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139 T.C. No. 5
UNITED STATES TAX COURT
GERDAU MACSTEEL, INC. & AFFIILIATED SUBSIDIARIES, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 12642-01.
Filed August 30, 2012.
Q and its subsidiaries are an affiliated group (Ps). During Ps'
taxable year ended Oct. 31, 1997 (TYE 1997), Ps actively pursued
Q's making of two sales expected tio result in millions of dollars in
taxable capital gains for TYE 1997 and TYE 1998. Ps' outside
accountants (D), mindful of the expected gains, approached Ps with
an idea that D promoted to create at multimillion-dollar tax loss to
shelter the gains for Federal income tax purposes. Q has a group
benefits plan under which Q provides health and welfare benefits to
its eligible employees and their dependents. Q's subsidiaries
included two inactive corporations, QS and QW. In order to report a
desired tax loss of approximately $38 million to shelter Ps' taxable
gains from Federal income tax, Ps entered into a series of interrelated
transactions in late October 1997 that included, among others, a
recapitalization of QW (renamed QHMC), and Q's transfer to QS
(and then QS' transfer to QHMC in exchange for newly issued class
C stock) of $38 million and the assumption of certain contingent
liabilities (i.e., Q's obligations to pay medical plan benefits (MPBs)
i SERVED AUG 3 0 2012
under Q's benefits plan) which Ps v alued at $37,989,000. Ps reported
that the transfers qualified for nonrecognition under I.R.C. sec. 351(a)
and that QS' basis in the class C stuck was determined by taking into
account the $38 million transferred to QHMC but not the value of the
MPBs. Each share of class C stock was entitled to receive annual
dividends of $9.50 and was not allowed to receive any other dividend.
Upon the class C stock's redemptica, which QHMC and the class C
shareholders could respectively catse five and seven years after the
stock's issuance, the class C sharel~olders were entitled to receive for
each share the greater of $125 or ar amount equal to the lesser of a
percent of any cumulative cost savings in MPBs or of QHMC's book
net equity. The transactions were 5 tructured in such a way that it was
highly likely when the class C stock was issued that the class C stock
would be redeemed within the five- and seven-year periods and that
the redemption payment would be S125 per share. Shortly after the
transfer to QHMC, QS sold its clas i C stock to a former employee of
a Q subsidiary for $11,000 (the diference between $38 million and
$37,989,000). Ps claimed that QS realized a $37,989,000 short-term
capital loss on the sale, and Ps used that loss to offset Ps' unrelated
capital gains totaling a similar amo;mt.
After the transactions, Q continued to process claims for
MPBs, and Q's handling of the claims transferred to QHMC was the
same as the handling of claims with respect to individuals whose
MPBs were not transferred to QHMC. QHMC's reimbursements to Q
for claims were made through intercompany entries recorded on Q's
books as a receivable due from QHMC and on QHMC's books as a
payable. QHMC lent the $38 million to a subsidiary of Ps, and
QHMC eventually reimbursed Q fer the MPBs when QHMC received
payments on the loan.
Held: The class C stock is nanqualified preferred stock under
I.R.C. sec. 351(g) because i t "does not participate in corporate growth
to any significant extent" within th a meaning of I.R.C. sec.
351(g)(3)(A). Accordingly, pursur at to the agreement of the parties,
Ps are not entitled to deduct the claimed capital loss.
3Held, further, the transactions underlying the claimed capital
loss lacked economic substance. Accordingly, $352,251 in fees
incurred to effect the transactions is not deductible as an ordinary and
necessary business expense under I.R.C. sec. 162.
Held, further, in accordance with Heasley v. Commissioner,
902 F.2d 380 (5th Cir. 1990), rev'g T.C. Memo. 1988-408, and Todd
v. Commissioner, 862 F.2d 540 (5th Cir. 1988), aff'g 89 T.C. 912
(1987), which we follow under Golsen v. Commissioner, 54 T.C. 742,
757 (1970), aff'd, 445 F.2d 985 (10th Cir. 1971), Ps are not liable for
the 40% accuracy-related penalty under I.R.C. sec. 6662(h) that R
determined applied to any underpayment of tax attributable to the
disallowed claimed capital loss.
Held, further, Ps are liable for the 20% accuracy-related penalty
under I.R.C. section 6662(a) to the extent of the underpayment of tax
attributable to the disallowed claiined capital loss, and Ps are liable
for that 20% accuracy-related penalty to the extent of the
underpayment of tax attributable to the disallowed deduction for the
fees.
Jasper G. Taylor III, Lawrence Kalinec, Richard L. Hunn, Shawn R.
O'Brien, and Stephen M. Feldhaus, for petitioners.
Dennis M. Kelly and Jill A. Frisch, for respondent.
CONTENTS
FINDINGSOF FACT .............................................. 12
I.
PreliminaryMatters ..................................... 12
II.
Quanex ................ .............................. 12
III.
Petitioners Expectation of Realizing Millions of Dollars in
Taxable Capital Gains During TYE 1997 and TYE 1998 . . . . . . . . 14
IV.
ThePlan .............................................. 16
A. Background ......................................... 16
B. Health Care Offerings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
C. Health Care Cost Managunent Strategies . . . . . . . . . . . . . . . . . 17
1. Background .................................... 17
2. CS............................................ 18
a. Background ............................... 18
b. Quanex's In1-oduction to CS . . . . . . . . . . . . . . . . . 18
c. CS Fee Arrargements . . . . . . . . . . . . . . . . . . . . . . . 20
V.
D&T ............. ................................... 20
VI.
Other Relevant Quanex Employees/Officers . . . . . . . . . . . . . . . . . . 22
A. Rose ............................................... 22
B. Parikh . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
C. Royce ............... ............................... 23
VII. Liability Management Companies . . . . . . . . . . . . . . . . . . . . . . . . . . 25
A. Overview ........................................... 25
B. Rev. Rul. 95-74 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
C. D&T'sMatrix ....................................... 26
1. Background .................................... 26
2. DDCL......................................... 26
53. Singer Promotes DDCL-Type Transaction to Quanex . . . 30
VIII. Sales ofLaSalle and Tube Group ........................... 31
A. LaSalleSale......................................... 31
B. Tube Group Sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
IX.
Engaging D&T To Structure QHMC Transactions . . . . . . . . . . . . . 33
X.
DevelopingQHMC Transactions ........................... 38
A. Quanex'sFirstProposaltoCS .......................... 38
B. D&T's First Outline of Proposed Joint Venture Transactions . . 40
C. WW ............................................... 42
1. In General ..... . . ...... .. .. . . . . . ..... . . . . ..... . 42
2. FASB 106 ...... . ...... . . .. .... . ..... .. ....... . 43
3. WW's First Present Value Calculation of Quanex's
HealthCareBenefits ............................. 44
D. D&T's Revisions To Proposed Transaction . . . . . . . . . . . . . . . . 47
1. August 6-7, 1997, Revisions . . . . . . . . . . . . . . . . . . . . . . . 47
2. August 13, 1997, Revisions and Cashflow Analysis . . . . 51
3. August22, 1997, Revisions ....................... 54
E. Quanex'sNegotiationsWithCS ......................... 55
F. WW's Present Value Calculation Revisions . . . . . . . . . . . . . . . . 60
G. PatrickWannell...................................... 63
1. Background .................................... 63
2. Wannell and Health Care Costs at LaSalle . . . . . . . . . . . . 64
3. Quanex's Offer to Wannell . . . . . . . . . ... . . ... ... . . . . 65
H. D&T'sRevisedCashflowModel ........................ 67
XI.
ExecutingQHMC Transactions ............................ 71
A. Quanex's October 21-22. 1997, Board Meeting . . . . . . . . . . . . 71
B. October 23, 1997 . . .... . . ......... ... .. ... ..... . . . ... 75
1. QWRecapitalization ............................. 75
2. Amendmen1 and Re statement of QW's
CertificateofIncorporation........................ 76
a. Background .............................. 76
b. DividendRights ........................... 77
c. Preferences I pon Liquidation . . . . . . . . . . . . . . . . . 78
d. Voting:Righ1: .............................80
e. CallRights . .............................. 80
f. PutRights.. .............................. 81
3. Quanex's Transfer of QW Stock and Cash to QHMC in
Exchange for Class A and Class B Stocks and
ElectionofDirectors ............................. 82
4. Quanex's Transfer of Cash and MPB Obligations to
QSinExchange fo:·QS Stock ..................... 83
C. October 24, 1997 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84
1. Consulting Agreenunt Between Quanex and CS . . . . . . . 84
2. CS' Transfer of Cash to Quanex in
Exchange forClass B Stock ....................... 86
3. Class BDirectors . .............................. 88
D. October 25, 1997 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88
1. CS' Transfer of Cas h to QHMC in
Exchange forClass C Stock ....................... 88
2. QS' Transfer of Ca: h and MPBs to QHMC in
Exchange for Class C Stock ....................... 89
3. MPB Selection ... .............................. 90
4. ClassCDirector . ..............................92
E. October 28, 1997: QHM(:'s Transfer of Cash to
Piper in Exchange for Pro:nissory Note . . . . . . . . . . . . . . . . . . . 92
-7F. October 30, 1997: QS' Transfer of Class C Stock to
Wannell In Exchange for Cash . . ..... . . . . . . .. . ... . ... .. . 94
XII. PosttransactionActivities ................................ 95
A. D&T's Draft Opinion ...... . . .... . ... . ... .. . . . . .... .. . 95
B. 1997 Return . ...... ....... . . . . ..... . . . . . ..... . . ..... . 98
1. Background .................................... 98
2. Income ....... J................................99
I
3. EnclosedStatements ............................ 100
a. Overview .
040...............................
100
b. Statement20 ............................. 100
c. Statement22 ............................. 101
d. Statement23 ............................. 101
e. Statement24 ............................. 101
4. DeductionofFees .............................. 102
C. WW's 1999Valuations ............................... 103
D. D&T's 1999CashflowModel ......................... 110
E. QHMCOperations................................... 116
1. QHMC's Officers and Directors . . . . . . . . . . . . . . . . . . . 116
a. QHMC's Board Meetings and
Shareholders Meetings ..................... 118
b. Parikh as Director and Officer . . . . . . . . . . . . . . . 118
c. Peery as Director and Officer . . . . . . . . . . . . . . . . 118
2. BankAccounts. ............................... 119
3. Processing and Paying MPB-Related Expenses . . . . . . . 119
4. Shareholder Efforts To Manage MPB Obligations . . . . . 125
a. CS' Efforts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125
i. Background ........................ 125
ii. PPOProject ........................ 127
iii. Unipn Negotiations . . . . . . . . . . . . . . . . . . 129
iv. CS'1Consulting Bills . . . . . . . . . . . . . . . . . 130
b. Wannell's Efforts . . . . . . . . . . . . . . . . . . . . . . . . . 132
5. DividendPayments ............................. 133
6. Return on Investment Projections . . . . . . . . . . . . . . . . . 042134
7. QHMC'sTaxRetuns ........................... 136
8. FinancialStatemen's ............................ 137
F. NoticeofDeficiencv ... ............................. 137
OPINION ......................... ............................. 141
I.
BurdenofProof...... .... ............................. 141
II.
WitnessTestimony ....... ............................. 142
A. Background .......... ............................. 142
B. FactWitnesses........ ............................. 143
C. Expert Witnesses .................................... 144
1. Background ................................... 144
a. Overview ................................ 144
b. Strombom ............................... 144
c. Ross ....................................145
d. Eisenstadt ............................... 145
2. Analysis ...................................... 146
III.
NetShort-TermCapital Loss ............................. 147
A. Overview .......................................... 147
B. Section351(g)...................................... 148
C. Economic SubstanceDoctrine ......................... 162
1. Overview ..................................... 162
2. StandardofAnalys.s ............................ 163
3. QHMCTransactior:s ............................ 169
a. Objec tive Economic Substance . . . . . . . . . . . . . . . 169
i. Background ........................ 169
-9ii. Lack of Substantive Changes as a
Result of QHMC Transactions . . . . . . . . . 171
iii. Lack of Reasonable Expectation of
Nontax Benefits on Petitioners' Part . . . . . 173
b. Subjective Business Purpose . . . . . . . . . . . . . . . . 175
i. Background ........................ 175
ii. Petitioners' Entering Into QHMC
Transactions Solely as Means To
Generate Artificial Capital Loss To
Offset CapitalGains ................. 177
iii. Petitioners' Selection of Transferred
MPBs Without Regard to Effective
Medical Cost Management . . . . . . . . . . . . 183
iv. Equity Interest in QHMC Granted to
CS and Wannell as Meaningless
Incentive To Reduce Health Care Cost . . . 184
v. Unnecessary Assumption of MPB
Obliigations by QHMC . . . . . . . . . . . . . . . . 186
c. Conclusion ............................... 187
IV.
Fees Incurred in Furtherance of QHMC Transactions . . . . . . . . . . 188
V.
Accuracy-RelatedPenalties .............................. 189
A. Background ........ ............................... 189
B. Gross Valuation Misstatement . . . . . . . . . . . . . . . . . . . . . . . .. 190
C. Negligence......................................... 195
D. Substantial Understatement
. . . . . . . . . . . . . . . . . . . . . . . . . . 198
E. Section 6664(c) Reasonable Cause Exception . . . . . . . . . . . . . 202
1. Overview ..... ...............................202
2. Analysis ...... ............................... 207
VI.
Conclusion ........... ............................... 213
- 16 -
MARVEL, Judae: Quanex Corporation (Quanex)1 and its affiliated
subsidiary corporations (collective ly, petiuoners) petitioned the Court to
redetermine respondent's determin ation as to petitioners' taxable year ended
October 31, 1997 (TYE 1997). R e sponde:it determined a $9,561,458 deficiency in
petitioners' Federal income tax and a $3,N9,926 accuracy-related penalty under
section 6662(a), (b), and (h).2 The parties dispute three issues relating to
respondent's determination, and they agrea that certain subissues and arguments
underlie a decision regarding those issues. The three issues are:
1. whether petitioners may deduct i: $37,989,000 net short-term capital loss
from the sale of stock of Quanex Health Management Co., Inc. (QHMC). The sale
was part of a series of transactions (QHMC transactions) that occurred in October
1997 between and among Quanex, certain of Quanex's affiliated subsidiaries, and
two independent (yet loyal) facilitators. Petitioners claimed a $37,989,000 loss
deduction on the sale and applied S26,966,201 of the claimed loss to TYE 1997
1After the petition was filed, Quaneï changed its name to Gerdau Macsteel,
Inc., and became and remains the agent of the affiliated group for TYE 1997. See
sec. 1.1502-77A(a), Income Tax Regs. Wa hereinafter refer to Gerdau Macsteel,
Inc., as Quanex.
2Unless indicated otherwise, sectior: references are to the applicable
versions of the Internal Revenue Code (Code), and Rule references are to the Tax
Court Rules of Practice and Procedure.
- 11 and the balance to TYE 1998. Respondent disallowed the claimed loss deduction
in full. We hold that petitioners are not entitled to deduct any of the claimed loss;
2. whether petitioners may deduct $352,251 of transaction costs incurred to
effect the QHMC transactions as ordinary and necessary business expenses under
section 162(a). Petitioners claimed the $352,251 as a deduction for TYE 1997,
and respondent disallowed the claimed deduction in full. We hold that petitioners
are not entitled to deduct any of this amount;
3. whether petitioners are liable f r the 40% accuracy-related penalty that
respondent determined under section 6662(a) and (h)(or alternatively, the 20%
accuracy-related penalty that respondentidetermined under section 6662(a) and
(b)) with respect to the underpayment of tax attributable to the disallowed capital
loss deduction, and whether petitioners are liable for the 20% accuracy-related
penalty that respondent determined under section 6662(a) and (b) with respect to
the underpayment of tax attributable to the disallowed transaction costs deduction.
We hold in accordance with Heasley v. Commissioner, 902 F.2d 380 (5th Cir.
1990), rev'a T.C. Memo. 1988-408, and .Todd v. Commissioner, 862 F.2d 540 (5th
Cir. 1988), a_ff'g 89 T.C. 912 (1987), which we follow under Golsen v.
Commissioner, 54 T.C. 742 (1970), aff'd, 445 F.2d 985 (10th Cir. 1971), that
petitioners are not liable for the 40% accuracy-related penalty. We also hold that
- 12 petitioners are liable for the 20% accurac>-related penalty under section 6662(a) to
the extent of the underpayment of tax attributable to the disallowed capital loss
deduction and to the disallowed deduction for the transaction costs.
FINDINGS OF FACT
I.
Preliminary Matters
The parties have stipulated many facts. Some stipulations note a party's
objection to the admissibility of tlle stipu] tted fact(s), and we have sustained some
of those objections. We incorpora te herein the stipulated facts to the extent we
have not sustained an objection to their adrnissibility, and the stipulated facts are
so found (except to the extent we sustained an objection to their admissibility).
Quanex's principal office and prin cipal place of business were in Texas when the
petition was filed.
II.
Quanex
Quanex is a Delaware corporation whose common stock is publicly traded
on the New York Stock Exchange. Quanex was organized in 1927, and its
principal activity is manufacturing specia:ized metal products made from carbon
and alloy steel and aluminum. From at least 1995 through October 31, 1997,
Quanex's main operating groups consisted of a hot and cold finish steel bar
- 13 business, a hot and cold finish tubing business, and an aluminum building
products business.
Quanex is the common parent of petitioners' "affiliated group" (as that term
is defined in section 1504(a)). On July 14, 1998, petitioners filed a consolidated
corporate Federal income tax return for TYE 1997 (1997 return). Petitioners
reported in the 1997 return that Quanex was the common parent of the affiliated
group and that its subsidiaries and their principal business activities were as
follows:
Subsidiaries
Principal business activities
Michigan Seamless Tube Co.
LaSalle Steel Co.
Piper Impact, Inc.
Quanex Wire, Inc.
