# UNITED STATES TAX COURT > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/agency%3Atax-court%3Aac8e9e0ea7541668 ## Record - **Collection:** Agency decision - **Document type:** Agency decision ## Text 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 memoranr 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 torted 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 ; .see aho sec. 357(c)(3). Section 351(a) does not apply to the extent that the transferee's stock received in the exchange is NQPS. See sec. 351(g)(1). Section 351(b) requires that a transferor recognize any inherent gain in property transferred to a corporation in a section 351 exchange, to :he extent of the amount of money and the fair market value of "other property" raceived in return, and NQPS is "other property" for that purpose. See sec. 351(g)(1)(B). If the only stock received by the transferor(s) in the exchange is NQPS. then the transfer is completely outside the nonrecognition rule of section 351(a). See sec. 351(g)(1). The parties agree that, if the class C stock is NQPS, then the basis in the class C stock sold to Wannell was $11,000 as of the time of that sale (rather than the claimed basis of $38 million) and, accordingly, that the sala did not result in the claimed loss. Section 351(g) was added to the Code as part of the Taxpayer Relief Act of 1997, Pub. L. No. 105-34, sec. 10] 4(a), 111 Stat. at 919, generally effective for transactions after June 8, 1997. The specùl rule for NQPS was included in section 351 to remove from that nonrecognition provision "certain exchange transactions" where an "investor has * * * obtained a more secure form of investment" in the form of "preferred stock". See H. R. Rept. No. 105-148, at 472 (1997), 1997-4 -151C.B. (Vol. 1) 319, 794. For this purpose, "preferred stock" is "stock which is limited and preferred as to dividends and does not participate in corporate growth to any significant extent." See sec. 351(g)(3)(A). With limited exceptions, none of which is applicable here, this preferred stock is then "nonqualified" (and thus NQPS) if the preferred stock meets any of the following four conditions: (1) the holder of the stock may require the issuer or a related person to redeem or purchase the stock, (2) the issuer or a related person must redeem or purchase the stock, (3) the issuer or a related person may redeem or purchase the stock and, as of the issue date, it is more likely than not that this right will be exercised, or (4) the dividend rate on the stock varies in whole or in part (directly or indirectly) with reference to interest rates, commodity prices, or other similar indices. See sec. 351(g)(2)(A); see also sec. 351(g)(2)( [Text truncated at 120,000 characters. The full text is on the page linked above.] --- Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/agency%3Atax-court%3Aac8e9e0ea7541668. Public record. Not legal advice.