Hoosier Energy Rural Elec. v. John Hancock Life

• Decision Date: 25 November 2008
• Docket Number: Case No. 1:08-cv-1560-DFH-DML.
• Parties: HOOSIER ENERGY RURAL ELECTRIC COOPERATIVE, INC., Plaintiff, v. JOHN HANCOCK LIFE INSURANCE COMPANY; OP Merom Generation I, LLC; Merom Generation I, LLC; AE Global Investments, LLC; Ambac Credit Products, LLC; Ambac Assurance Corporation and CoBank, ACB, Defendants.
• Court: U.S. District Court — Southern District of Indiana

588 F.Supp.2d 919

HOOSIER ENERGY RURAL ELECTRIC COOPERATIVE, INC., Plaintiff, v. JOHN HANCOCK LIFE INSURANCE COMPANY; OP Merom Generation I, LLC; Merom Generation I, LLC; AE Global Investments, LLC; Ambac Credit Products, LLC; Ambac Assurance Corporation and CoBank, ACB, Defendants.

Case No. 1:08-cv-1560-DFH-DML.

United States District Court, S.D. Indiana, Indianapolis Division.

November 25, 2008.

COPYRIGHT MATERIAL OMITTED

Benjamin W. Hulse, James C. Joslin, Reed S. Oslan, Kirkland & Ellis, LLP, Chicago, IL, Erin L. Connell, Ryan L. Leitch, Riley Bennett & Egloff LLP, Indianapolis, IN, for Plaintiff.

Gary J. Clendening, Mallor Clendening Grodner & Bohrer, Bloomington, IN, George T. Patton, Jr., Kathleen I. Hart, Steven M. Badger, Bose McKinney & Evans, LLP, John R. Schaibley, III, Robert K. Stanley, Baker & Daniels, Indianapolis, IN, Matthew J. Herrington, Michael Baratz, Steptoe & Johnson, LLP, Washington, DC, Israel Dahan, Jonathan M. Hoff, Steven Lenkowsky, Cadwalader Wickersham & Taft LLC, New York, NY, David Roy Day, Church Church Hittle & Antrim, Fishers, IN, for Defendants.

ENTRY ON HOOSIER ENERGY'S MOTION FOR PRELIMINARY INJUNCTION

DAVID F. HAMILTON, Chief Judge.

Introduction

This case provides a case study of some of the worst aspects of modern finance. The case arises from an elaborate transaction that combines the sometimes toxic intricacies of credit default swaps and investment derivatives with a blatantly abusive tax shelter. Investment bankers and lawyers made more than $12 million in fees for putting together the paper transaction known as a "sale in—lease out" or "SILO" transaction of an electrical generating plant. Although all parties have been making all payments required under the contracts, the transaction is now in crisis because credit rating agencies have downgraded the credit ratings of one of the parties.

At this stage of the case, plaintiff Hoosier Energy Rural Electric Cooperative, Inc. seeks a preliminary injunction to enjoin defendants (i) John Hancock Life Insurance Company, Merom Generation I, LLC, and OP Merom Generation I, LLC (collectively, "John Hancock"); and (ii) Ambac Assurance Corporation and Ambac Credit Products, LLC (collectively, "Ambac") from making any demand or any payment pursuant to any assertion that a default has occurred and enjoining John Hancock from asserting that a default has occurred. The court has received and considered the memoranda from both sides, including affidavits and supporting documents. The court has also heard and considered arguments presented at the hearing on Hoosier Energy's motion held on November 19, 2008. The court now states its findings of fact and conclusions of law pursuant to Rules 52 and 65 of the Federal Rules of Civil Procedure. As explained below, the court finds that the preliminary injunction should be granted, that further proceedings are needed on the issue of appropriate security for the injunction, and that discovery should proceed immediately.

As with any preliminary injunction matter, the court's findings of fact and conclusions of law are tentative because they are the result of an expedited process. That is true to an unusual degree in this case. This case was pending in an Indiana state court, which had granted temporary relief to Hoosier Energy. The state court's temporary restraining order was set to expire at midnight on November 18, 2008, and the state court had set a hearing on the preliminary injunction for 3:00 p.m. on November 18th. At approximately 1:30 p.m. on that day, defendants removed the case to this court. That left only a few hours to address the issue before the state court TRO expired. The TRO could not be extended further without the consent of the defendants. The defendants later consented to a brief extension of the terms of the state court TRO until 2:00 p.m. on Friday, November 21st, and on that day agreed to a further extension until midnight tonight, Tuesday November 25th. Because of the very short time frame that resulted from the timing of the removal, the court emphasizes that these findings and conclusions are tentative and subject to further examination at the request of any party at any time if additional evidence becomes available or further argument would be fruitful.