Manufacturing
Manufacturing
Manufacturing
Investments
Quanex Bar, Inc.
Quanex Solutions, Inc.
Quanex Mfg., Inc.
Quanex Steel, Inc.
Investments
Investments
Investments
Investments
Quanex Enters., Inc.
Quanex Tech. Inc
Quanex Metals, Inc.
Nichols-Homeshield, Inc.
Inactive
Inactive
Inactive
Inactive
For TYE 1997 through TYE 2001 petitioners had an annual accounting
period ending on October 31, and they each maintäined books and records using
an accrual method of accounting. As of October 31, 1997, petitioners had 13
- 14 manufacturing plants throughout the United States and 1 plant in the Netherlands.
Also as of that date, petitioners had 3,771 employees, approximately 1,000 of
whom were covered by collective bargaining agreements.
III.
Petitioners Expectation of Realizing Millions of Dollars in
Taxable Capital Gains During TYE1997 and TYE 1998
During TYE 1997 Quanex was acti3 ely pursuing the sales of two
subsidiaries. Those sales were expected to generate millions of dollars in taxable
capital gains during TYE 1997 and TYE 1998. The first sale involved Quanex's
wholly owned subsidiary LaSalle Steel Co (LaSalle). Quanex's board of directors
(Quanex's board) resolved on February 27, 1997, to make that sale, and the sale
closed shortly thereafter in TYE 1997. For TYE 1997, petitioners reported as to
that sale (and to a minor extent the sale of other business property) that they
realized a capital gain of $26,966,201 and ordinary income of $21,374,634. The
second sale involved Quanex's dec ision to sell a portion of its tubing operations
(Tube Group).3 In or before September 1997 Quanex began negotiating that sale,
and the sale occurred on December 3, 1997. For TYE 1998 petitioners reported as
3The Tube Group included Michigan Seamless Tube Co. (MST), Gulf States
Tube Division (GST), and the Tube Group administrative office. The Tube Group
also included Quanex's heat treating and nitro steel divisions, but Quanex retained
those divisions, and they were still a part of Quanex as of the time of trial.
- 15 to that sale that they realized a net capital gain of $12,458,171 and ordinary
income of $8,090,766.
Contemporaneous with petitioners' activities with respect to the two sales,
and with knowledge of petitioners' intest to make those sales, petitioners' outside
accounting firm, Deloitte & Touche, LLP (D&T), through one of its tax partners,
Steven Singer, approached petitioners and promoted an idea for a multistep
transaction that, if artfully structured to comply literally with the Code and certain
interpretations thereunder, could create for petitioners a multimillion-dollar tax
loss to shelter the gains from the unrelated sales for Federal income tax purposes.
Quanex entered into the QHMC transactions as a result of that promotion, and
Quanex claimed that it realized a $37,989,000 capital loss on one of the steps in
the QHMC transactions that effectively offset the amount of gains on the unrelated
sales. The QHMC transactions were ostensibly structured around the Quanex
Corporation Group Benefits Plan (plan) with an aim towards generating an
artificial multimillion-dollar tax loss that would offset the large gains on the sales
and would appear to be generated from Quanex's business activities.
- 16 IV.
The Plan
A.
Background
Effective September 1, 1949, Quane x established the plan to provide certain
health, welfare, and other similar benefits for eligible Quanex employees and their
dependents. Quanex reserved the right to amend the plan at any time and reserved
the right, without an authorizing resolution from Quanex's board, to reduce or
completely eliminate any coverage provided under the plan for current and/or
former employees and their beneficiaries. Quanex also could terminate the plan at
any time by a written resolution of Quanex's board.
B.
Health Care Offerings
Pursuant to the plan, Quanex offered both its nonunion and union
employees a choice of medical plans, whit h were generally indemnity and health
maintenance organization (HMO) plans. la the early 1990s Quanex also instituted
cafeteria benefits with respect to its indemnity plan offerings. Under the plan,
Quanex was required to appoint a commit^ee to perform any administrative
function with respect to the plan that the respective insurer or HMO was not
required to perform.
- 17 Effective January 1, 1995, Quanex amended and restated the plan, and the
plan remained in effect for TYE 1997.4 From 1995 through the end of TYE 1997,
Quanex provided group medical benefits to its employees under the plan, and
Quanex deducted the costs of those benefits as they were incurred as ordinary and
necessary business expenses.
C.
Health Care Cost Management Strategies
1.
Background
The cost of providing health care is influenced by numerous factors, e.g., an
employee's age, number of dependents, and geographic location. Other less
predictable components, such as political pressures, also can influence health care
costs. From at least 1985 Quanex experienced a rise in the cost of providing
health care to its employees. As early as 1985 Quanex began to look at ways to
reduce its overhead and streamline its benefits, including its health care costs,
pensions, and medical benefits for both active and retired employees.
4As of October 31, 1997, petitioners provided health care benefits to their
nonunion employees through either an indemnity (self-insurance) medical plan or
a managed care program.
-182.
CS
a.
Backgrounsì
ChapmanSchewe, Inc. (CS), is a hec Ith care management firm that Doug
Schewe and Harry Chapman organized on July 1, 1992.5 As of the time of trial CS
had 12 subcompanies, all of which were davoted to health care, and its employee
benefits practice managed health benefits for approximately 9 million individuals
throughout the United States. During TYl: 1997 Chapman was CS' chairman and
chief executive officer, and he owne d app:·oximately 37% of CS' stock. Chapman
has a bachelor's degree and a master's det ree in public administration, and as of
the time of trial he had 23 years of experience in the health care industry.
b.
Quanex's Introd retion to CS
Ron Howard joined CS in 1994 as ca associate/benefits consultant. Howard
was a former financial portfolio manager with a master of business administration
(M.B.A.) degree and 10 years of experienee in banking. During his previous
career in banking, Howard had formed rebtionships with members of Quanex's
senior management, including Quanex's 1hen chief financial officer (CFO) Wayne
Rose. Howard contacted Quanex shortly . tfter he joined CS to persuade his
5While CS was apparently formed under a different name, we refer to CS
and any of its predecessors as CS.
- 19 Quanex contacts to let CS negotiate Quanex's HMO contracts, and to pursue a
working relationship with Quanex.
On April 7, 1994, CS representatives met with Quanex representatives.
During the April 7 meeting, Howard and Chapman gave a sales presentation to
Joseph Peery. Peery has a bachelor's degree in business administration and 34
years of experience in human resources, and he was Quanex's vice president of
human resources from 1984 until he retired in April 1998. Shortly after the April
7 meeting, Quanex gave CS the opportunity to reduce Quanex's health care costs
through HMO negotiations.
In CS' first project, Howard negotiated a fee for Quanex with one HMO,
which saved Quanex money. Quanex then expanded its involvement with CS but
still limited CS to HMO work. The substance of CS' work consisted of
negotiating Quanex's premium amounts with HMOs and of analyzing HMO cost
structures.
Howard was the CS executive in charge of the Quanex account during TYE
1997, and sometime before 1998 he attempted to negotiate rate guaranties for
Quanex. Howard had previously informéd Quanex that CS could negotiate
multiyear rate guaranties and performance guaranties with HMOs.
- 20 Before the QHMC transactions, Chapman participated in the negotiation of
Quanex's HMO contracts. Chapman tried to achieve the best results possible from
the negotiations, and Chapman used the ne gotiations to speak more frequently
with Quanex's human resources departmei t and to sell Quanex additional health
care consulting services.
c.
CS Fee Anangerients
CS offered flexibility to its c lients through different payment arrangements
(e.g., CS' fee might be a percentage of the expense saved, or it might be calculated
on the basis of a percentage of revenue). Hefore the QHMC transactions, CS
informed Quanex that CS' comper sation was performance based; i.e., CS would
be compensated only if, and to the extent, CS saved Quanex money. Before the
QHMC transactions, CS and Quanex did r:ot have a written consulting agreement,6
but CS acted as a broker to secure rnedica l coverage for Quanex's employees
through HMOs, and the HMOs (or Quane1 in one or two instances) paid CS a
brokerage commission for its services.
V.
D&T
Quanex first engaged D&T (or one of its predecessors) as early as 1978 for
external auditing, tax, and consulting serv ices. The consulting services related to,
6It Was not unusual for CS to forgo a consulting agreement with a client.
- 21 among other things, debt restructuring, potential bankruptcy filings, and the
purchases and sales of assets and subsidiaries. During TYE 1997 D&T certified
petitioners' consolidated financial statements and reviewed petitioners'
consolidated Federal income tax returns, in addition to providing petitioners with
other professional services.
Singer is an attorney and a certifièd public accountant (C.P.A.), and he has
practiced in the field of taxation for over three decades. He joined D&T in 1981,
and he became a partner in D&T's tax practice one year later. He became the
D&T partner in charge of the Quanex a5count in 1989. Singer was based in
D&T's office in Houston, Texas, during TYE 1997, and he remained in charge of
D&T's Quanex account as of the time of trial.
From 1989 through the end of TYE 1997, Singer consulted with Quanex
regarding its current and prospective purchases, and he reviewed and signed
Quanex's corporate returns as a paid preparer. From 1995 through the end of TYE
1997, Singer had intimate, first-hand knowledge of Quanex and its business,
acquired mainly from his supervising ar d managing D&T's Quanex account since
1989, his visits to some of Quanex's facilities, his participation in Quanex's
financial statement audits, and his cony rsations with Quanex's senior
management.
- 22 VI.
Other Quanex Employees/Officers
A.
Rose
Rose is a C.P.A. with a bachelor's dagree and an M.B.A. degree, and he was
Quanex's CFO from 1986 through 1998. 1 Ie was Quanex's controller before 1986
(and before that, he worked for a large national public accounting firm for six
years), he was the president of Qua nex's engineered products group from the end
of 1998 until 2001, and he was Quanex's i ice president of special assignments
from June 2000 through March 2001.
When Quanex bought or sold a subs tantial asset, Rose, as CFO, and his
department were responsible for projectint the results of that transaction. Rose
generally knew what tax results he wanted going into purchase or sales
negotiations, and he preferred to buy net a ;sets and to sell subsidiaries. During his
tenure as Quanex's CFO, Rose knew the importance of tax basis and the effect that
liabilities had on a determination o f Quanex's bases in its subsidiaries.
B.
Parikh
Viren Parikh is a C.P.A. with a bacl:elor's degree and a master's degree,
both in accounting, and he was Quanex's controller from 1993 through December
2002. He left Quanex on December 31, 2002.
- 23 As Quanex's controller, Parikh was responsible for Quanex's accounting
department; its duties included financial reporting, corporate accounting, and tax
return preparation. Parikh, as controller, also (with Thomas Royce and Rose) was
responsible for reviewing Quanex's asset sales and projecting their results. If
Quanex sold a significant asset, Parikh decided how the transaction would be
recorded on Quanex's financial statements, and he was involved in deciding how
any tax implication would be reported. He and his department also, while
negotiations for Quanex's potential sales were ongoing, would project gains and
losses on those potential sales for purposes of financial reporting, periodically
updating the projections as the negotiations drew to a close.
C.
Royce
Royce is a C.P.A. with a bachelor's degree in business administration
(majoring in accounting), and he was Quianex's tax director. Beginning in TYE
1997, Royce also was Quanex's director/manager of financial benefits
administration (FBA manager). Royce reported to Parikh during TYE 1997, and
Royce remained Quanex's tax director and FBA manager as of the time of trial.
As tax director, Royce was responisible for Quanex's consolidated Federal
income tax returns and any subsidiary returns, for all tax planning, for tax audits,
for employee benefit returns, and for all State income and franchise tax returns.
- 24 As FBA manager, Royce was responsible !br the accounting of the employee
benefits in Quanex's pension and section 401(k) plans, for audit preparation, for
the filing of employee benefit information returns, and for working with welfare
benefit plans and third-party administrator i for both pension and section 401(k)
plans.
Royce, as tax director and eventuall y also FBA manager, also reviewed
Quanex's sales and made corresponding p ojections. When Quanex negotiated the
sale of a substantial asset, Royce projecte¿ the potential Federal income tax
ramifications from the sale during the neg »tiations.7 If a sale was concluded,
Quanex would usually at the end of the year calculate the actual Federal income
tax consequences of the sale. Parikh wou:d review the overall tax provision that
had been made for the sale for financial s11tement purposes, but Parikh would not
review Royce's estimates of the potential income tax consequences.
7Royce testified that when Quanex -1egotiated the sale of a significant asset,
neither he nor anyone else at Quanex projected what tax benefits and detriments
would result from the sale. We do not find Royce's testimony on this point to be
credible, and we decline to rely upon it.
- 25 VII. Liability Management Companies
A.
Overview
As of the end of TYE 1996, Quanex had a potential liability for medical
plan benefits (MPBs) that might be provided under the plan. Quanex also faced a
potential environmental liability of $15 nillion to $20 million. Quanex assumed
the potential environmental liability in 1996 when Quanex acquired Piper Impact,
Inc. (Piper). As part of that acquisition, the seller established an escrow to cover
this exposure.
B.
Rev. Rul. 95-74
Singer, Parikh, Royce, and Rose a tended a Quanex quarterly meeting in
1996, in or before the summer of that year. During that meeting, Singer informed
the Quanex representatives that the Internal Revenue Service (IRS) had issued a
ruling, Rev. Rul. 95-74, 1995-2 C.B. 36 (revenue ruling), which Singer believed
allowed Quanex to achieve tax benefits by transferring either its environmental
liabilities or its MPB obligations to a liability management company in a joint
venture. In the revenue ruling the IRS r led that certain contingent environmental
liabilities that a transferee assumed in a section 351 exchange were not liabilities
for purposes of sections 357(c)(1) and 358(d) and that the transferee, in
accordance with its method of accounting, could, as appropriate, either deduct the
- 26 -
liabilities as business expenses under section 162 or capitalize the liabilities as
capital expenditures under section 263.
C.
D&T's Matrix
1.
Background
D&T maintained an electronic repo (itory of tax ideas that D&T
professionals could discuss with D&T clit nts to increase D&T's business with
those clients and generate additional revenue for D&T. Various D&T
professionals contributed ideas in their art as of expertise to the repository
(referred to as D&T's client service matrin (matrix)), and D&T envisioned that
D&T might provide the client with a tax epinion on any transaction described in
the matrix which a client entered into. Th e matrix was for internal use only, and
D&T believed it would be at a competitiva disadvantage if competitors gained
access to the ideas in the matrix.
2.
DDCL
Singer occasionally consulted the rnatrix to obtain ideas to present to D&T
clients. In the summer of 1996, after Singer learned of the revenue ruling, he read
an undated section of the matrix referenced as "Double Deducting Environmental
and Other Contingent Liabilities" (DDCI. ). Singer was not responsible for the
- 27 ideas in the DDCL, and he believed the DDCL was the only section of the matrix
referencing the revenue ruling.8
The DDCL proposed a transaction for accrual method taxpayers whom the
accrual method prevented from deducting accruals on their balance sheets for
estimated future environmental liabilities. The DDCL concluded that, in the
setting of a consolidated group, a transaction could be structured to allow such a
taxpayer to immediately deduct a capital loss equal to the amount of the
environmental reserve and to claim an additional deduction when the accrued
liability was paid. The DDCL stated that the "proper structuring" of the
transaction revolved around the use of an environmental management company
and the sale outside the group of some of the company's stock at a price equal to
the stock's fair market value. The DDCL summarized the transaction as follows:
SUMMARY OF TRANSACTION
Parent Corporation (Parent) is a parent corporation in a consolidated
group, which includes Environmental Management Company
(EMCo) and several other operating companies. EMCo is a newly
established, wholly-owned subsidiary of Parent. Parent also owns S1,
and S1 owns S2. Parent now desires to use EMCo to strategically
manage the groups [sic] environmental liabilities and clean-up efforts.
Sl has a reserve for environmental liabilities on its books in the
amount of $10x, which has not been deducted for income tax
8After the QHMC transactions were completed, D&T added to the matrix
another idea dealing with a contingent liability transaction.
- 28 purposes. S1 also has an intercomp2ny receivable account with S2 in
excess of $10x.
First, S2 pays off a portion of its intercompany debt to S1 by issuing a
10-year promissory note for $10x. S1 then contributes this note
receivable, and its $10x environmen tal reserve, to EMCo in exchange
for 100 shares of new, voting Class H stock. These shares may be
either preferred or common. These shares have only a nominal value,
as the net book value of the contributed property is nominal. (S1
remains legally liable for the environmental costs if EMCo is unable
to pay them.) These shares s.hould be designated as being entitled to a
limited percentage of dividends and distributions paid to all classes of
stock (for example, 15%). The perc;ntage must be established so that
at least 80% of the vote and value of all stock remains with the Class
A (common) stock.
S1 then sells the Class B shares of I MCo to EMCos [sic] officers for
their fair market value, a nominal ar tount. As the tax basis in this
stock is $10x, S1 recognizes a capital loss of $10x on the sale. As
EMCO makes expenditures on the environmental reserve, it also has a
deduction for these payment s.
The DDCL noted that "it is clear that a buainess purpose is required for the
transaction" and listed the following business purposes for the transaction: (1)
better management of S1's environmental liabilities through EMCo's devotion of
its resources solely to environmental projects, (2) the ability to provide incentives
more easily for the better management of1he environmental liabilities by creating
a separate company, and (3) improvement of S1's credit arrangements and banking
relationships by taking its environmental :iabilities off its balance sheet and
- 29 transferring them to another of P's subsidiaries. The DDCL described the
business purposes regarding incentives (No. (2) above) as follows:
S1 will sell Class B stock in EMCo to the EMCo officers in order to
give these individuals an ownership interest in EMCo. S1 also then
agrees to repurchase each officers [sic] shares, once the
environmental liabilities have been settled or the officer leaves the
employment of EMCo, at the greater of their cost to the officer * * *
or the per share book value of EMCo. If the environmental liabilities
are satisfied for less than the amount originally estimated, the book
value of EMCo will increase, providing the individual officers with a
gain when their shares are sold back to S1.
