurally identical, ABN swap. The second respect in which the swaps differed was that Merrill Capital occupied the position of the net creditor in the BFCE hedge swap but that of the net debtor in the ABN swap. The hedge swap between ABN and Kannex was in all respects identical to the hedge swap between Merrill Capital and ABN, except that ABN now assumed the position of net debtor. The effect of the back-to-back hedge swaps would have been to transfer from Merrill Capital to ABN and from ABN to Kannex a portion of the value extracted from the partnership through the transaction spreads it was charged in the contingent payment sale. This transfer partly indemnified Kannex for its share of the partnership's economic loss. - 75 By separate swap confirmations effective November 27, 1989, Merrill Capital agreed to pay ABN, and ABN agreed to pay Kannex, interest at the rate of LIBOR minus 25 basis points on a notional principal of $903,765, an amount that corresponded to Kannex's share of the 5/8 discount incurred by the partnership in the sale of the Citicorp Notes and origination of the LIBOR Notes. Following the distribution of the BFCE Notes to Southampton, the notional principal was reduced to $680,156. This revised amount represents the product of Kannex's then current percentage interest as reflected on a preliminary draft revaluation worksheet (87.06 percent) multiplied by the portion of the discount attributable to the BOT Notes retained by the partnership ($781,250). The documentation characterized these agreements as "swaps". This is a misnomer, however, because the payment obligations were unilateral. The parties' characterization reflects the fact that these "one-sided swaps" were negotiated in conjunction with the back-to-back hedge swaps and were intended to complement them. Like the hedge swaps, the one-sided swaps had the effect of compensating Kannex for a loss that it would otherwise have borne in connection with the contingent payment sale. We have previously discussed how the partnership chose to account for the 5/8 discount incurred in the contingent payment sale for financial and tax accounting purposes. Rather than - 76 recognizing this transaction cost, the partnership included it in the carrying cost of the LIBOR Notes. Although this method of accounting was calculated to result eventually in the allocation of all of the transaction cost to Kannex's partners, as long as recognition of the cost was deferred, the capital accounts of Kannex's partners were overstated, and Kannex's share of partnership income was understated. According to the revaluation worksheets, the partners' capital account balances as of the end of FYE 11/30/89, were restated at fair market value as follows: Kannex MLCS Southampton Total $170,617,686 (82.68%) $603,976 (0.29%) $35,145,281 (17.03%) $206,366,943 (100%) Had the $1,093,750 discount been recognized and allocated, say, entirely to Southampton at this time, Kannex's pro rata interest in partnership assets and share of partnership income would have been .4402742 percentage points higher and Southampton's .4402742 percentage points lower: Kannex MLCS Southampton Total $170,617,686 (83.12%) $603,976 (0.29%) $34,051,531 (16.59%) $205,273,193 (100%) This .4402742 percentage point discrepancy corresponds to Kannex's allocable share of the discount: $205,273,193 x .4402742% = $903,765 = $1,093,750 x 82.63%. - 77 Under the one-sided swaps, ABN received from Merrill Capital and Kannex received from ABN a return on this .4402742 percentage point discrepancy in the capital accounts. When the transaction cost was subsequently recognized in part and charged to Southampton's capital account upon the distribution of the BFCE Notes, the understatement of Kannex's capital account was partly corrected and the notional principal amount on which the one-sided swap payment obligations were based was accordingly reduced. This compensatory arrangement appears to be critical to an understanding of why ABN agreed to an accounting policy that caused the partners' capital accounts to misrepresent the agreed allocation of costs to Kannex's detriment. An unexecuted version of the one-sided swap between Merrill and ABN ran for a 5-year period coterminous with the hedge swap. In the executed agreements, the termination date was December 1, 1990. At the expiration of this term, the one-sided swap between ABN and Kannex was extended for a second year. There is no record of any similar extension of the corresponding one-sided swap between ABN and Merrill. Through another series of swaps arranged by ABN New York, Kannex effectively eliminated its risk of loss and opportunity to gain from allocations of the Yield Component of the Colgate debt. The counterparty in these swaps was ABN Cayman Islands, but it was den Baas and others at ABN New York who executed the - 78 transactions on behalf of both counter parties. With respect to each issue of fixed-rate Colgate debt acquired by the partnership, Kannex entered into a fixed-for-floating interest rate swap on a notional principal amount corresponding to the dollar amount of Kannex's exposure to interest rate risk on the debt. Whenever Southampton elected to adjust the Yield Component sharing ratio or Kannex's partnership interest changed, the notional principal amounts of Kannex's swaps were adjusted to cover the amount of its exposure. The net effect for Kannex resembled an investment in a portfolio of LIBOR-based assets whose value would not vary in relation to the value of its LIBOR-based liability under the Revolving Credit Agreement. The swaps with ABN Cayman Islands effectively offset Kannex's losses and gains from the intrinsic treasury risk of the Colgate debt