Findings of Fact and Conclusions of Law

I. Structure of the Merom SILO Transaction

Plaintiff Hoosier Energy owns and operates an electrical generating plant in Merom, Indiana on the Wabash River. In 2002, Hoosier Energy and the other parties entered into a complex transaction known as a "sale in—lease out" or "SILO" in which Hoosier Energy leased certain assets at its Merom power plant to John Hancock for a term of 63 years (longer than its useful life) and then leased the same assets back for a term of 30 years. At the risk of oversimplifying a complex transaction, the court will try to summarize. John Hancock made an immediate one-time payment of $300 million for its 63 year lease. John Hancock then immediately leased these assets back to Hoosier Energy. Hoosier Energy kept about $20 million, and approximately $278 million was deposited with various Ambac entities, which in turn were required to make lease payments on Hoosier Energy's behalf to John Hancock. Hoosier Energy made payments into other funds controlled by Ambac with an eye toward the back end of the deal, when it would be virtually certain that Hoosier Energy would remain in control of the Merom plant.

The transaction was promoted and designed by lawyers and investment bankers (transaction costs were more than $12 million) with the hope that it would allow John Hancock to claim to be the "owner" of the Merom plant for tax purposes and thus enable it to claim tens of millions of dollars of tax deductions. Those deductions were of no use to Hoosier Energy as the plant owner because it simply does not earn significant profits. It is a cooperative made up of members that are rural electric cooperatives.

As part of the complex transaction (documented in approximately 4000 pages of fine print), Hoosier Energy was required to obtain a "credit default swap" from Ambac to give John Hancock further assurance that it would actually receive the promised lease payments. Bernardi Aff. ¶ 12; Knowlton ¶ 19. In general terms, the parties agreed that if Hoosier Energy defaulted on its obligations under the contracts, John Hancock could demand a "termination payment" from Ambac, and Ambac could turn to Hoosier Energy for payment under a closely parallel credit default swap contract between Ambac and Hoosier Energy. Ambac also provided a surety bond for the benefit of John Hancock.

As part of the terms of this credit protection for John Hancock, the parties agreed that if Ambac's credit rating dropped below a specific threshold, Hoosier Energy would have sixty days to find a new qualified swap provider. Bernardi Aff. ¶ 12. Hoosier Energy's failure to secure a new qualified swap provider would allow John Hancock to declare a default under the contracts, to terminate the entire transaction, and to demand an early termination payment from Ambac. In that event, Ambac would be able to demand very substantial payments from Hoosier Energy. The parties agreed to a schedule for the termination payment, depending on the date of the payment. The schedule was designed to give John Hancock, in the event of termination, the "Net Economic Return" it hoped to receive from the entire transaction, based on the assumption that it would be entitled to all of the hoped-for tax benefits. Id., ¶¶ 13-14; see also Pl.Ex. 5 at 52-53 ("Termination Value" is "an amount intended to maintain the Net Economic Return of the Owner Participant [John Hancock] through the date in question"); id. at 28 (defining "Net Economic Return" to include John Hancock's after-tax returns).

Because of the significant tax risk associated with the Merom SILO transaction, the deal's documents included a Tax Indemnity Agreement. Hoosier Energy insisted, and John Hancock agreed, that Hoosier Energy would not have liability for indemnification for loss resulting from, among other things, "a determination that the transactions contemplated by the Operative Documents are a sham, lack a valid business purpose or have a substance that is different from their form...." Pl. Ex. 6 (Tax Indemnity Agmt.) § 6(s) at 20.

II. Rulings from the IRS and Subsequent Credit Crisis

Around the time these parties closed the Merom SILO transaction in 2002, the IRS began disallowing claimed income tax deductions from taxpayers who had participated in other SILOs. See Pl. Ex. 29 (IRS Notice 2005-13 regarding SILO transactions). Courts have decided in favor of the IRS on transactions structured similarly to the Merom SILO transaction among these parties. See, e.g., BB & T Corp. v. United States, 523 F.3d 461, 477 (4th Cir.2008) ("LILO" or lease in—lease out); AWG Leasing Trust v. United States, 2008 WL 2230744, at *35 (N.D.Ohio May 28, 2008) (SILO). The IRS has gone so far as to offer earlier this year a form of tax amnesty for parties to similar SILO and LILO transactions, which the IRS deems abusive tax shelters. See Pl. Exs. 30-32. The IRS has announced that taxpayers involved in more than 80 percent of the SILO and LILO transactions have accepted the offer. Pl. Ex. 33. John Hancock apparently has chosen not to take advantage of this offer, at least with respect to the Merom SILO transaction.¹

At the time these parties entered into the Merom SILO transaction, they received opinions from several law firms to the effect that the transaction would produce legally valid and enforceable rights and obligations according to the terms of the agreements. Compl. Exs. 54-56, 58-60. The parties have not directed the court's attention to any opinion by counsel, even in 2002, to the effect that the transaction would be treated properly as a genuine sale and lease-back for federal income tax purposes so that John Hancock could be deemed a...