The DDCL acknowledged that the transaction referenced therein presented
risks and could be subject to antiavoidance provisions such as section 269 or
section 1.1502-20, Income Tax Regs. The DDCL envisioned that its substance
could be adapted for use with a variety of contingent liabilities and reserves,
including medical claims. D&T structured the transaction described in the DDCL
to offer to its qualifying clients a deductible capital loss equal to the amount of
contingent liabilities transferred in the transactions. The appeal of the DDCL
transaction (or a variation thereof) was to minimize a taxpayer's Federal income
- 30 tax liability by accelerating the deduction of and double deducting environmental
or other contingent liabilities.
3.
Singer Promotes_DDC] -Type Transaction to Quanex
Singer decided to approach Quanex to promote to Quanex the transaction
described in the DDCL, or a variation theraof. While the DDCL referenced a
consolidated setting, Singer preferred imp ementing the transaction described
therein in a deconsolidated setting becaust he was concerned about rules under
which the loss could be disallowed in the consolidated setting.
Before discussing the DDCL and th a revenue ruling with Quanex, Singer
read some of the cases mentioned in the n:ling. He had developed an
understanding of the revenue ruling and it i implications, and he had previously
discussed a contingent liability transaction with at least one other client. Singer
took the position that an implication of the revenue ruling was that a taxpayer
could use a liability management company to create a capital loss which, in turn,
could reduce the taxpayer's Federal incou e tax liability.
In February 1997 at Quanex's quarterly review meeting with D&T, Singer
advised Rose, Parikh, and Royce that D& F could structure a contingent liability
transaction for Quanex to generate a tax loss for Quanex. At that time, Singer
- 31 knew that Quanex was selling LaSalle ahd would have a significant gain on the
sale.
VIII. Sales of LaSalle and Tube Group
A.
LaSalle Sale
On February 27, 1997, Quanex's board resolved to sell all of Quanex's
stock in LaSalle to a third party. The LaSalle sale closed on April 18, 1997.
Singer knew at least as early as the 1996 quarterly meeting that this sale was
probable, and he understood in or before March 1997 that Quanex hoped to close
the sale by April 1997. Singer and Rose also both knew that the sale was expected
to generate a significant gain.
On January 13, 1998, petitioners filed their Form 10-K, Annual Report
Pursuant to Section 13 or 15(D) of the Securities Exchange Act of 1934, for TYE
1997 (1997 Form 10-K). Petitioners reported in the 1997 Form 10-K that they
completed the LaSalle sale for approximately $65 million. In their 1997 return
petitioners reported that they realized a $28,697,957 capital gain and a
$20,721,360 ordinary gain on the sale. Petitioners' 1997 return included their
section 338(h)(10) election regarding the sale of LaSalle. From April 18, 1997
(the date of the LaSalle sale), through July 14, 1998 (the date petitioners filed their
1997 return), LaSalle's buyer tried to renegotiate a lower purchase price, and the
- 32 buyer and Quanex disagreed on purchase j-rice allocation issues related to the
section 338(h)(10) election. In or before that period Quanex made several
estimates of the income tax ramifications c f the sale.' Royce, in particular,
performed rough calculations comparing the results of completing the sale as a
stock sale rather than an assets sale under section 338(h)(10). Royce shared his
calculations with Parikh.
Singer knew during April 1997 that petitioners would realize millions of
dollars of ordinary income and capital gain on the LaSalle sale.1° Over the next
five months, he devoted a substantial portion of his time to determining the tax
implications of the sale, including the amcunt of ordinary income and capital gain
9COntrary to other testimony, Royce testified that Quanex did not consider
the tax consequences during the negotiations because the buyer and Quanex had
agreed to the sec. 338(h)(10) election, tha: the tax consequences of the LaSalle
sale were not important to Quanex before the April 1997 closing, and that the tax
consequences were irrelevant for purposen of negotiating LaSalle's sale price. We
do not find Royce's testimony on this mat:er to be credible, and we decline to rely
upon it.
1°Singer testified that he knew by A pril 18, 1997, that Quanex had an
economic gain on the sale but that he did not know the exact amount of the capital
gain on the sale until approximately a we(. k or two before he finalized petitioners'
1997 return. We do not find this testimony to be credible, and we decline to rely
upon it.
- 33 to be generated from the sale." Before the QHMC transactions closed, Singer and
Royce discussed the anticipated amount of capital gain on the LaSalle sale.
B.
Tube Group Sale
The Tube Group sale involved the sale of both stock and assets. The first
closing occurred on December 3, 1997. Petitioners reported on their 1997 Form
10-K that the Tube Group sale was completed for approximately $30 million, and
they reported a $12,458,171 capital gain and $8,090,766 of ordinary income from
the Tube Group sale on their Federal inc{ome tax return for TYE 1998 (1998
return).
IX.
Engaging D&T To Structure QHMC Transactions
Over several months, at a time when D&T and Quanex were already aware
of petitioners' expected multimillion-dollar sales, D&T and Quanex discussed the
possibility of Quanex's engaging in a series of transactions similar to those in the
DDCL and the revenue ruling. During sþme of these discussions, D&T gave
presentations either through Singer alone or through Singer and one of his
Houston-based tax partners, Mark Schneider. Singer asked Schneider during 1997
to help him structure a contingent liability transaction for Quanex, and they
"For June 29 through September 20, 1997, D&T billed Quanex $22,190 for
60.5 hours of "Consultations regarding the sale of LaSalle" by Singer and other
D&T professionals.
- 34 discussed the potential tax implications of the transaction. When Singer initially
discussed the DDCL and the revenue ruling with Quanex, he informed Quanex
about potential issues with section 1.1502-20, Income Tax Regs., and similar loss
limitation rules that applied to consolidate.1 groups. Singer advised Quanex that
its liability management company (QHM( ), if deconsolidated from petitioners'
affiliated group, could be reconsolidated v:ith the group if puts and calls were
exercised in relation to the company's stot k." Singer advised Quanex that it
needed a business purpose for the QHMC transactions.
On the basis of the discussions bety.een D&T and Quanex, Rose believed
that D&T's structuring of a joint venture 1 > manage petitioners' liabilities could
result in a capital tax loss that petitioners could use to shelter the anticipated
unrelated gains. Singer advised Quanex f om the outset, however, that he did not
know whether D&T could actuall3 structure such a joint venture. Nevertheless, at
some time on or before March 24, 1997, R ose asked D&T for an engagement letter
concerning the structuring of a series of tr.msactions between Quanex, some of
Quanex's affiliates, and a third-party liability management consulting firm (what
"As discussed infra, Quanex charat terized QHMC, formerly know as
Quanex Wire, Inc. (QW), a wholly owned inactive subsidiary of Quanex, as its
liability management company to effect the QHMC transactions.
- 35 became the QHMC transactions)." Singer wanted the engagement letter so that he
could be certain that D&T would be paid for its time whether or not the
transactions were completed.
Quanex and D&T entered into an agreement that was set out in an
engagement letter dated March 24, 1997 (engagement letter). The engagement
letter was signed by Singer on D&T's behalf, and it was executed by Rose on
Quanex's behalf on June 30, 1997. Through the engagement letter, which was
prepared by or under the direction of Singer, Quanex asked D&T to provide
Quanex with-assistance in considering the federal income tax consequences
associated with a series of prospective transactions between Quanex
Corporation and several of its affiliates * * * an independent third
party management consulting firn specializing in either employee
benefits and medical insurance matters, or in environmental matters,
* * * ® as well as with a form of the prospective transaction that
additionally or alternatively may contemplate an independent third
party investor.
"Rose directed Royce and Parikh to help complete the QHMC transactions.
Parikh, however, did not make decisions about the details of the transaction's
structure.
"Although Rose had previously rejected Singer's suggestion to use a
liability management company to control Quanex's environmental liabilities,
Singer referenced those liabilities in case Rose changed his mind.
- 36 The engagement letter notes that "the form and content of this prospective
transaction is [sic] somewhat fluid at present" and that D&T would participate in
meetings and discussions related to the structuring of the transaction. Singer
informed Rose that the transaction contemplated by the engagement letter was a
recent development, and Singer did not represent that he had experience with the
type of transaction described. The engagement letter stated that D&T's
professional fees would be calculated on tl e basis of its standard hourly charges,
but if the transaction were completed, the hes would be approximately $400,000
plus an estimated additional $10,000 for out-of-pocket expenses.
D&T and Quanex contempla ted undar the engagement letter that D&T's
assistance and advice would "culminate in the delivery to Quanex of a tax opinion
letter * * * limited solely to the specific federal income tax consequences to
Quanex" and that the opinion letter would be "based upon all the facts of the
transactions and representations rnade to [D&T] in a Letter of Representation
provided by Quanex." The engage ment le:ter stated that D&T could not confirm
the conclusions it reached until it s igned it s opinion letter, although it might
"informally indicate prior to that point whather or not * * * [D&T] anticipate[d]
that a position taken by Quanex should be sustained on its merits if challenged by
the IRS", and conditioned D&T's agreement to provide a tax opinion on D&T's
- 37 "ability to satisfy ourselves that all of our professional standards for the conduct of
this work and the issuance of our opinion have been met." D&T required as a
condition of the engagement that Quanex agree in the engagement letter that
D&T's liability for any damages arising out of the services that D&T provided in
the engagement be limited to the fees paid to D&T for its services giving rise to
the liability. D&T required as a condition of the engagement that Quanex agree in
the engagement letter that it would indemnify D&T from any liability, cost, or
expense (including attorney's fees and expenses) stemming from the engagement,
absent D&T's bad faith or willful misconduct. When Singer signed the
engagement letter, he contemplated that D&T would provide Quanex with a tax
opinion letter if a transaction were completed and Quanex wanted such a letter.
D&T assisted Quanex with the QHMC transactions, and the process of
developing the transactions (including the discussions before the engagement
letter) extended from approximately Feb ary through October 1997. Petitioners
conducted no independent investigation of the tax consequences of the QHMC
transactions.
- 38 X.
Developing QHMC Transactions
A.
Quanex's First Proposal to C8
On several occasions in 1997. Rose met with Quanex's management group
and Singer to form an initial proposal to tcnder to CS as to its participation in the
QHMC transactions. By letter dated July 21, 1997, Peery contacted Chapman to
determine CS' interest in the proposal for the "somewhat unique arrangement we
are seeking" to "manage[] our corporatioris non-union medical expenses,
including both HMO and indemni1y plan t overage for active employees and
retirees." Rose and Peery drafted this letter together, and they showed the letter to
Singer before Peery sent it.
The July 21 letter described QuaneL's proposal as an opportunity for an
employee benefits firm to enter imo a part nering arrangement with Quanex for a
term of approximately 7 to 15 years to assume responsibility for and management
of ongoing health care costs. The letter stated that the management
responsibilities would include meeting the insured health care needs of certain
nonunion Quanex employees at care leve: s comparable to those already in place,
but with more efficient service delivery to Quanex's employees and an ultimate
result of reduced costs to Quanex. The le tter explained that the management firm
would acquire a class of stock in a medical management subsidiary of Quanex, the
- 39 subsidiary would hold a 7- to 15-year prbmissory note issued by a Quanex entity,
and the subsidiary would use the interest and principal payments on that note to
reimburse the insured health care costs df the covered nonunion Quanex
employees.
The July 21 letter further explained that although CS would be paid, in part,
for contract services on a periodic basis, Quanex was seeking an arrangement
where CS' performance premium for economic savings under the contract would
be partially realized by efficiencies and cost savings. According to the letter,
Quanex anticipated that these savings would lead to an accretion in the value of a
designated class of the subsidiary's stock and that the premium for performance
would be shared through equity holdings in the subsidiary. The letter stated that
Quanex designed this arrangement because "The senior management of Quanex is
committed to delivering above market returns to our equity shareholders, and as
such, has increasingly focused on reconfiguring certain central business
relationships into a shared ownership or joint venturing mode."15
Because Quanex was a good customer for CS and CS wanted to retain its
relationship with Quanex in any way it could, CS agreed to meet with Quanex to
isAs of then, Rose had not considered using a consulting agreement, rather
than a separate corporate structure, to provide incentives to reduce the health care
costs.
- 40 discuss the proposal. CS and Quariex met during the summer of 1997, and
Quanex informed CS that Quanex wanted to create a medical management
business unit that would focus on self-insured, indemnified contracts.16
B.
D&T's First Outline o f Propo ted Joint Venture Transactions
Sometime on or before July 30, 199', but at a time when Quanex knew it
would have substantial gains from the LaSalle and Tube Group sales, Quanex
requested that D&T prepare an outline of1he first draft of the proposed QHMC
transactions. Singer and Schneider prepaud the outline. Schneider reviewed the
outline before it left D&T, and by }etter dated July 30, 1997 (July 30 outline), he
sent the outline to Parikh, Rose, and Peery "
The July 30 outline stated that Quarex wished to broaden the scope of CS'
HMO evaluation services to include review of Quanex's indemnity medical plan
and other medical cost and quality matters The outline reiterated that CS'
compensation with regard to the additional scope of services would be paid
16Chapman also attended a meeting where Singer made a presentation about
the proposed transactions. The record is not clear regarding whether this
presentation occurred during this initial maeting.
"Although Peery was included on some of the correspondence relating to
the structuring of the transaction, Peery did not have any discussions with D&T
about the structure of QHMC. Peery also did not participate in any decisions or
make any recommendations with respect t o how QHMC would be structured.
- 41 pursuant to a consulting agreement that provided for either hourly or performancebased compensation and for "additional!long term incentive equity". The outline
proposed that (1) Quanex or QHMC have the option of purchasing the incentive
equity after five years for cash, (2) CS hhve the option of selling the same to
Quanex or QHMC after seven years for cash, and (3) the purchase or sales price be
the greater of $12,500 or a formula value based, in part, on QHMC's expectations
for its medical claim expenses.
The capital loss deduction generated through the QHMC transactions would
be approximately equal to the amount of the MPBs that were transferred in those
transactions, and the amount of the MPBs Quanex would transfer in the QHMC
transactions would be based on the amount of the capital gains Quanex wanted to
offset. Under the proposal set forth in the outline, all actuarial calculations for the
QHMC transactions, including calculations of the present values of the MPBs to
be transferred, would be done by the actuarial firm of Watson Wyatt & Co. (WW)
or another Quanex designee. WW was Quanex's then-current consultant on
pension plans and retiree health care plans. Sometime before June 30, 1997,
Royce asked WW to compute the present value of Quanex's future health care
benefits for active and retired Quanex employees. Royce did so because he
- 42 wanted Quanex to know the amount of its outstanding MPBs as it analyzed the
structure of the proposed transactions.
C.
WW
1.
In General
As part of WW's consulting service i provided to Quanex, WW prepared
Quanex's report (FASB 106 report) requir d by Financial Accounting Standards
Board Statement No. 106 (FASB 106). Tl e FASB 106 report includes a
calculation of a liability for the balance sh et and an annual expense for the
income statement as to an organization's retiree health care plans and other retiree
welfare plans. An FASB 106 liability is a liability for financial statement
purposes. The MPB obligation, i.e., the fLture health care costs for active
employees of Quanex, is not an FASB 106 liability.18
18As discussed infra, the trar sferred MPB obligations had not been incurred
by Quanex as of October 31, 1997, and when those obligations were assumed by
QHMC, they were not reported as a liability on Quanex's financial statements.
- 43 2.
FASB 106
FASB 106 sets forth standards for determining the present value of an
employer's future retiree health care payments owed to currently retired
individuals and current employees who will retire in the future and ratably
accruing that present value on the employer's financial statement over each
employee's career in an effort to match the benefits paid to employees to their
service as they earn the benefits. FASB 106 requires the making of certain
actuarial assumptions on matters such as the average cost of health care per
person, the projection of increases in fut re average costs, and a discounting of
projected future costs to calculate present value. (An assumption relating to
increases in health care costs into the future is referred to as health care cost
inflation or a health care cost trend.) Other assumptions relate to employee
demographics, including mortality, job turnover, retirement age, and the likelihood
of electing coverage under the employer's plan upon retirement.
Different types of trends exist for short-term and long-term calculations.
For purposes of FASB 106, the timeframe for short-term calculations is typically
from 4 to 10 years. Commonly, for a valuation under FASB 106, after a trend rate
is determined for the first year of the calculation (initial trend rate), the initial
trend rate gradually changes over the years to an ultimate health care inflation rate
- 44 (ultimate trend rate). From the initial year of the calculation until the ultimate
trend starts, the ultimate trend rate can be adjusted and is generally not the same
number for all 4 to 10 years. The initial trend rate may be either greater or less
than the ultimate trend rate.
3.
WW's First Present Value Calculation of Quanex's
Health Care Benefits
WW had the information to perform the present value calculations requested
on or before June 30, 1997, because it had prepared Quanex's FASB 106 report
for TYE 1996.19 By letter dated June 30, 1997, Michael Ringuette, a WW actuary,
sent Royce (in his capacity as Quanex's tax manager) the requested calculations
for FASB 106 (June 30 calculations). The letter stated that the calculations
applied only to people employed by or retired from Quanex as of November 1,
1996, and that WW did not include any additional amounts for employees that
19Later, WW also prepared Quanex's FASB 106 report for TYE 1997. For
purpose of the FASB 106 reports, WW measured the present value of the annual
retiree health care expense as of the first day of the fiscal year; e.g., for Quanex's
TYE 1997 report, the expense was measured as of November 1, 1996. In addition,
usually in the November right after the clo se of the fiscal year, WW made a
subsequent measurement as of October 31 of the just closed fiscal year to
determine the liabilities to be disclosed orj Quanex's yearend financial statements;
e.g., for Quanex's TYE 1997 report, the subsequent expense was most likely
measured in November 1997. During Oct ober 1997, WW knew the assumptions
for TYE 1997 that it would make as to the discount and inflation rates because it
and Quanex discussed those assumptions during that month.