held by the partnership. The swaps also offered Kannex the opportunity to profit from the spread risk of the Colgate debt. its swaps. Kannex was required to pay interbank swap rates on The fixed interbank swap rates were determined by adding a spread to the prevailing yields on comparable Treasury securities. For every piece of Colgate debt purchased, there was a referenced Treasury rate. To the extent that the yields on the partnership's Colgate debt exceeded these rates, Kannex kept the difference. ABN profited from the spreads that it earned in hedging its swap positions through coordinated trading of - 79 Treasury securities or futures, or through matching swaps with third parties. In order for the hedging of Kannex's risks to be both effective and lucrative, the selection of Treasury securities used in the construction of hedge positions had to be consistent with the selection of Treasury securities used in the revaluation of the Colgate debt within the partnership. Aware of these hedging operations, Merrill accommodated them by consulting with ABN on the valuation of ACM's Colgate debt whenever changes in value were likely to affect Kannex's capital accounts. Thus, one Merrill internal memorandum described the procedures for an upcoming revaluation: Since Kannex must actually trade Treasuries based upon the Base Treasury yields, Kannex would determine yields on Base Treasuries for each Note. These yields, along with previously determined spreads, are used by ML to set prices of each Note. Under its Revolving Credit Agreement with Kannex, ABN reserved the right to sell participations, provided that it would remain solely responsible for performance of the obligations owed to Kannex under the Agreement.18 Beginning in the fall of 1989, ABN offered a number of banks the opportunity to participate in 18 Details of the syndication of the loan to Kannex and details of Kannex's ultimate liquidation, which are related hereafter, shed light on the character of the relationship between Kannex and ABN. - 80 its loans to Kannex as well as to other special purpose corporations that ABN Trust had organized for section 453 partnerships. The participations ABN proposed were short-term and renewable. ABN would guarantee an interest rate of LIBOR plus 35 basis points or 50 basis points. ABN would possess the exclusive right to enforce the loan. ABN's relationship to Kannex was a source of some confusion. An internal memorandum of Banco di Roma outlining the syndication proposal described ABN as a "shareholder in Kannex together with another major U.S. Corporation". In the attempt to reassure prospective investors that their principal would be secure, den Baas went further than the terms of the formal Participation Agreement in defining ABN's position in the arrangements: "Since there is neither a scheduled interest payment on the notes held in the portfolio nor a principal repayment you would look even more to ABN to take you out at the maturity date of the loan". Within Banco di Roma, the participation was recommended for approval with the following explanatory gloss: "The repayment source of our advance is the committed facility provided by ABN through its Curacao or Grand Cayman Branch." concludes: "Taking into consideration: The memorandum The de facto guarantee of ABN, * * * we recommend your authorization to participate". An internal credit proposal of Banco Espirito Santo E Comercial De Lisboa (Banco Espirito Santo) reflects a similar - 81 understanding. Beside the heading "Guarantor", the following explanation appears: "Subsidiary of ABN will borrow against a firm takeout at maturity". Considering its reliance on the repeated participation of a small group of banks to sustain its involvement in numerous section 453 partnerships, it is not surprising that ABN would wish to imply, and that the investors would be prepared to infer, that they could look to ABN for repayment. Generale Bank, Banco Espirito Santo, and Banco di Roma acquired participations in Kannex's loan in amounts between $25 million and $75 million. July 1991. All participations were repaid by The loan from ABN Cayman Islands was ultimately repaid out of the liquidating distribution that Kannex received at the end of November 1991. Owing to the preferred return that Kannex received from Southampton and appreciation of Colgate debt as a result of the decline in interest rates, there was a sizeable surplus remaining after repayment of the loan, as shown on Kannex's balance sheet for the period ended November 30, 1991. Kannex did not retain this surplus. Kannex also did not distribute this surplus to its nominal shareholders when Kannex was liquidated shortly thereafter. Following the redemption, Kannex's swaps with ABN were terminated. The benefit that Kannex had enjoyed from a fall in interest rates for purposes of the valuation of its partnership - 82 interest was offset by the appreciation of the fixed-rate cash flows that it was obligated to pay relative to the floating rate cash flows it was entitled to receive under the Colgate debt swaps. Kannex owed ABN Cayman Islands $3,180,453. For reasons that the record does not disclose, the amount Kannex paid was higher by $1,655,000, and this excess was credited to den Baas' Financial Engineering Group. The back-to-back hedge swaps between Kannex and ABN New York and ABN New York and Merrill Capital were also terminated at the same time. Although the terms of the swaps were identical, for reasons not disclosed in the record, the termination payment that ABN New York made to Kannex was $500,000 less than the terminat [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%3A2b70547701cb5701. Public record. Not legal advice.