- 45 might be hired later. The letter was the first written product WW gave Royce as a
result of the assignment to compute the present value of the future benefits, and
Quanex knew WW's calculations were estimates. Rose decided which groups of
employees were included in WW's calculations and the length of the term WW's
projections covered. Rose also ratified WW's decisions about what assumptions
were included in the calculations.
WW's June 30 calculations were entitled "Present Value of Active Health
Care Benefits Provided to Employees Hired as of 11/1/96". The calculations
relied on data from Quanex's salaried employees at its Corporate, GST, Heat
Treating, Maesteel (MS)-Michigan, MS-Arkansas, MS-General Office, MST, and
Tube Group Office locations, and from Quanex's hourly employees at its GST,
MS-Michigan, MS-Arkansas, and MST locations.20 The calculations were broken
down by the estimated present value of active health care benefits and of retiree
health care benefits for active employees, on the one hand, and for retired
employees, on the other hand. WW provided the following estimated present
values of the active health care benefits:
20MS was a division of Quanex.
- 46 Location
Current
gmpky_eg
Estimated P.V. of active
health care benefits
35
55
27
1:2
120
30
06
51
496
$2,468,146
3,741,751
2,148,863
8,113,866
8,976,903
2,044,664
4,530,899
3,471,742
35,496,834
2 18
165
2 52
2 22
8 B7
15,799,142
11,399,603
17,479,494
13,164,471
57,842,710
Salaried employees:
Corporate
GST
Heat Treating
MS-Michigan
MS-Arkansas
MS-General Office
MST
Tube Group Office
Total
Hourly employees:
GST
MS-Michigan
MS-Arkansas
MST
Total
The June 30 calculations relied on the following assumptions:
Aging
Initial trend rate
Ultimate trend rate (2004·)
Average cost per
employee (1997 age 40)
Interest rate
2%
9.29%
5.5%
$3,500
7.5%
The accompanying letter stated that the in:erest rate and trend rate assumptions for
the active employee and retiree health care were the same as those used for WW's
"November 1, 1996 FASB valuation (pubHshed February 20, 1997)".
- 47 D.
D&T's Revisions To Proposed Transaction
1.
August 6-7, 1997, Revisions
Quanex and D&T revised the terms of the QHMC transactions according to
information that Royce gave D&T on how the QHMC transactions could be
structured. Upon Quanex's request, by letter dated August 6, 1997, D&T (through
Singer and Schneider) provided Quanex with revisions to the July 30 outline
(August 6 outline). Singer and Schneider prepared the letter together, and Singer
signed the letter and reviewed it before it left D&T. The revisions included an
outline of the proposed capitalization and subsequent sale of QHMC and Quanex
Steel, Inc. (QS), another wholly owned Quanex subsidiary, which the letter
characterized as "part of the overall plan to expand the scope of services of
consultants".
The August 6 outline combined the proposed QHMC transactions into five
steps. Step 1 provided for the reconfiguration of an inactive Quanex subsidiary
(which eventually was QW) through certain substeps that included, among others:
(1) renaming the subsidiary QHMC; (2) amending QHMC's articles of
incorporation to provide for three classes of stock, to wit, class A voting common
stock (class A stock), class B voting preferred stock (class B stock), which the
letter termed "Incentive Equity", and class C voting preferred stock (class C
- 48 stock); (3) providing for voting rights meat ured in terms of ability to elect
directors, and including CS principals or employees on QHMC's board of
directors (QHMC's board) and as officers; (4) providing for dividends on the class
A stock as declared and dividends of 9.5% payable quarterly and cumulative, for
the class B and class C stocks; (5) allowing for the transfer of stock only with the
consent of all shareholders; (6) providing 01at the class A stock be subject to
assessment for capital calls and that the capital call assessment for the class B and
class C stocks be limited to an assumed $1 )0 per share investment price; (7)
providing Quanex or QHMC with call rigl- ts after five years and CS with put
rights after seven years; and (8) providing for a liquidation value of the class B
and class C stocks at an amount equal to tl:e greater of $125 or a formula value
that was based on CS' success in achieving certain performance goals set by
Quanex and on the difference between the value of QHMC's projected and actual
MPB expenses.
Step 2 of the August 6 outline addressed the "Determination of Medical
Liability and Contribution of Note" and stated that the present value of Quanex's
and Piper's medical liabilities had to be determined. The purpose of this step was
to determine which groups of employees would have their contingent medical
liabilities contributed to QHMC. Under tl:is step, Quanex would contribute $45
- 49 million and $44,998,000 worth of contingent liabilities to QS, and Piper would
contribute $2 million and $1.99 million of contingent liabilities to QS. As a
footnote to Quanex's proposed contributions to QS (footnote), the outline stated
that for purposes of the document, "we have assumed that $36 million pertains to
LaSalle and $9 million to MST (and possibly GST)."" This footnote referred to
the anticipated gains on the sales of those assets.
Step 3 provided for CS' purchase of all of the class B stock for $41,700.
Step 4 provided for CS to contribute $6,000 to QHMC in exchange for class C
stock, and for QS to contribute the cash and liabilities it received from Quanex to
QHMC in exchange for class C stock with a net fair market value of $11,000.
Step 5 provided for QS to sell some or all of its class C stock for the same price
per share that CS "paid" for its class C stock.
Royce gave D&T some comments on the August 6 outline, and those
comments were read by Singer, Schneider, and Walt Mooney. Mooney was a
recently hired senior tax manager in the D&T tax department in Houston, and he
In addition to providing Quanex with requested revisions in the August 6
outline, D&T provided Quanex with a chart summarizing the updated steps of the
transaction. According to the chart, Quanex would contribute $35 million and
$34,990,100 of MPBs to QS, and Piper would contribute $10 million and
$9,998,900 of MPBs to QS. The chart made no mention of any cash or MPB
contributions from LaSalle, MST, or GST.
- 50 was assigned to the Quanex engagement to work under Singer, assisting him with
tasks related to the QHMC transactions but without any authority to make material
decisions about the structure of the transactions. Mooney, in consultation with
Singer or Schneider, prepared a memoran< um (Mooney memorandum) with
respect to Royce's comments, and D&T ferwarded a copy of the Mooney
memorandum to Royce on August 7, 1997. The Mooney memorandum stated that
the August 6 outline was incorrect in that QS was to contribute a note to QHMC
along with the liabilities rather than cash. The Mooney memorandum stated in
response to one of Royce's comme nts, "V hy do we need Quanex Steel?", that QS
"creates tax basis in the note."22 The Moo·1ey memorandum did not state that the
footnote in the August 6 outline was, incor rect or otherwise address the footnote.
The Mooney memorandum also ga ve no indication that Royce or anyone else had
commented on the footnote.
In a letter dated August 7, 1997, D&T provided Quanex (through Parikh,
Perry, Rose, and Royce) with revis ions thtt Quanex requested with respect to the
August 6 outline. The August 7 letter proposed the same general structure for the
QHMC transactions as the August 6 outline, but revised step 4 to propose that QS
contribute a $45 million note to QHMC, rather than cash, along with $44,998,000
22At trial, Singer could not (or woull not) explain what this response meant.
- 51 of contingent liabilities. The August 7 letter retained the proposal that Quanex
contribute $45 million and $44,998,000 of contingent liabilities to QS and
included a footnote stating that D&T assumed that $36 million pertained to
LaSalle and $9 million to MST and GST. Singer reviewed and signed the August
7 letter.
2.
August 13, 1997, Revisions and Cashflow Analysis
By a fax transmission dated August 13, 1997 (August 13 fax), Singer sent
Rose a letter with new versions of the proposed transactions that were designed to
overcome what Singer believed was a potential issue with section 1.1502-13(g),
Income Tax Regs. The August 13 fax stated that Singer and Schneider had
"further refined" the transactions as Quanex had requested and included details
with respect to the class C stock.
The primary changes to the transactions as described in the August 13 fax
were the deletion of a provision requiring Piper to contribute cash and liabilities to
QS and the addition of a provision stating that in no event would the formula
value result in the aggregate value of thè class B and class C stocks' equaling or
exceeding 50% of the total value of all çlasses of stock. The August 13 fax
retained the same five general steps as the previous outlines of the proposed
transactions. In addition, the August 13 fax retained the proposed Quanex
- 52 contribution to QS and the accompanying footnote regarding LaSalle, MST, and
GST.
By a second fax dated August 13, 1997 (second August 13 fax), D&T
provided Quanex with two docume nts to a :sist Quanex in its presentations to and
negotiations with CS. One document was 1 checklist entitled "QHMC/QUANEX
TRANSACTION TASK CHECKL (ST FOR CHAPMAN" (checklist). The
checklist retained most of the provisions d scussed in the August 13 fax, but
eliminated those that did not directly addre ss CS' potential role in the transactions.
The second document was a discounted ca shflow analysis (August 13 cashflow
analysis) that D&T used to value all of the proposed classes of QHMC stock as of
October 1997. The August 13 cashflow aralysis assumed, among other things,
that QHMC would hold a $38 milli on note receivable with a 15-year term and that
a $4,714,000 payment, comprising both in:erest and principal, would be made on
the note each year.
The August 13 cashflow analysis projected Quanex's "Cash Flow from
Operating and Investing Activities" over a 15-year period. The analysis projected
that 576 employees would be covered by ()HMC in each year, that interest income
from the note receivable would decrease steadily, and that the projected medical
costs for the covered employees wordd increase steadily. The August 13 cashflow
- 53 analysis projected that the "Cash Flows from Financing Activities (excluding
Dividends)" would consist of 15 annual principal payments on the note in amounts
that increased from $1,294,000 in year 1 to $4,325,000 in year 15 (for total
principal payments of $38 million over the 15-year period) and that positive
cashflow would be available to the equity holders for only the first 6 years. The
analysis projected increasing net operating losses (NOLs) for years 2 through 7.
The relevant specifics of the August 13 projections included the following
amounts (in thousands):23
Interest
income
Medical
costs
Total cashflow
from operating
and investing
Cashflow
Principal
available to
gp_aid equity holders
1
$3,420
2
3,304
3
3,177
4
3,038
5
2,887
6
2,723
7
2,544
8
2,348
9
2,135
10
1,903
11
1,650
12
1,375
13
1,074
14
746
15
389
Total 32,714
($3,193)
(3,470)
(3,748)
(4,026)
(4,298)
(4,561)
(4,812)
(5,077)
(5,356)
(5,651)
(5,962)
(6,290)
(6,635)
(7,000)
(7,385)
(77,466)
$227
(166)
(572)
(988)
(1,411)
(1,839)
(2,269)
(2,729)
(3,221)
(3,748)
(4,311)
(4,915)
(5,562)
(6,254)
(6,996)
(44,753)
$1,294
1,411
1,538
1,676
1,827
1,991
2,171
2,366
2,579
2,811
3,064
3,340
3,640
3,968
4,325
38,000
Year
$1,521
1,244
966
689
416
153
(98)
(363)
(642)
(937)
(1,247)
(1,575)
(1,921)
(2,286)
(2 673)
(6,753)
Cumulative
cashflow
NOL
$1,521
2,765
3,731
4,419
4,836
4,988
4,890
4,528
3,885
2,949
1,701
126
(1,795)
(4,081)
(6 753.)
No D&T
total
$227
(166)
(738)
(1,726)
(3,137)
(4,975)
(7,244)
-0-0-0-0-0-0-0-0No D&T
total
23We DOte some computational er ors in the projections. These errors are
not material to our analysis.
- 54 3.
August 22, 199LRevit ions
By letter dated August 22, 1997 (August 22 letter), Singer sent Parikh and
Royce some documents to assist them in tFeir presentation of the QHMC
transactions to CS. These documents inchaded, among other things, a schematic
diagram of the capitalization of QHMC (and other transfers related thereto), two
examples of CS' potential return on invest nent, another task checklist for CS
(which was nearly identical to the previous CS task checklist), and a proposed
Letter of Intent to be executed by Quanex and CS. The diagram proposed the
following transactions related to QHMC's capitalization: (1) Quanex transfers
$50,000 to QHMC in exchange for class A stock; (2) Quanex transfers $13,000 to
QHMC in exchange for class B stock; (3)Quanex transfers class B stock to CS in
exchange for $13,000; (4) CS transfers $2,000 to QHMC in exchange for class C
stock; (5) QS transfers $38 million and $37,989,000 worth of MPBs to QHMC in
exchange for class C stock; and (6) Piper 1cansfers a $38 million affiliated note to
QHMC in exchange for $38 million. The $37,989,000 assigned to the MPBs was
the present value ultimately assigned to tlu MPBs that were transferred as a part of
the QHMC transactions.
- 55 E.
Quanex's Negotiations With CS
By letter dated September 3, 1997, Singer provided Royce with a set of
documents for WW and a set of documents for CS. Quanex had asked D&T to
prepare those documents for Quanex to gauge CS' and WW's interests in
becoming medical consultants with QHMC.24 D&T prepared the documents with
input from Quanex, and Singer consider d the documents to be part of an effort to
present CS with key points of the transaction.25 The documents contained a
PowerPoint presentation of key deal terms (September 3 presentation), a task
checklist for the investing medical consultant, and the same capitalization diagram
that D&T provided to Quanex in the August 22 letter.
According to the September 3 presentation, CS would provide health
management consulting services, including vendor management for both HMO
and indemnity plans, continue its HMO consulting agreements, receive service
24Sometime during 1997 Ringuette and Clay Cprek, a WW retirement
consultant, attended a meeting in WW's·Southfield, Mich., office where Quanex
(through Parikh, Royce, and possibly Róse) gave WW the opportunity to invest in
what became QHMC. Quanex informed Ringuette and Cprek that the tax aspects
of the QHMC transactions were proprietary and declined to explain the details of
the tax aspects to WW. WW did not in est in QHMC.
25We do not discuss the WW doc ments separately because they do not
differ significantly from the CS documents, and WW did not invest in the
transactions.
- 56 contracts for specific additional projects, and purchase QHMC stock for an equity
stake in QHMC. The terms did not differ significantly from those discussed above
with respect to the August 6 outline and its subsequent revisions. According to
the September 3 presentation, the purpose of the QHMC transactions was to
"reduce Quanex's overall medical costs, v ithout compromising quality of care
provided to employees." The September 3 presentation contained no reference to
the tax aspects of the QHMC transactions .>r to the role that tax aspects played in
structuring the transactions.
The September 3 presentation also i icluded a summary of return-oninvestment scenarios which assurned annu al savings in medical costs of 5%, on
the one hand, and 10%, on the other hand. The example scenarios projected the
following net returns for a five-year invest ment and for a seven-year investment:
Net return
Anmial savi ias of 5%
Annual savinas of 10%
Length of investment
5 Years
7 Years
5 Years
7 Years
If personnel remain constant
$170,502 4295,072
$413,783 $660,073
If personnel increase
5% per annum
for the first 5 years
182 666
313,322
438,111
696,573
If personnel decrease
5% per annum
for the first 5 years
158 338
276,822
389,455
623,572
- 57 Sometime on or before September 10, 1997, Peery again contacted CS about
the potential transactions and to inquire into whether CS would be interested in
participating in them. On September 10, 1997, Chapman and Howard met with
Quanex to discuss the proposal. Quanex proposed all aspects of the structure of
the transactions to CS, including that Quanex's MPB obligations be put in a
separate corporation, and the substance of Quanex's presentation at the September
10 meeting was the same as at the September 3 presentation. Quanex provided CS
with the return on investment example scenarios, but Quanex did not give
Chapman any support for the computations. When CS and Quanex representatives
discussed Quanex's participation in the QHMC transactions, CS was not
represented by counsel, CS was not involved in structuring the relevant corporate
entities or transfers, CS did not determine the QHMC stock's issue price, and CS
did not select the liabilities that were ultimately transferred to QHMC.
Chapman prepared a memorandum for CS' board of directors and officers
dated September 11, 1997 (memo). In the memo, Chapman informed CS' board of
the terms of the proposal and stated that, under the proposal, CS and Quanex
would enter into a joint venture that would be responsible for the cost of Quanex's
benefits program. Chapman also informed CS' board that for a $15,000
investment in QHMC stock, Quanex would guarantee the stock, CS would earn a
- 58 guaranteed annual dividend of 9.5%. and "when Quanex re-acquires the stock it
will be based on its actual value but no les , than $125 per share." Chapman
explained that the stock value would be ca:culated on the basis of actual savings as
compared to actuarial formulas that WW d aveloped. Chapman understood that the
only risk CS faced from participating in th : QHMC transactions was Quanex's
credit risk and that CS, by accepting the puposal, could potentially expand its
business relations with Quanex.
In describing the proposed transactions, Chapman explained that the
number of Quanex employees that CS ser; ed would increase significantly because
CS would have responsibility with respect to approximately 600 salaried nonunion
employees (whose health benefits were induded in the QHMC transactions), in
addition to all other employees at Quanex 'acilities (not included in the QHMC
transactions). Chapman also explained th2t Quanex had 3,900 employees at that
time but planned to sell two divisions with a combined total of 900 employees,
which in turn, Chapman explained. meant that CS would lose the commission
income it was earning on those 900 employees. Chapman stated in the memo that
if CS took part in the joint venture. it would have global responsibility for 3,000
employees, with the 600 salaried/nonunior employees being covered by the
proposed health care arrangement and the remaining 2,400 by CS' standard
- 59 commission schedule.26 Chapman explained that CS would earn an estimated
$50,000 in consulting fees for servicing the QHMC population as well as CS'
standard earnings formula on the nonunion employees whose MPBs would be
transferred to QHMC.
By letter dated September 19, 1997, Parikh informed Chapman that Quanex
was pleased with Chapman's interest in the proposal, that Quanex believed "a
proven employee benefits firm can offer an expertise in the management of
ongoing health costs", and that "Establishing a health management company and
allowing your employee benefits firm an opportunity to participate in its
ownership can prove to be beneficial to all parties." Parikh also stated that
Quanex was still in the process of refining the pool of MPBs that would be
transferred to QHMC.
Parikh included a draft set of working documents with the September 19
letter, and he requested that Chapman provide Quanex with his comments to the
documents "by Friday, September 26, 1997." Parikh emphasized in the letter that
Quanex was on a "tight time schedule" for completing the transactions, as CS
already knew. Parikh wanted the transactions completed by October 31, 1997,
26CS' HMO arrangement with Quanex would therefore not change because
it had always been on a commission basis and remained on a commission basis.
- 60
because he knew that Quanex anticipated a gain from the LaSalle sale and that the
QHMC transactions would result in an artif icial capital loss that could offset the
gam.
F.
WW's Present Value Ca!culati on Revisions
Royce was Ringuette's main contact for most aspects of Ringuette's
assignments related to present value calculttions. Before September 19, 1997, but
after receiving the June 30 calculations, Ro yce directed WW to revise the June 30
calculations without taking into account the Tube Group locations that Quanex
intended to sell. Royce gave WW the Quanex companies to use in the
calculations. In addition, Quanex g ave WW the actual claims activity for the
given locations.
WW had further discussions with Qtanex relating to present value
calculations, and WW gathered more speci fics on the claims experience for the
Quanex locations and performed additiona: present value calculations. On
September 19, 1997, Ringuette sent Cprek and Maureen Cotter, a WW health care
consultant, an email describing a conversa:ion with Royce on September 18, 1997.
Ringuette stated that Royce wanted WW to value all Quanex salaried groups
(except for the Tube Group) and the MS-A rkansas nonunion hourly group and that
- 61 "this calculation will be used to determine the amount of the promissory note to be
given to the medical management subsidiary."
By a letter dated October 13, 1997, that Ringuette prepared and signed, WW
provided Royce with the revised calculations of the present value of lifetime
health care benefits for certain groups of active Quanex employees. Ringuette
stated in the cover letter that the calculations addressed Quanex's corporate, MSMichigan salaried, MS-Arkansas salaried, MS-Arkansas nonunion hourly, MS-
General office, Heat Treating, and Nitro Steel employees. No retirees were
included in the analysis. As Ringuette and Royce had discussed, WW based its
calculations on only those employees employed by Quanex as of October 13,
1997, and did not include any amounts for future Quanex hires.
WW determined the number of active employees and their average age
using November 1, 1996, employee census data provided for the FASB 106
valuation performed as of that date, and WW assumed the number and average age
of employees in each division from November 1, 1996, to November 1, 1997,
would not change. WW also projected the assumed number of employees
remaining in future years and their average age using assumptions used for the
November 1, 1996, FASB 106 valuation, and WW assumed the average cost of
health care would increase in future years in accordance with the following
- 62 assumptions: "2.0% increase in cost for each/year increase in average age" and
"8.75% inflation in 1998, decreasing linearly over time to 5.50% in 2004 and
remaining at that level thereafter (s ame as FASB Statement No. 106 assumption)."
The 2% aging assumption was chosen on t he basis of data WW had collected on
health care costs for many different health care plans and was used, in part,
because WW wanted to reflect that some o f the groups had a higher average age
than others and might have corresponding higher health care costs. Ringuette
used the 8.75% initial trend to project the ricrease in the average health care costs
per person from November 1, 1997, throut h October 31, 1998, to November 1,
1998, through October 31, 1999.
WW also assumed an average health care cost per employee of "$5,877
(1998 Age 40)", which represented the es imated health care cost per employee
included in the present value calculation for TYE 1998, adjusted to assume an
average age of 40, and a 7.5% interest rate to discount future cashflows to
November 1, 1997. WW included with th j October 13 letter a chart entitled
"Development of Average Health Care Cost Per Active Employee", which showed
how WW arrived at its $5,877 assumption
- 63 WW's October 13, 1997, "Present Value of Active Health Care Benefits
Provided to Employees Hired as of 11/1 97" calculations were as follows:"
Location
Corporate
Heat Treating
MS-Michigan
MS-Arkansas
MS-General
Office
Nitro Steel
Total
Estimated Present Value
Number of Avg.
Avg.
Active Retiree Health Care Benefits
employees attained retirement health care
Active
Retired
tjglay
age
age
benefits
employees employees
Grand
total
35
27
112
120
46
35
45
42
63
63
63
63
$3,792,243
3,302,078
12,469,349
13,796,098
0
0
0
0
0
0
0
0
$3,792,243
3,302,078
12,469,349
13,796,098
30
13
337
47
46
43
63
63
63
3,142,329
1,337,608
37,839,705
0
0
0
0
0_
0
3,142,329
1,337,608
37,839,705
At various times from approximately a week or two after receiving the
October 13 report through early 1999, Royce asked WW to change its present
value calculations to, for example, (1) include the MS-Arkansas nonunion hourly
information in the present value calculation, (2) change the lifetime until
retirement projection to a 15-year projection for estimated present value, and (3)
exclude the Heat Treating and Nitro Steel Divisions in the groups of employees.
G.
Patrick Wannell
1.
Background
Patrick Wannell is a chartered engineer and an Institution of Metallurgists
fellow. He received his formal education and professional training in England,
"We note that the average attained age is actually 43.5. The discrepancy
does not affect our analysis.
- 64 and he worked for approximately 20 years primarily in technical positions for a
large integrated steel company in England. He later joined LaSalle in the summer
of 1980 and was given a range of managen ent responsibilities. He became
LaSalle's vice president and general mana; er in May 1991, and he worked in that
capacity until he retired in February 1997. After LaSalle was sold in April 1997,
Wannell consulted for LaSalle's new owners for approximately one year to help
them understand LaSalle's operations, and he performed one other consulting
project for Quanex, primarily reviewing dccuments related to the sale for
accuracy. Neither consulting project dealt with medical expenses.
2.
Wannell and Hegith Ca -e Costs at LaSalle
While working for LaSalle, Wannel: believed that the business was "clearly
struggling" because it was breaking even f nancially. He reviewed the business
and concluded that LaSalle's health care costs were high in relation to those of
other Quanex divisions and were rising annually by approximately 30%. He
formed a two-step approach to reduce LaS tlle's health care costs. First, he
renegotiated the health care contract for LaSalle's hourly employees because it did
not require an employee payment. Second, he developed a wellness program that
looked at the causes of employees' illnesses rather than the employees' symptoms.
The wellness program addressed is sues (such as weight, diet, exercise, stress, and
- 65 smoking) through, among other things, annual physicals, exercise facilities, and
subsidized health club memberships. When Wannell retired, LaSalle had
approximately 450 employees, and LaSalle's health care costs were declining by
approximately 10% per year.
3.
Quanex's Offer to Wannell
Rose had known Wannell since 1982 and was familiar with his efforts to
control health care costs at LaSalle. By letter dated October 13, 1997, Rose asked
Wannell to join QHMC's board as a director. The letter stated:
We are establishing a company to manage our health care benefits
and selling a minority interest to a benefits management consulting
firm. We believe giving the consulting firm an equity interest will be
an extra incentive for them to come up with creative and innovative
strategies in health care management. Since this is a new concept we
will start small and try this out on Corporate and MACSTEEL
salaried employees health benefits only. * * *
Further, the letter stated, Quanex wanted Wannell to join QHMC's board because
We need your knowledge and experience in the areas of labor
relations, negotiations, employee management, and morale. This
company will manage the health care benefits of employees. We
want it to be efficient as possible but also fair to the employees it will
effect [sic]. We need an outside director who will bring a balance to
the discussion and consider all points of view, not just those of * * *
[QHMC] or * * * [CS].
On or about October 20, 1997, after the negotiations between Quanex and
CS were completed, Wannell spoke with Rose by telephone. During that call,
- 66 Rose offered Wannell the opportunity to ir:vest $11,000 in QHMC. Peery,
Quanex's vice president of human resources, did not know that Rose was inviting
Wannell to participate in QHMC, and Peery was not asked for his advice or
recommendation on individuals who miglr be interested in participating.
Wannell expressed concern that he would have to incur travel and hotel
costs for QHMC board meetings, burt Rose assured Wannell that the costs would
be reimbursed, meetings would be minima:, and Wannell could vote by fax. Rose
also informed Wannell that although the t< nn of the investment would be 15 years,
the parties could unwind the investment irí either 5 or 7 years. Wannell made
handwritten notes during the call that exprassed, in part, his understanding of the
worst case scenarios for his offered investment. Under the heading "worst case",
Wannell made three entries: "9.5%/yr", v iich reflected his understanding of the
annual dividend he would receive; "no los ( of $11,000", which reflected his
understanding that he would not lose his investment;28 and "+ 25% over 5 yrs",
2sIn contradiction to his notes, Wanrell testified that he did not consider the
risk to be zero that he would lose h is $11,C00 investment. We do not find this
testimony to be credible, and we decline to rely upon it.
- 67 which reflected his understanding that his investment would grow 5% each year to
the five-year point where Quanex could wind things up.29
Wannell accepted Rose's October 20, 1997, offer to invest in QHMC the
same day. The terms of Wannell's investment were set by Quanex, without any
negotiations between Quanex and Wannell. Wannell viewed the dividend
payments as approximately equivalent to consultant fees for his time and the fiveyear, total $25 per share return on his $100 per share investment as equivalent to
what he was earning in his bank account. Wannell understood that QHMC's
credit risk was minimal because it was a subsidiary of Quanex.
H.
D&T's Revised Cashflow Model
D&T prepared revised cashflow calculations for Quanex for the proposed
transactions and gave them to Royce in a document entitled "Cash Flow Model as
of 10/21/97" (October 21 calculations). The purpose of these calculations was to
model the liabilities QHMC would need to satisfy, the payments QHMC would be
obligated to make, and the income QHMC would need to pay the liabilities. The
29If the class C shares were redeemed after five years for $125 per share, the
holders of each share would receive $25 more than the $100 initially paid to
purchase the share, which averages to $5 per year or 5% of $100 for each of the
five years.
- 66 calculations also were needed to se t the rer>orted fair market value of QHMC's
stock.
Within the October 21 calculations, D&T estimated the present value for the
medical costs associated with Quanex's cerporate, MS-Arkansas, MS-General
office, and Nitro Steel locations to total $37,320,000, as determined as follows:
Location
Corporate
MS-Arkansas
MS-Arkansas
MS-General Office
Nitro Steel Division
Total
Grand total of PV
Cashflows 1997
Employees
as of 10/21/97
$3,496,000
11,051,000
18,421,000
3,062,000
1,290,00,
37,320,000
$420,000
86,000
470,000
457,000
128,000
1,561,000
35
27
112
120
30
324
D&T also projected that for all years of tlm investment, other than the first year,
medical costs would exceed the interest income from the $38 million note
receivable but, taking into account the principal repayments, cashflow would be
available to equity holders for the first se3 en years of the investment and NOLs
would accumulate in years 2 through 6 of the investment. D&T also projected
positive net present value of the cashflows. Relying on these factors and others,
D&T projected that the total value of equity for all classes of QHMC stock would
equal $76,000, as determined as follows:
- 69 Total PV of cashflows
Plus: Cash on hand
$879,000
65,000
Less: Uncertainty of future
medical costs adjustment
Equals: Total value of equity
(868,000)
76,000
Within the October 21 calculations, D&T also projected liquidation and net
return values with respect to QHMC's preferred stock. D&T projected that if the
five-year call option was exercised and a five-year cumulative savings of
$1,622,959 was assumed, the liquidation value of the class B and class C stocks
would be $356,441 and the net return orì investment for the underlying
shareholders would be $348,566. D&T projected that if the seven-year put option
was exercised and a seven-year cumulative savings of $2,430,142 was assumed,
the liquidation value of the class B and class C stocks would be $565,998 and the
net return on investment for the underlying shareholders would be $560,973.
D&T also made cumulative savings projections for 1998 through 2012 as follows
(in thousands):
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Initial
undiscounted
MPBs
$2,793 $3,017 $3,245 $3,473 $3,701 $3,927 $4,145 $4,358 $4,569 $4,792 $5,025 $5,270 $5,527 $5,797 $6,081
Actual MPBs
2,514 2,715 2,921 3,126 3,331 3,534 3,731 3,922 4,112 4,312 4,523 4,743 4,975 5,217 5,473
Yearly savings
279
302
325
347
370
393
415
436
457
479
503
527
553
580
608
Aggregate yearly
cum. savings
279
581
905 1,253 1,623 2,016 2,430 2,866 3,323 3,802 4,305 4,832 5,384 5,964 6,572
The projections assumed a 10% variance factor and 324 covered plan participants
per year.
- 70 D&T also included in its October 21 calculations a section entitled
"Analysis of NOL Usage" for 1998 through 2004. D&T included this section to
show Quanex the amount of NOLs that QH MC would generate but that the
Quanex consolidated group could not use if QHMC were deconsolidated. The
NOL projections assumed a 6% risk-free rate and a 40% tax rate and were as
follows (in thousands):
NOL generated
NOL carryforward
1998
1999
2000
2001
2002
2003
2004
-0-0-
$276 $622
276 897
$976
1,873
$1,339
3,213
$1,710
4,923
$2,086
7,009
309
400
482
555
PV of annual
NOL tax benefit
-0-
98
209
Cumulative PV of NOL benefits (as rounded) at the end of year 7
2,054
At a time not disclosed in the record. Royce reviewed the October 21
calculations. Royce subsequently requeste d new calculations from both D&T and
WW. Royce testified at trial that the October 21 cashflow model used the wrong
groups of employees and assigned the wrong numbers of employees to those
groups.
- 71 XI.
Executing QHMC Transactions
A.
,
Quanex's October 21-22, 1997, Board Meeting
On October 21 and 22, 1997, Quanex's board held a regular meeting which
addressed, in part, the QHMC transactions. The meeting was attended by
Quanex's board members and, among others, Peery, Rose, James Davis, and
Michael Conlon. Davis was Quanex's executive vice president and chief
operating officer (COO) from 1997 through February 1999 and Quanex's
president and COO from March 1999 through December 2000. Conlon was an
attorney with Fulbright & Jaworski, LLP (Fulbright).
At the board meeting, Rose explained the venture, which the meeting
minutes described as
a proposal to establish one of the Company's subsidiaries as the
holder of all rights and obligations of the medical plan benefits for the
Company's active salaried employees at its corporate offices in
Houston and within the MacSteel Group * * * and to enter into a
relationship with a professional health plan advising firm, * * * [CS),
to create incentives to reduce the overall health plan costs to the
Company.
Rose provided materials to Quanex's board through which the participants of the
meeting discussed the general nature of the proposed transactions and the various
resolutions needed to implement them.
- 72 Under the proposed resolutions,,Quenex would effect the QHMC
transactions through a series of steps, each of which was part of a single plan, and
all of which Rose considered interrelated. These steps were as follows:
(1) designate QS and QW as restrici ad subsidiaries under the Quanex
$250,000,000 revolving credit and tenn loan agreement dated July 23, 1996, as
amended (revolving credit agreement);3°
(2) ratify the actions of Quanex's of icers in amending the revolving credit
agreement to provide for the designation of certain subsidiaries as restricted
subsidiaries if Quanex owned an interest in the subsidiary of as little as 60%;
(3) approve, as QW's sole shareholder, QW's plan of recapitalization, which
provided for authorization of stock in the 1orm of the class A stock, the class B
stock, and the class C stock;
(4) approve and adopt QW's amend ad and restated certificate of
incorporation, by which QW changes its n1me to "Quanex Health Management
3°In this context, a restricted subsidiary is a Quanex subsidiary that
guarantees a debt of Quanex and consolidates its funds with those of Quanex in
accordance with Quanex's revolving credit agreement. Royce believed that
QHMC had to be a restricted subsidiary of Quanex to participate in the
transactions. QHMC eventually (on a date not disclosed in the record) guaranteed
the obligations of Quanex pursuant to the revolving credit agreement.
- 73 Company, Inc." and changes its authorized capital as described in the plan of
recapitalization;
(5) approve and acknowledge that as a result of QW's recapitalization, the
1,000 shares of QW common stock that Quanex held would be converted to 500
shares of class A stock and 130 shares of class B stock;
(6) make a $62,000 capital contribution to QW in anticipation of QW's
recapitalization;
(7) assign all of its rights, duties, and obligations relating to approximately
$37,989,000 of selected MPBs to QS;
(8) transfer $38 million and assign its rights, duties, and obligations relating
to all the selected MPBs in exchange for 1 share of common stock and the
assumption of the duties and obligations under the MPBs;
(9) enter into an assignment and assumption of liabilities agreement with
QS under which rights related to MPBs would be assigned to QS and related
duties and obligations would be assumed by QS;
(10) enter into a consulting agreement with CS pursuant to which CS would
agree to assist Quanex in evaluating and implementing cost-saving strategies with
respect to health care plans for the benefit of certain employees of Quanex for an
hourly fee, and Quanex would agree to sell to CS an equity interest in QHMC,
- 74 with Quanex having the right to purchase from CS the shares representing the
equity interest after five years and CS havmg the right to sell those shares to
Quanex or QHMC after seven years at a pr ice calculated on the basis of a formula
value but not less than $125 per share;
(11) sell its 130 shares of class B steck that it would hold as a result of the
recapitalization of QHMC to CS for a $13 000 cash payment;
(12) enter into a stock purchase agreement between Quanex and CS with
respect to its proposed sale of the class B s tock to CS;
(13) upon its sale of the class B stoc k to CS, enter into a shareholders
agreement among QHMC, CS, and Quane1 providing for restrictions on the
disposition of QHMC stock, and agree, as the holder of the class A stock, to
provide QHMC with additional capital to pay for any forecasted cash shortfalls, as
determined by QHMC's board;
(14) upon issuance of QHMC's clan C stock to QS and CS, enter into a first
amendment to shareholders agreement to reflect additional stock issuances; and
(15) upon QS' subsequent sale of the class C stock to another investor, enter
into an amended and restated shareholders agreement to reflect the additional
investor.
- 75 Also at the meeting, Rose explained the tax benefits of the transactions to
Quanex's board, informing the board that the transactions would generate a large
artificial capital loss.31 On October 22, 1997, Quanex's board unanimously
approved all of the proposed resolutions. As of that time, Quanex intended to sell
the class C stock to Wannell.
B.
October 23, 1997
1.
QW Recapitalization
Before October 17, 1997, QW was a Delaware corporation that was an
inactive, wholly owned subsidiary of Quanex. QW had assets of $1,000 in cash,
no liabilities, and 1,000 outstanding shares of capital stock. On October 17, 1997,
Quanex wired $62,000 into QW's account at Comerica Bank in anticipation of
QW's recapitalization.
Six days later, on October 23, 1997, Quanex approved QW's plan of
recapitalization, and QW was recapitalized. Under that plan of recapitalization,
QW was authorized to issue 760 shares of capital stock, of which 500 shares were
class A stock, 130 shares were class B stock, and 130 shares were class C stock.
All 760 shares had a par value of $100. Under the plan of recapitalization,
Quanex, as record holder, was to receive 0.5 shares of class A stock and 0.13
Rose knew that the loss was not an actual economic loss.
- 76 shares of class B stock for each sha re of QW common stock that Quanex held
before the recapitalization.
Also on October 23, 1997, Q W's be trd unanimously consented to the plan
of recapitalization. QW's directors were R ose, Peery, and Vernon Oechsle.
Oechsle was Quanex's president and chief executive officer (CEO) from 1997
through February 1999, Quanex's CEO frc in March 1999 through February 2001,
Quanex's vice president from March throu gh July 2001, and Quanex's corporate
initiatives executive from August 2001 thr >ugh May 2002.
2.
Amendment and Restat ament of QW's
Certificate of Inno2po_r; tion
a.
Background
Also on October 23, 1997, QW was renamed QHMC (incident to the
recapitalization) and its certificate of incorporation was amended and restated
(certificate) to provide for the three classen of stock." The certificate set forth
rights on dividends, liquidation preference3, voting, and the right to call or put
shares.
32We hereinafter refer to QW as QHMC with respect to events that occurred
after the name change.
- 77 b.
Dividend Rights
Under the certificate, QHMC's board generally could declare dividends on
class A stock as it deemed appropriate. As one exception, a dividend could not be
declared or paid on the class A stock during any period when QHMC failed to pay
a dividend on the class B or class C stock for any preceding quarter. The class B
and class C shareholders were entitled to receive from QHMC's surplus or net
profits, when and as declared by QHMC's board, cash dividends of $9.50 per
share per annum, payable quarterly. The cash dividends for the class B stock were
cumulative and payable for the current year and for all previous fiscal years during
which any class B stock was outstanding (and applicable quarters thereof). The
same was true for the class C stock when any class C stock was outstanding. If
QHMC's available funds were insufficient to pay the dividends on the class B or
class C stock, then the class B and class C shareholders would share ratably in the
amount available for payment in proportion to the full dividend payment to which
they were otherwise entitled. The class B and class C shareholders were not
entitled to receive any dividends or share of profits, whether payable in cash,
stock, or property, in excess of these dividends.
- 78 c.
PreferencesJlp_on Liquidation
If Quanex was liquidated, class A sl areholders were entitled, after payment
of all liabilities, and subject to the liquidat:on preferences of the class B and class
C stocks, to receive QHMC's assets on the basis of the number of shares held.
The liquidation preferences of class B shareholders were as follows:
In the event of liquidation, dissolution, or winding up [collectively,
liquidation] of the Company. whether voluntary or involuntary, the
holders of the issued and oulstandin Class B Voting Preferred Stock
shall be entitled to receive out of the assets of the Company legally
available for distribution to stockho ders and before any distribution
to the holders of the Class A Comman Stock liquidation distributions
in an amount equal to the greater of (i) $125 for each share or (ii) the
Formula Value * * * for each share. plus all accrued but unpaid
dividends thereon to the date fixed f or redemption. After payment of
the full amount of the liquidating di tributions to which they are
entitled, the holders of shares of Cla ss B * * Stock will have no right
or claim to any of the remaining ass ts of the Company.
Class C shareholders had the same rights as those provided to class B
shareholders.
The certificate defined the formula value (formula value) as the lesser of:
(a) 45% of (i) the sum of the saving i or deficiency of the Initial
Undiscounted Medical Plan Benefi1 ; ("IUMPB" * * *) over the
Actual Medical Plan Benefi1s ("AMPB" * * *) for each completed
fiscal year, commencing with the fis cal year ending October 31, 1998,
divided by (ii) the total number of outstanding shares of Class B
Voting Preferred Stock and Class C Voting Preferred Stock on the
applicable date of the event of liquidation, dissolution or winding up
of the company, or (b) 50% of the nat equity shown on the books and
- 79 records of the Company as of the calendar month immediately
preceding that date (as determined in accordance with generally
accepted accounting principles). * * *
The certificate defined "AMPBs" as the actual medical plan benefits paid by
QHMC to participants in medical benefil plans that QHMC managed during the
applicable fiscal year and "IUMPBs" as the medical plan benefits as computed for
purposes of the net present value of the expected cashflows of QHMC as of
October 31, 1997, determined in accordance with the cashflow model used by
D&T to value QHMC on October 31, 1997." The certificate stated that the
savings or deficiency of the IUMPB over the AMPB would be determined for each
of QHMC's fiscal years and computed as follows:
(A) The difference between (a) an amount (which may be a positive
or a negative number) equal to (i) he IUMPB divided by the number
of the assumed covered plan participants, reduced by (ii) the AMPB
for the applicable fiscal year divided by the number of the actual
covered plan participants for that year, multiplied by (b) the number
of actual covered plan participants for that year, and (B) the amount
of consulting fees paid or accrued by the Company during the
applicable fiscal year. * * *
The certificate also stated that the formula value would be zero if the
formula value of the total number of shares of the class B and class C stock was
less than zero, or if the date of liquidation occurred before October 31, 1998. The
33QuaneX would bear all medical costs in excess of these benchmark
amounts; i.e., the QHMC preferred shareholders would never bear these costs.
- 80 certificate also stated that upon QHMC's hquidation, the class B and class C
shareholders would share ratably in any di;tribution of assets in proportion to the
full liquidating distributions to which the3 would otherwise be entitled if QHMC's
available assets were insufficient to pay the liquidation distributions on all
outstanding shares of class B and class C ttock.
d.
Voting :Righ_ß
Under the certificate, each share of QHMC stock entitled the holder to one
vote in all proceedings in which action mi ;ht be taken by the QHMC shareholders.
If any share of class B or class C stock wa ; issued and outstanding, class A
shareholders had the right to elect six dire ators of the company, class B
shareholders had the right to elect two directors, who would be designated class B
directors, and class C shareholders had the right to elect one director, who would
be designated a class C director. Class A shareholders had the right to elect all of
QHMC's directors if no class B or class C shares were issued and outstanding.
e.
Call Righn
The certificate did not provi de any :-edemption rights for class A stock. The
certificate did provide redemption rights f or the class B and the class C stocks, and
these rights were the same for both classe :. At any time after September 30, 2002,
QHMC could redeem any or all shares of class B and class C stocks by paying
- 81 cash equal to the greater of (i) $125 per share or (ii) the formula value per share,
plus an amount equal to all distributions accrued and unpaid thereon to the date
fixed for redemption. For this purpose, any reference in the formula value to the
"date of liquidation, dissolution or winding up of the Company" would be
replaced with a reference to the "Notice Date".
f.
Put Rights
The certificate did not provide any put rights for class A shareholders. The
certificate did provide put rights for the class B and class C stocks, and these
rights were the same for both classes. After September 30, 2004, each holder of
class B or class C stock could require QHMC to purchase from the holder all or
any portion of the shares of class B stock or class C stock at a cash price equal to
the greater of (i) $125 per share or (ii) the formula value per share, plus an amount
equal to all distributions accrued and unpaid thereon to the put date. For this
purpose, any reference in the formula value to the "date of liquidation, dissolution
or winding up of the Company" would be replaced with a reference to the "Put
Date".
- 82 3.
Quanex's Transfe;r of Q W Stock and Cash to QHMC in
Exchange for Class A avid Class B Stocks and
Election of Dire ctors
On October 23, 1997, Quane x transjerred the $62,000 that was previously
wired into QW's bank account and 1,000 s hares of QW common stock to QHMC
in exchange for 500 shares of class A stock and 130 shares of class B stock. Also
on October 23, 1997, Quanex, as QHMC's sole class A and class B shareholder,
elected Oechsle, Peery, Rose, Parikh, Wan 1ell, and Carolyn Babb34 as QHMC's
class A directors, and Gary Hellner and Be wley as QHMC's class B directors.
Also on October 23, 1997, Hellner and Be .vley informed QHMC they were
resigning effective the same day, doing so through a one-page document that
apparently had been typed for each of thern simply to sign and to date. The text of
each document contained a single sentence which stated: "The undersigned hereby
resigns as a Class B director of Quanex He alth Management Co., Inc., a Delaware
corporation, such resignation to be effectiv e as of the date set forth under my
signature below."
34Babb was Quanex's compensation and benefits manager from 1997
through July 1999, and she was Quanex's compensation and benefits director from
August 1999 through the time of trial.
- 83 4.
Quanex's Transfer of Cash and MPB Obligations to
QS in Exchange for QS Stock
QS was incorporated in 1990 as a wholly owned subsidiary of Quanex, and
QS remained as such until October 23, 1997. Before October 23, 1997, QS was an
inactive corporation and had assets of $1,000 in cash, no liabilities, and 1,000
shares of outstanding capital stock. Under QS' certificate of incorporation, dated
August 7, 1990, QS was authorized to issue 10,000 shares of common stock.
As of October 23, 1997, in exchange for 1 share of QS capital stock,
Quanex transferred $38 million to QS and assigned to QS certain obligations
relating to certain MPBs. Under an exchange agreement bearing the same date,
Quanex and QS agreed to treat the exchange as one described in, and qualifying
for nonrecognition treatment under, section 351. Parikh, as Quanex's corporate
controller and as QS' vice president and treasurer, signed the Quanex-QS
exchange agreement on behalf of both parties.35
The transferred MPBs were health care benefits provided under the plan,
and they represented the future medical costs of active Quanex employees working
in selected groups during the 15-year period beginning November 1, 1997, and
"Approximately 4 years later, on February 20, 2001, QS' board of directors,
consisting solely of Oechsle and Terry M. Murphy, ratified the actions that QS'
corporate officers took to execute the exchange agreement and to issue the share
of QS stock.
- 84 ending October 31, 2012. An assignment ,md assumption of liabilities agreement
executed between Quanex and QS on Octe ber 23, 1997, and signed by Rose on
behalf of both Quanex and QS, described the transferred obligations as "relating to
those MPB's computed for purposes of the net present value of the expected
cashflows of Assignee [QS] as of October 31, 1997, determined in accordance
with the cash flow model which was used by Deloitte & Touche LLP to value the
Assignee [QS] on such date".
C.
October 24, 1997
1.
Consulting Agrexment Between Quanex and CS
Quanex and CS entered into a constlting agreement dated October 24, 1997
(consulting agreement). Under the consul:ing agreement, CS agreed to review the
costs and benefits of the health care plans that Quanex maintained and
administered for the benefit of the active ularied employees from Quanex's
Corporate, MS-General Office, and MS-Michigan locations, and both active
salaried and nonunion hourly employees f om MS-Arkansas, and to recommend,
among other things, "several * * * potential cost saving strategies ('Strategies') for
the Plans, the implementation of which coald result in substantial cost savings to
Quanex." Quanex and CS also agreed tha t it would be in their respective best
interests to provide CS a means of compensation that (1) took into consideration
- 85 the potential value added by CS' services in the successful implementation of the
cost saving strategies, (2) gave CS a voice in QHMC's management, and (3)
required CS to maintain a fmancial risk in QHMC. Under the consulting
agreement, Quanex thus agreed to hire CS to assist Quanex
in evaluating and implementing the Strategies, including, but not
limited to reviewing, analyzing, and making recommendations
regarding the Strategies and other relevant cost-savings measures,
advising Quanex regarding the operational, organizational and
governance aspects of the Company, serving on the board of directors
of the Company, negotiating with third-party administrators, assisting
in the request for proposal ("RFP") process with potential outside
vendors, claims administration, enrollment, benefits coordination, and
any other services as requested from time to time by Quanex during
the term of this Agreement.
Pursuant to the consulting agreement, CS was entitled to consulting fees in
accordance with CS' benefits consulting fee schedule, but in no case more than
$250 per hour, plus reasonable out-of-pocket costs actually incurred. The
consulting agreement also entitled CS to buy "more than a 20% limited equity
interest" in QHMC from Quanex, QHMC's sole shareholder as of the time of the
consulting agreement, subject to CS' entering into a shareholder agreement with
Quanex. The consulting agreement further stated that in the event the put or call
rights described in the certificate were exercised, the price CS would be paid for
the equity interest would equal the greater of $125 per share or the formula value.
- 86 Although CS executed a consulting agreement with Quanex,36 no such
agreement was executed between CS and QHMC between 1997 and 2002. Before
October 31, 1997, Howard did not receive requests from Quanex for advice on the
QHMC project, see any WW reports for the QHMC proposal, or review any
assumptions with respect to the proposal.
2.
CS' Transfer of Cash to Quanex in
Exchange for Class B Stock
Before October 23, 1997, Quanex offered CS the opportunity to purchase
(1) 130 shares of the class B stock from Quanex for $13,000 and (2) 20 shares of
the class C stock from QHMC for $2,000. Chapman did not consider the $15,000
cost for the QHMC stock ($13,000 for class B stock plus $2,000 for class C stock)
to be a material amount of money for CS.
On October 24, 1997, CS purchased 130 shares of class B stock from
Quanex for $13,000," and Quanex and CS signed a stock purchase agreement of
the same date. That agreement described the class B stock the same way the class
36CS was still responsible for negotiating Quanex's HMO contracts as of the
time of trial.
"Because of Singer's concerns regarding deconsolidation, Singer structured
the QHMC transactions so that Quanex's interest in QHMC and Quanex's voting
power with respect to QHMC would be less than 80%. Accordingly, on October
24, 1997, the date CS purchased the class B stock from Quanex, QHMC ceased to
be a member of petitioners' affiliated group for Federal income tax purposes.
- 87 B rights were described in the certificate and included a copy of the certificate as
an attachment thereto.
Quanex, QHMC, and CS also entered into a shareholders' agreement dated
October 24, 1997 (October 24 shareholders' agreement). Parikh executed the
October 24 shareholders' agreement as Quanex's controller and as QHMC's vice
president and treasurer. John Micale, who as of the time of trial had been a CS
employee for approximately five years, signed the agreement as CS' president and
COO.
Under the October 24 shareholders' agreement, Quanex and CS agreed that
they would not transfer their QHMC stock or permit it to be transferred without
the express written consent of all QHMC shareholders. Quanex also agreed that,
as the holder of QHMC's class A stock, it was subject to assessment for capital
calls as determined by QHMC's board, and it acknowledged that "The Board shall
assess the holders of shares of Class A Common Stock in the event that the Board
determines that * * * [QHMC] will have a Forecasted Cash Shortfall for any
calendar quarter." The October 24 shareholders' agreement defined a "Forecasted
Cash Shortfall" as "the excess, if any, of forecasted cash expenditures (including a
reasonable reserve for future expenditures and dividends on the Class B Voting
Preferred Stock and Class C Voting Preferred Stock, as determined by the Board)
- 88 over forecasted cash receipts, determined with respect to any calendar quarter."
No such provision was made with respect to class B or class C shareholders.
The October 24, 1997, QHMC stock purchase was the first time CS
acquired an equity interest in a clierrt. Chapman believed that CS' participation in
the QHMC transactions would both contin ae and expand CS' consulting
relationship with Quanex and give CS the potential to earn fee-based revenue.
3.
Class B Directoni
On October 24, 1997, CS (through Micale) elected Chapman and Micale as
QHMC's class B directors.
D.
October 25, 1997
1.
CS' Transfer of Cash to OHMC in
Exchange for Class C btock
As of October 25, 1997 (a Saturday », CS contributed $2,000 to QHMC in
exchange for 20 shares of class C stock. ('S was not involved in setting the price
of the class C stock (or the class B stock). Although CS purchased both class B
and class C stocks, it made no diffbrence 1a CS which class of preferred stock it
acquired.
- 89 2.
QS' Transfer of Cash and MPBs to QHMC in
Exchange for Class C Stock
Also as of October 25, 1997, QS contributed $38 million to QHMC, and by
an assignment and assumption of liabilities agreement dated October 25, 1997
(QS-QHMC assignment and assumption agreement), QS assigned to QHMC the
MPBs Quanex had assigned to QS by agreement dated October 23, 1997. Parikh,
as vice president and treasurer of each entity, signed the QS-QHMC assignment
and assumption agreement on behalf of both QS and QHMC. An October 25,
1997, exchange agreement executed between QHMC and QS described the
transferred MPBs as "certain medical plan benefits (MPB's), being those MPB's
computed for purposes of the net present value of the expected cash flows of * * *
[QHMC] as of October 31, 1997, determined in accordance with the cash flow
model * * * which was used by [D&T] * * * to value [QHMC] on such date."
Quanex had not deducted the medical costs represented by the MPBs transferred
to QHMC. If Quanex had retained the MPBs, the MPBs would have been an
expense of Quanex's trade or business; and if Quanex had paid the MPBs as they
were incurred, Quanex could have deducted the payments as ordinary and
necessary business expenses.
- 90 In return for the cash and MPBs assamption, QS received from QHMC 110
shares of class C stock. Upon becoming a QHMC shareholder, QS signed a first
amendment to shareholders' agreement (ainended shareholders' agreement), dated
October 25, 1997, through which QS agreed to become a party to the October 24
shareholders' agreement. QHMC and QS also agreed to treat this exchange as one
qualifying for nonrecognition treatment urder section 351. The amended
shareholders agreement was signed by Ro .e on behalf of QS, Quanex, and
QHMC, as vice president of each entity, and by Micale as the president and COO
of CS.
3.
MPB Selection
The selected employee groups cove -ed by the MPBs that QHMC transferred
were the following active Quanex employaes located at petitioners' facilities:
Location
Group
No. of employees'
Houston
Corporate
37
Arkansas
MS-Salaried
117
Arkansas
Michigan
MS-Nonunion h aurly
MS-General office
249
31
Michigan
Total
MS-Salaried
112
546
1This column lists the numbe,: of active employees working in
the identified groups as of October l997. The actual number of
employees covered by the MPBs cculd fluctuate during the 15-year
period that QHMC assumed the obligation to pay the MPBs.
- 91 The identified employee groups were considered a part of Quanex's core
businesses and were nonunion when they were selected (although not all of
Quanex's nonunion employees were selected). The health benefits of Quanex's
union employees were subject to union contracts. Quanex could not unilaterally
change the terms of the union contracts, which usually spanned 3 to 4 years, and
Quanex's primary opportunity to reduce health care costs subject to those
contracts was upon their renewal. Quanex was not so restrained regarding
nonunion employees.
Both Royce and Rose were involved in the MPB selection process,38 and
Royce determined which groups' MPBs would be included in QHMC on the basis
of WW's June 30, 1997, present value calculation. Peery, Quanex's vice president
of human resources, made no recommendation about which groups of employees
should have their MPBs transferred to QHMC. Peery also made no specific
recommendation regarding which types of health care benefits should be included
in the QHMC transactions. Parikh also
as not involved in selecting which
employee groups would have their MPBs transferred to QHMC. The only Quanex
38Rose testified that he chose the t¡ransferred liabilities and that, rather than
making a decision about the amount of the liability Quanex was willing to transfer,
he first decided which liabilities would be transferred to QHMC and then had WW
assign a value to those liabilities. We do not find Rose's testimony on this point
credible, and we decline to rely upon it.
- 92 -
employees who were notified that Quanex had assigned the designated health care
benefit obligations to QHMC were the Quanex employees who worked on the
QHMC transactions and the accounting thurefor.
Wannell, who was invited to participate in the QHMC transactions allegedly
because of his experience managing LaSa).e's health care costs, also played no
part in deciding which MPBs would be tra isferred to QHMC. No one asked
Wannell for any recommendation specific to the MPB obligations either before or
after he agreed to invest in QHMC.
4.
Class C Director
On October 25, 1997, QHMC's clas : C shareholders elected Davis to be the
class C director.
E.
October 28, 1997: OF{MC's ' 'ransfer of Cash to
Piper in Exchange for Promis .ory Note
On October 28, 1997, QHMC transí 3rred the $38 million it received from
QS to Piper, and Piper issued to QHMC a promissory note (Piper note) in return.39
Piper promised in the Piper note to pay QI lMC "the principal sum of Thirty-Eight
million dollars ($38,000,000) toget her with interest on the unpaid principal
39Although Quanex contributed the 538 million to QS, which in turn
contributed the $38 million to QHMC, Quanex wanted the use of that money and
understood at the time of the contributions that the $38 million would be lent back
to Quanex or to its affiliates.
- 93 balance from time to time remaining outstanding at an interest rate of seven and
one-half percent (7½%)." The Piper note provided that interest was due and
payable quarterly as it accrued and that the outstanding unpaid principal balance
was due and payable in full on October 31, 2012, but let Piper prepay all or part of
the note at any time without penalty. Rose signed the Piper note as Piper's vice
president.
Also on October 28, 1997, QHMC's board unanimously approved the loan
to Piper pursuant to the terms and conditions of the Piper note. That loan was the
first loan that QHMC ever made, and the interest on the loan was QHMC's only
source of income. Piper's board of directors also approved the $38 million loan
from QHMC. As of that date, Piper's directors were Oechsle, Peery, and Rose.
Singer understood that Quanex wanted to use the $38 million that was put
into QHMC, but the $38 million was transferred to Piper because Piper had a more
immediate need for the cash than Quanex. Piper used the funds primarily for plant
expansion, equipment purchases, and short-term debt reduction; Piper spent
approximately $32.5 million in plant construction during TYE 1998.
- 94 F.
October 30, 1997: QS' Transf er of Class C Stock to
Wannell in Exchange for Cas±
On October 30, 1997, QS sold 110 shares of class C stock to Wannell for
$11,000. Wannell did not negotiate the price of this stock, which according to a
stock purchase agreement executed between QS and Wannell on October 30,
1997, retained the rights and attributes des.:ribed in the certificate. Wannell,
QHMC, Quanex, and CS executed an amended and restated shareholders'
agreement dated October 30, 1997, to refle.:t the substitution of Wannell for QS as
a QHMC shareholder/investor.
When Wannell purchased the <QHMC stock, he understood that as a QHMC
director he was expected to attend some QHMC board meetings and to contribute
to the business between board meetings as appropriate. He also understood
QHMC to be responsible for everything re'ated to the costs of the employee
medical expenses in the venture, including paying, managing, and reducing them,
but he had only a vague idea of how QHMC would pay those costs. Wannell had
no knowledge of QHMC's assets, 1iabilitics, or overall worth, and he did not know
why put and call provisions were in his steck arrangement. He also did not know
why he had purchased the stock from QS, rather than directly from QHMC, and
why he was offered preferred stock rather than common stock. The only choice
- 95 Quanex gave Wannell in relation to his QHMC investment was whether to
invest.4°
XII.
Posttransaction Activities
A.
D&T's Draft Opinion
On April 13, 1998, Singer delivered a 59-page unsigned draft opinion letter
(draft opinion) to Quanex that provided D&T's opinion on certain Federal income
tax consequences of the QHMC transactions. The draft opinion was prepared
under Singer's supervision, and Singer told Quanex the draft was subject to final
review although he believed it to be correct. Singer included with the draft a
cover letter that similarly stated that he hoped the draft was "the final draft of the
opinion letter" but reaffirmed he was "awaiting final review approval from our
Washington National Tax partner." The draft opinion was stamped "DRAFT" in
large bold letters at the top of each of its 59 pages and was never finalized or
signed by D&T.
In the draft opinion, D&T reached the following conclusions:
A. Deconsolidation. The sale of the Class B Voting Preferred Stock to
Consultant [CS] should cause QHMC to break affiliation with Parent on the
date of sale under section 1504.
4°Wannell testified that it was not certain when he purchased his stock in
1997 that he would exercise his redemption rights at the first opportunity. We do
not find this testimony to be credible, and we decline to rely upon it.
- 96 B. Tax Basis of Transferor s QHMC Stock.
1. Parent's [Quanex's] transfer of cash and the assignment of certain
MPB's to Transferor [QS] ce nstitute ; an exchange governed by section 351.
Transferor's transfer of cash to QHl\1C in exchange for QHMC Class C
Voting Preferred Stock plus 1he assu nption by QHMC of the MPB's also
constitutes an exchange governed b3 section 351. Accordingly, no gain or
loss should be recognized by either Parent or Transferor on the transfers.
Section 351(a).
2. Transferor should have a basis fo tax purposes in its QHMC Class C
Voting Preferred Stock equa) to the cash transferred to QHMC. Section
358(a). Accordingly, the MPB's, w) ich will be assumed by QHMC, should
not be taken into account in determining Transferor's basis in the QHMC
shares received in the section 351 ex change. Section 357(c)(3).
C. Deductibility of Medical Pavmer ts to QHMC. The MPB's assumed by
QHMC in the section 351 exchanget described above more likely than not
will be deductible by QHMC as meäcal expenses under section 162(a) or as
capital expenditures under section 263, as appropriate, when they would
otherwise be deductible under QHMC's method of accounting. No income
should be recognized by Parent (or tay member of Parent's affiliated group)
as a result of the payment by QHMC of the MPB's.
D. Transferor's Loss on Sale of Shares. To the extent Transferor realized a
loss in connection with the taxable ule of its shares of QHMC Class C
Voting Preferred Stock to Investor, any such loss should be recognized in
the year of sale.
D&T cited various Code sections, revenue rulings, and cases to support its
conclusions in the draft. The draft opinior: also includes the following section:
c. Application of section 351(g), added by TRA of 1997. The
Taxpayer Relief Act of 1997 added new section 351(g) which
provides that certain preferred stock which is callable or puttable is
- 97 not to be treated as stock for purposes of section 351(a).48 The term
"preferred stock" for purposes of ection 351(g) does not include
stock which participates in corporate growth to any significant
extent.49 As discussed above, the Class C Voting Preferred Stock has
a liquidation value which is equal to the Formula Value. The
Formula Value is equal to forty-five (45%) [sic] of the increase in the
equity value of QHMC. Although there is no guidance in the statute
or legislative history regarding the extent to which the stock must
participate in corporate growth to be considered "significant", we
believe the Class C stock should not be treated as "preferred stock"
for purposes of section 351(g). It is difficult to argue that 45% is not
significant.
48Section 351(g)(2).
49Section 351(g)(3)(A).
Rose was unaware of a letter of representations that was prepared and
provided to D&T, and the record does not establish how D&T obtained the
background information it relied on in the draft opinion. In addition, Royce knew
that the draft opinion was a draft. Yet Royce never asked anyone at D&T to
provide petitioners with a final tax opinibn, and petitioners never received a final
tax opinion from D&T. Quanex's tax department did not prepare a tax opinion or
a memorandum discussing the tax consequences of the QHMC transactions.
- 98 B.
1997 Return
1.
Background
Petitioners filed their 1997 return on July 14, 1998. Royce decided what to
put into the 1997 return regarding the QHMC transactions, and he, upon
consultation with Singer, caused Quanex personnel to draft the return in
accordance with the draft opinion. Royce reviewed Quanex's work and had
Singer cause one of his managers 10 review the 1997 return. Royce also caused
Singer to review the manager's comments and then to look at the return himself.
Singer signed the 1997 return on behalf of D&T as the paid preparer.
Parikh signed the return as Quanex's controller, but he did not prepare the
return or make decisions on how specific transactions would be reported on the
return. Parikh also did not review the rett rn line by line before signing it. Parikh
asked Royce if D&T thoroughly reviewed the return and agreed upon how it was
prepared, but Parikh did not speak with ar yone at D&T about how the QHMC
transactions were recorded on the return.
Before signing the return,:Parikh knew that an approximately $38 million
capital loss was reported on the return. Parikh saw Singer's signature on the
return, and he was aware of D&T's draft opinion. Parikh did not read the draft
opinion before signing the return.
-992.
Income
On their 1997 return petitioners reported a $37,989,000 short-term capital
loss from QS' sale of the 110 shares of class C stock to Wannell and a gain or loss
of zero from Quanex's sale of the 130 shares of class B stock to CS. Petitioners
reported specifics of those sales as follows:
Stock
Date acquired
Date sold
Basis
Sale price
Class C
Class B
10/25/97
10/23/97
10/30/97
10/24/97
$38,000,000
13,000
$11,000
13,000
Petitioners also reported on the 1997 return that they realized a $26,966,201
net capital gain and a $21,374,634 net ordinary gain from the sale of the LaSalle
stock and other business property.41 Petitioners offset the net capital gain by
$26,966,201 of the reported capital loss and carried the remainder of the reported
loss, $11,022,799 ($37,989,000 - $26,966,201), to TYE 1998. Petitioners applied
the $11,022,799 to TYE 1998 to offset almost all of their $12,090,938 net longterm capital gain primarily from the Tube Group sale.42
41As discussed above, petitioners reported a $28,697,957 capital gain and
$20,721,360 of ordinary gain from their sale of LaSalle.
42As discussed above, petitioners reported on their 1998 return a
$12,458,171 capital gain and $8,090,766 of ordinary gain from the Tube Group
sale.
- 100 For financial statement purposes, in or about September 1998 Quanex
established a $9,621,000 reserve for taxes due in the future regarding the capital
loss claimed on the sale to Wannell. Subsequently, after claiming the $11,022,799
capital loss carryover to TYE 1998, Quanc x increased that reserve to $13,479,000.
3.
Enclosed Statements
a.
Overview
Petitioners' 1997 return includes va ious "Statements" related to the QHMC
transactions. These statements include Stctement 20, Statement Pursuant to IRC
Regulation Section 1.368-3(a); Statement 22, Statement Regarding Tax Free
Contribution to Capital Pursuant to Regulation Section 1.351-3(a); Statement 23,
Statement Regarding Tax Free Contribution to Capital Pursuant to Regulation
Section 1.351-3(a)&(b); and Statement 24 , Statement Regarding Tax Free
Contribution to Capital Pursuant to Regulation Section 1.351-3(a). Petitioners did
not notify any Government agency other than the IRS of the transactions involving
the MPBs.
b.
Statement 20
Statement 20 reported the October 23, 1997, amendment and restatement of
QW's certificate pursuant to its plan of reorganization to provide for class A, class
B, and class C stocks in a tax-free reorganization under section 368(a)(1)(E). This
- 101 statement also reported QW's name change to "Quanex Health Management
Company, Inc." in a tax-free reorganiza ion under section 368(a)(1)(F)."
c.
Statement 22
Statement 22 reported Quanex's October 23, 1997, exchange of $62,000
and 1,000 shares of QHMC common stock for 500 shares of class A stock and 130
shares of class B stock as a tax-free contribution by Quanex to QHMC.
d.
Statement 23
Statement 23 reported Quanex's October 23, 1997, contribution to QS of
$38 million in exchange for 1 share of QS common stock and QS' assumption of
$37,989,000 of MPBs as a tax-free contribution.
e.
Statement 24
Statement 24 reported QS's October 25, 1997, contribution to QHMC of
$38 million in exchange for 110 shares of class C stock and QHMC's assumption
of the $37,989,000 of MPBs as a tax-free contribution.
4Petitioners reported elsewhere in their 1997 return that QW acquired 500
shares of class A stock, acquired and disposed of 130 shares of class B stock, and
disposed of 1,000 shares of common stock. That reporting listed the name of QW
as "QUANEX WIRE, INC (QUANEX HEALTH MAN)".
-1024.
Deduction of Fee s
On their 1997 return, petitioners de¿ucted fees of $320,692, $29,114, and
$2,445 that Quanex paid to D&T, Fulbrigl t, and WW, respectively. The fees
Quanex paid to Fulbright and to WW were for services provided to effect the
QHMC transactions. The fees Quanex paid D&T were for services D&T
performed, as memorialized in invoices lis ting the following relevant data:44
Date of
Billing
invoice
period±nling
Amount
Hours billed
7/21/97
8/20/97
9/02/97
9/17/97
10/13/97
10/28/97
12/04/97
1/05/98
6/28/97
7/25/97
8/09/97
8/23/97
9/.20/97
10/18/97
11/15/97
12/13/97
$12,775
21,055
41,566
165,801
65,140
46,950
50,880
16,525
35
53
99
205
176
102
2130
39
320,692
839
Totals
iWhile the parties stiptlated that this amount is $65,801,
the record indicates that the amount should be $65,800. The
discrepancy does not affect oar resolution of the issues in this
case.
44The "amount" and "hours billed" columns show the hours and fees on
D&T invoices dated July 21, 1997 through January 5, 1998, that were labeled
"Consultations regarding the management of medical liabilities". Although D&T
employed both health care consultants and tax consultants, no one from D&T's
health care consulting group appeared on the invoices.
- 103 2While the parties stipulated to this amount, the record
indicates that this amount should be 131.5. The discrepancy
does not affect our resolution of the issues in this case.
D&T's work on the transactions that resulted in petitioners' reporting the
$37,989,000 loss was included within the scope of D&T's engagement letter.
C.
WW's 1999 Valuations
Although petitioners reported a $37,989,000 capital loss on their 1997
return as a result of the MPB transfers and related stock sales and relied on that
amount in their workpapers, Quanex continued to request new MPB valuations
from WW and D&T through 1999. By email dated January 17, 1999, Ringuette
sent Royce a calculation of the present value of active health care benefits as of
November 1, 1998, for the groups of employees who had their MPBs transferred
to QHMC. That email also provided tables for the "Projected Cashflow of Active
Health Care Benefits as of 11/1/98" and the "Development of Average Health
Care Cost Per Active Employee". The January 1999 calculation is the earliest
valuation document in the record to include only the employee groups whose
MPBs were transferred to QHMC. All previous valuation documents (i.e., the
WW June 30, 1997, PV Calculations; the WW October 13, 1997, PV Calculations;
and the D&T Oct. 21, 1997, cashflow model) used information from either
- 104 different or additional employee groups. The relevant data from those previous
documents is as follows:
Employee groups
inc. in the calc.
and No. of employees
Groups transferred:
Corporate
MS--General Office
MS--Arkansas hourly
MS--Arkansas
MS--Arkansas
MS--Michigan
WW June 30, 1997
PV calculatt.ons
WW Oct. 13, 1997
PV calculations
D&T Oct. 21,1997
cashflow model
35
30
252
120
--112
35
30
--120
--112
35
120
--27
112
---
27
---
27
13
--30
55
---
---
248
66
222
51
165
1,383
----------337
----------324
Groups not transferred:
Heat Treating
Nitro Steel
GST
GST hourly
MST
MST hourly
Tube Group Office
MS--Michigan hourly
Total
WW relied on the following assumptions to perform its January 1999
calculations on the "Present Value of Active Health Care Benefits as of 11/1/98":
Aging
Initial trend rate
Ultimate trend rate (2003)
2%
8%
4.75%
Average cost per employee (1998/ 1999)
$6,437
Interest rate
"Target Present Value"
6.75%
$37,989,000
- 105 Those calculations were as follows:45
Location
Corporate
MS-Arkansas salaried
Number of
employees
today
Average Estimated
attained
through
age
2008/2009
Present value
through
2009/2010
37
117
46
42
$2,771,431
8,096,317
$3,000,623
8,765,867
249
31
112
546
36
47
45
40
15,300,295
2,368,451
8,224,701
36,761,195
16,565,601
2,564,317
8.904.868
39,801,276
MS-Arkansasnonunion
hourly
MS-General Office
MS-Michigan salaried
Total
Quanex requested present value cálculations for selected groups of
employees from the Corporate, MS-Michigan salaried, MS-Arkansas salaried,
MS-Arkansas nonunion hourly, and MS-General Office groups from WW in
addition to those provided in the January 17, 1999, email. Sometime after January
17, 1999, in approximately early 1999, Quanex received the additional
calculations in an undated letter signed by Ringuette (undated calculations).
Ringuette either prepared or supervised the preparation of the undated
calculations.
45We note that the average attained age is actually 43.2. The discrepancy
does not affect our analysis.
- 106 Royce asked Ringuette to determine how many years of cashflows would
result in a present value of $37,989,000 for the MPBs. The resultant calculations
were as follows:46
Present Value of Active Health Care Benefits as of 11/1/97
Number of
employees
Average
attained
Estimated
through
Present value
through
Location
today
age
2010/2011
2011/2012
Corporate
MS-Arkansas salaried
37
117
46
42
$2,775,851
8,109,224
$2,952,832
8,626,248
249
31
112
546
36
47
45
40
15,324,695
2,372,226
8.237.814
36,819,810
16,301,759
2,523,473
8..763..036
39,167,348
MS-Arkansasnonunion
hourly
MS-General Office
MS-Michigan salaried
Total
The undated calculations relied on factors and assumptions different from
those used in the WW calculations of Oct aber 13, 1997, and January 17, 1999.
For example, in contrast to the October 13 valuation, WW based the undated
calculations on the assumption that the nt rnber and average age of employees in
each group would remain constant over ti·ne. In the undated calculations, WW
also projected the value over an approxiirately 15-year period rather than the
approximately 12-year period used in the January 17 valuation and the lifetime
46We note that the average attained age is actually 43.2. The discrepancy
does not affect our analysis.
-107calculation in the October 13 valuation." Both of these changes affected how
WW measured the present value of the health benefits.
WW also used the followmg assumptions for the undated calculations:
Aging
Initial trend rate
2%
7%
Ultimate trend rate (2003/2004)
Average cost per employee (1997/1998)
Interest rate
"Target Present Value"
5%
$5,238
6.75%
$37,989,000
Ringuette believed the assumptions werÀ within a reasonable range, but they
differed from those used in the valuations of October 13, 1997, and January 17,
1999. The assumptions WW used for its June 30, 1997, October 13, 1997, January
17, 1999, and undated 1999 present value calculations compare as follows:
6/30/97
10/13/97
1/17/99
Undated 1999
Assumption used
valuation
valuation
valuation
valuation
Aging
Initial trend rate
Ultimate trend rate
2%
9.29%
5.5%
2%
8.75%
5.5%
2%
8%
4.75%
2%
7%
5%
Interest rate
(2004)
7.5%
(2004)
7.5%
(2003)
6.75%
(2003/2004)
6.75%
$3,500
(1997)
$5,877
(1998)
$6,437
(1998/1999)
$5,238
(1997/1998)
Avg. cost per
employee
"Rose chose the length of the period.
-103Quanex's 1997 Form 10-K s tated w th respect to FASB 106 information and
assumptions that "The assumed healthcare cost trend rate was 8.8% in 1997,
decreasing uniformly to 5.5% in the year 2003 and remaining level thereafter. The
assumed discount rate used to measure the accumulated postretirement benefit
obligation was 7.5% at October 31, 1997 nnd October 31, 1996," Quanex's Form
10-K for TYE 1998 stated that "The assumed healthcare cost trend rate was 8% in
1998, decreasing uniformly to 4.75% in the year 2003 and remaining level
thereafter. The assumed discount rate used to measure the accumulated
postretirement benefit obligation was 6.74% and 7.5% at October 31, 1998 and
1997, respectively." WW chose the 8% lualth care cost trend rate assumption for
1998, and the rate related back to November 1, 1997. Quanex was not obligated to
use the 8% assumption.
Royce was dissatisfied witl1 the initial and ultimate trend inflation rates and
the aging assumptions WW used in the October 13, 1997, valuation.
Consequently, Royce instructed WW to change the initial trend rate to 7%. Royce
also wanted WW to raise the ultimate trer:d assumption. Royce wanted a 5% rate
rather than the 4.75% rate WW used in its January 17, 1999, calculation. Royce
also wanted WW to change the interest rete from the 7.5% WW used in the
October 13 calculation to 6.75%. WW agreed to make the changes. When asked
- 109 at trial "why was it necessary for you to see if it [the target present value] was
within the range [of values WW determined for the selected employees MPBs]?",
Royce testified: "Because the transaction had already been done, the cash to fund
the expected MPBS of $38 million had been transferred. We were trying to
transfer the substantial assets equal to the cash contributed."
Royce also instructed WW to include employees in the undated calculations
that were different from the October 13 valuation, but the same as those used in
the January 17 calculations. Changing the number of employees helped WW
target $38 million. The October 13 valuation did not contain a target present value
assumption. The January 17, 1999, calculation and the undated calculations used
a $37,989,000 target value.
Although numerous changes were made between the October 13, 1997,
January 17, 1999, and undated calculatións, in each instance WW arrived at
approximately the same present value for the MPBs of the employee groups
considered.48 The present value totals were as follows:
48At trial, Ringuette did not remember Quanex's expressing any
dissatisfaction with the methodology that he used in performing the present value
calculations or with the product contained in the calculations.
- 110 -
D.
Calculation
Prer ent value of MPBs
10/13/97
1/17/99
1/17/99
Undated
Undated
$37,839,705
36,761,195
39,801,276
36,819,810
39,167,348
D&T's 1999 Cashflow Mode!
The undated calculations represented WW's final report on the present
value of the MPBs, and Royce did not ask WW to prepare any additional revisions
or reports on the matter. Royce did ask D&T to prepare calculations on the basis
of the undated WW calculations. By letter dated March 25, 1999, D&T provided
the revised calculations to Royce (March 25 analysis). The letter, which was
signed by David Roth of D&T, sta ted that upon Royce's request D&T "modified
and refined the calculations previously mude in October 1997 relating to the
valuation of * * * [QHMC] for the purpose of closing the transaction" and that
D&T understood that QHMC would use the analysis, along with other
information, "in establishing cash flows to various classes of its capital stock."
D&T also stated in the letter that it had n( t independently assessed discount rates,
cashflows, or other terms relating to the Piper note. D&T provided Quanex with
the following table, which calculated the present values of the cashflows of the
MPBs transferred to QHMC:
-111-
Location
Grand total of PV
Cashflow
No. of
employees
today
$2,947,000
8,610,000
16,271,000
2,819,000
8,747,000
39,394,000
$151,000
429,000
1,064,000
100,000
517,000
12,262,000
37
117
249
31
112
546
Corporate
MS-Arkansas salaried
MS-Arkansas nonunion hourly
MS-General Office
MS-Michigansalaried
Total
'Although the cashflows totaled $2,261,000, the table indicated the
total was $2,262,000.
The March 25 analysis also stated that the "total payments to Quanex * * *
under QHMC's note receivable" would equal $5.5 million at the conclusion of
each of the first 2 years, $4 million at the conclusion of years 3 and 4, $3 million
at the conclusion of years 5 through 7, $5 million at the conclusion of years 8
through 14, and $310,000 at the conclu ion of year 15, and that the payment
schedule indicated a total value of equity for all classes of QHMC stock of
$76,000. D&T calculated its present values of cashflows on the basis of the
cashflow analysis, and D&T calculated the equity value as follows:
Total PV of cashflows
Plus: cash on hand
$594,000
65,000
Less: uncertainty of future
medical costs adjustment
Equals: total value of equity
(583,000)
76,000
- 112 Royce used the note payment schedule to r riticipate the principal payments on the
note throughout 15 years.
In addition to the present value cash dow calculations for the employee
groups and the equity determination, D&T 's March 25 analysis contained several
other projections and calculations, includirg the following discounted cashflow
analysis (in thousands):49
Cashflow from
Int. inc. Principal Medical Cashflov, avail. Cum. cash- operating/invest. NOL
Year from note from note costs
to equityj olders
flow
activities
buildup
1998 $2,850
1999
2,651
2000
2,438
2001
2,320
2002
2,194
2003
2,134
2004
2,069
2005
1,999
2006
1,774
2007
1,532
2008
1,272
2009
993
2010
892
2011
369
2012
22
Total 25,310
$2,650
2,849
1,562
1,680
806
866
931
3,001
3,226
3,468
3,728
4,007
4,308
4,631
258
38,000
($2,870)
(3,071)
(3,274)
(3,479)
(3,685)
(3,892)
(4,097)
(4,302)
(4,517)
(4,742)
(4,980)
(5,229)
(5,490)
(5,764)
(6,053)
(65,443)
$2,63(
2,429
72h
52:
(68f)
(897)
(1,09~)
696
48^
25L
2(
(220)
(490)
(764)
(5_J_41)
(2,131)
$2,630
5,059
5,785
6,306
5,621
4,729
3,632
4,331
4,814
5,072
5,092
4,864
4,374
3,609
(L1_33)
No D&T
total
($20)
(420)
(836)
(1,159)
(1,491)
(1,758)
(2,028)
(2,302)
(2,742)
(3,210)
(3,707)
(4,238)
(4,798)
(5,395)
(6,031)
(40,133)
($20)
(420)
(1,256)
(2,415)
(3,905)
(5,663)
-0-0-0-0-0-0-0-0-0No D&T
total
D&T thus projected for every year that QHMC's medical costs would exceed its
interest income from the Piper note and that QHMC's equity holders would have
49We note some computational errors in the projections. These errors are
not material to our analysis.
- 113 negative cashflow for 7 of the 15 years of the investment.5° D&T also projected
that QHMC would build up NOLs over the first six years, but D&T did not project
the NOLs for the remaining nine years. D&T provided specific NOL projections
as follows (in thousands):
NOL generated
NOL carryforward
PV of annual
NOL tax benefit
1998
1999
2000
-0-0-
$420 $838 $1,159
420 1,258 2,415
-0-
149
.281
2001
367
2002
2003
2004
$1,491 $1,758
3,905 5,663
$2,028
7,691
446
Cumulative PV of NOL benefits at end of year 7
496
539
12,278
1D&T assumed a risk-free rate of 6% and a tax rate of 40% for
the NOL analysis.
Royce understood the concept of NOLs, and he admitted that on the basis of the
information on projected medical expenses provided in the March 25 analysis,
which he accepted, QHMC would have an NOL every relevant year. Royce also
admitted that as Quanex's in-house tax adviser he would have been aware of
existing NOLs and would have considered how to use them.
50At trial Royce admitted that if none of the principal on the note was paid
off in years 1 through 15, the maximum interest income to QHMC would be the
$2,850,000 reflected in the first year ofthe schedule. In no year were the
projected medical expenses less than $2,850,000.
-114In its March 25 analysis, D&T also inade projections with respect to the
formula value. D&T projected that there would be 546 actual and projected
covered plan participants each year and calculated the following (in thousands):
1998
Initial
undiscounted
MPBs
Actual MPBs
Yearly saving
Agg. yearly
cum. savings
1999
2000
2001
2002
7003
2004
2005
2006
2007
2008
2009
2010
2011
2012
$2,870 $3,071 $3,274 $3,478 $3,685 $?,892 $4,09" $4,302 $4,517 $4,742 $4,980 $5,229 $5,490 $5,764 $6,053
2,583 2,764 2,946 3,131 3,317 .1,503 3,68~ 3,871 4,065 4,268 4,482 4,706 4,941 5,168 5,447
287
307 327
348
369
3B
41(
430
452
474
498
523
549
576
605
287
594
922
1,269 1,638
J,027
2,435
2,867
3,319
3,793
4,291
4,814
5,363
5,939
6,544
On the basis of these numbers, D& T deter nined that if the call option was
exercised in year 5, the class B and class C shares would have a $360,327
liquidation value and a $352,452 net return, and if the put option were exercised in
year 7 (with the call option still outstandirg), the liquidation value of the class B
and class C shares would equal $567,719 with a net return of $562,694. D&T
calculated these liquidation and net return values as follows:
- 115 Preferred stock called in 5 years
Cum. savings at end of yr 5:
$1,637,928
Less management consulting fees:
(250,000)
Net savings:
1,387,928
Performance weighting factor:
45%
Formula value = 45% savings:
624,568
No. of B and C shares outstanding:
260
Est. max. formula value per share:
2,402
No. of CS class B & C shares:
150
Liquidation value of B & C shares: 360,327
Total dividends paid:
7,125
Total return over 5 years:
367,452
Less initial investment:
(15,000)
Net return:
352,452
Preferred stock called in 7 years
Cum. savings at end of yr 7:
$2,436,768
Less management consulting fees:
(250,000)
Savings:
2,186,768
Performance weighting factor:
45%
Formula value = 45% savings:
984,046
No. of B and C shares outstanding:
260
Est. max. formula value per share:
3,785
No. of CS class B & C shares:
150
Liquidation value of B & C shares:
567,719
Total dividends paid:
9,975
Total return over 7 years:
577,694
Less initial investment:
(15,000)
Net return:
562,694
D&T also projected the following values (in thousands) under the heading "Total
Value of All Classes of Stock on Redemption Date":
Modified cashflow
Value at end
Value at end
Year
assuming savings
of year 5
of year 7
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
$2,917
2,736
1,054
869
(317)
(503)
(687)
1,128
935
732
518
294
59
(188)
(5,137)
$3,814
3,439
1,241
958
(327)
(486)
(823)
959
744
545
382
193
38
(108)
(2,762)
$4,480
3,919
1,414
1,092
(373)
(554)
(710)
1,092
848
622
412
219
41
(123)
(3,148)
- 116 The record does not contain credible evidence that Quanex's board was
informed of WW's and D&T's valuation changes. The meeting minutes for
QHMC's board meetings (QHMC board ireetings) reflected no discussion of the
changes.51 (QHMC's board meetings are discussed in greater detail below.)
E.
QHMC Operations
1.
QHMC's Officç1s and Directors
From 1997 through the time of trial, QHMC had the following officers and
directors:52
"Royce testified that both WW's and D&T's new calculations were
discussed at QHMC's April 9, 1999, board meeting and that he adequately
informed the board of the changes. Because Royce prepared the April 9 board
meeting minutes (and all other QH MC meeting minutes), and because he testified
that he put the important activities that took place during the meetings in the
minutes, we do not find his testimony that the board was informed of the changes
credible.
52Jean, Giddens, and Dockery are Raymond Jean, Paul Giddens, and Harva
Dockery, respectively.
-117-
Oechsle
Jean
Parikh
4/17/01-03
annual
meeting
10/23/9710/24/97
10/24/9710/25/97
10/25/97
4/9/99
4/9/994/10/00
4/10/004/17/01
Dir., Pres.
Dir., Pres.
Dir., Pres.
Dir., Pres.
Dir., Pres.
---
---
---
---
---
---
Dir., Pres.
Dir., V.P.,
Dir., V.P.,
Dir., V.P ,
Dir., V.P.,
Dir., V.P.,
Dir., V.P.,
Treas.
Treas.
Treas.
Treas.
Treas.
Treas.
Rose
Dir., V.P.
Dir., V.P.
Dir., V.P.
Dir., V.P.
---
---
Peery
Davis
Giddens
Murphy
Wannell
Babb
Dir., V.P.
V.P.
----Dir.
Dir.
Dir., V.P.
V.P.
----Dir.
Dir.
Dir., V.P.
Dir., V.P.
----Dir.
Dir.
--Dir., V.P.
Dir., V.P.
--Dir.
Dir.
--Dir., V.P.
Dir., V.P.
Dir., V.P.
Dir.
Dir.
Hellner
Bewley
Dir.
Dir.
-----
-----
-----
-----
Micale
Chapman
Conlon
Royce
Dockery
--Sec.
Asst. Sec.
Asst. Sec.
Dir.
Dir.
Sec.
Asst. Sec.
Asst. Sec.
Dir.
Dir.
Sec.
Asst. Sec.
Asst. Sec;.
Dir.
Dir.
Sec.
Asst. Sec.
Asst. Sec.
Dir.
Dir.
Sec.
Asst. Sec.
Asst. Sec.
--V.P. (until 10/1/02)
Dir., V.P.
Dir., V.P.
Dir.
Dir.
Dir.
---
Dir.
Dir.
Sec.
Asst. Sec.
Asst. Sec.
Except for Wannell, each class A director was a Quanex employee as of the date
he or she was elected. Except for Conlon and Dockery, both attorneys with
Fulbright, each QHMC officer was a Quanex employee as of the date he or she
was elected. QHMC did not compensa e its directors or its officers.
QHMC had no employees, other than, possibly, some individuals whom the
Code deems to be employees for certaiis purposes such as employment taxes. ,
e_g.., sec. 3121(d)(providing that the term "employee" includes certain common
law employees and corporate officers).
- 118 a.
OHMC's Board Meetings and Shareholders Meetings
QHMC held board meetings and shareholders meetings on April 9, 1999,
April 10, 2000, April 17, 2001, and October 1 and 16, 2001. No board meetings or
shareholders meetings were held in 1998."
b.
Parikh as Director and Officer
In his capacity as a QHMC board member and a QHMC officer, Parikh
participated in QHMC board meetings and discussions relating to health
management plans, signed QHMC's tax rt turns, and reviewed QHMC's financial
statements. Parikh had no specific daily a1:tivities or responsibilities to perform for
QHMC.
c.
Peery as Director and Officer
From the time the QHMC transactions were completed until his retirement in
April 1998, Peery attended meetings with CS in relation to Quanex matters. Peery
was not involved in QHMC's operations.
Following his retirement, Peery attended no
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