In re the Heritage Organization, L.L.C.
| Decision Date | 11 May 2009 |
| Docket Number | Adversary No. 06-3377-BJH.,Bankruptcy No. 04-35574-BJH-11. |
| Citation | 413 B.R. 438 |
| Parties | In re THE HERITAGE ORGANIZATION, L.L.C., Debtor. Dennis Faulkner, Trustee, Plaintiff, v. Gary M. Kornman, et al., Defendants. |
| Court | U.S. Bankruptcy Court — Northern District of Texas |
Laurie Dahl Babich, Baker & McKenzie LLP, Cynthia Williams Cole, Beirne Maynard & Parsons, LLP, Dennis S. Faulkner, Lain Faulkner & Company, PC, David William Parham, Baker & McKenzie LLP, Dallas, TX, for Debtor.
Elizabeth Banda, Perdue, Brandon, Fielder, Collins & Mott, Frank Hill, Hill & Gilstrap, Arlington, TX, John C. Bjorkman, Holly A. Harris, Preston Gates Ellis, LLP, Michael J. Gearin, Kirkpatrick & Lockhart Preston Gates Ellis LLP, Seattle, WA, Dan S. Boyd, The Boyd Law Firm, P.C., Jay A. Brandt, Jay A. Brandt, P.C., John Mark Chevallier, McGuire, Craddock & Strother, Perry J. Cockerell, Cantey & Hanger, Scott W. Everett, Haynes & Boone, LLP, Donald H. Flanary, Jr., The Flanary Group, Nancy E. Freeman, Law Office of Nancy E. Freeman, P.C., Thomas Michael Herrin, Department of Justice, Richard H. London. Vinson & Elkins, LLP, Peter Malouf, The Law Office of Steven Malouf, P.C., Stephen F. Malouf, Law Offices of Stephen F. Malouf, P.C., William Brian Memory, Haynes & Boone, LLP, Kim E. Moses, Wright Ginsberg Brusilow, PC, Patrick J. Neligan, Jr., Neligan Foley LLP, Holland N. O'Neil, Gardere, Wynne and Sewell, Rosa R. Orenstein, Looper Reed & McGraw, Meredyth A. Purdy Donna Bice Read, IRS Office of Chief Counsel, John E. Richards, Richards & Valdez, Laurie A. Spindler, Linebarger Goggan Blair & Sampson, LLP, Jeffrey M. Tillotson, Lynn Tillotson & Pinker, L.L.P., Cliff A. Wade, Settle & Pou, P.C., Amy M. Walters, Haynes & Boone, LLP, Dallas, TX. Shawn M. Christianson, Buchalter Nemer, San Francisco, CA, Amy Catherine Dinn, Gardere Wynne Sewell, LLP, Houston, TX, Lawrence R. Elleman, Dinsmore and Shohl, Cincinnati, OH, Julie C. John, Forshey & Prostok, LLP, (Hay M. Taylor, Kelly, Hart & Hallman, Ft. Worth, TX, David N. Neale, Levene, Neale. Bender, Rankin & Brill, Los Angeles, CA, Toni Price, Jackson Walker, LLP, San Antonio, TX, John J. Schmidt, Dinsmore and Shohl, LLP, Cincinnati, OH, Robert E. Winter, Milbank, Tweed, Hadley and McCloy, LLP, New York, N.Y. for Creditor.
Carol E. Jendrzey, Cox & Smith, San Antonio, TX, Kevin M. Lippman, Munsch, Hardt, Kopf & Harr, P.C., M. David Bryant, Jr., Cox Smith Matthews Incorporated, Dallas, TX, for Spec. Counsel.
Mark H. How, Short, How, Frels & Heitz, Dallas, TX, Gilbert A. Lazarus, Lazarus & Lazarus, P.C., J. David Leamon, Cadwalader, Wickersham & Taft LLP, New York, NY, for Interested Party.
The Court tried this adversary proceeding on January 7-16, 2009. At the conclusion of the evidence, certain parties asked for the opportunity to file post-trial briefs and revised proposed findings of fact and conclusions of law. Pursuant to an agreed schedule, the last of those pleadings was filed on February 5, 2009. Due to scheduling complications with the parties, closing arguments did not occur until February 26, 2009. At the conclusion of closing arguments, the Court took the matter under advisement.
The Court has jurisdiction over the parties and the issues in accordance with 28 U.S.C. §§ 1334 and 157(b). This Memorandum Opinion contains the Court's findings of fact and conclusions of law in accordance with Federal Rule of Bankruptcy Procedure 7052.
The Heritage Organization, L.L.C. ("Heritage") is a Delaware limited liability company formed in 1994. Pretrial Order, docket no. 537 ("Pretrial Order"), Stipulation 1; Defendants' Exhibit ("D.Ex.") 91.1 After operating for ten years, on May 17, 2004, Heritage filed a voluntary petition for relief under Chapter 11 of the Bankruptcy Code, thereby commencing the above bankruptcy case (the "Case"). Pretrial Order, Stipulation 95. Prior to its bankruptcy filing, Heritage advised2 extremely high net worth individuals regarding estate planning, business planning, tax planning and asset planning. D.Ex. 23, DFT-0872.
The information and strategies about which Heritage advised its clients were enormously complex and individualized. Of particular relevance here, and for certain clients during the period 1998 to 2001, Heritage included a version of an investment transaction using a strategy involving § 752 of the Internal Revenue Code (the "752 Transaction") as part of an overall group of estate and tax planning strategies it presented to its clients.3 According to the Defendants, a 752 Transaction generally worked as follows:
The client would deposit money into a brokerage account having a margin feature. The client would then utilize margin to make an investment by executing a short sale of treasury notes. The cash proceeds from the short sale would then be combined into the brokerage account with the cash deposited by the client.
At this point in time, the brokerage account would have within it (a) assets consisting of the cash deposited into the account and the proceeds from the short sale, and (b) an obligation consisting of the obligation to return the treasury notes that had been borrowed to execute the short sale.
Once the short sale was executed, the client would then transfer the brokerage account, with its assets and liabilities, to a partnership ("Partnership A"). In return, the client would receive a limited partnership interest in Partnership A. Partnership A would thus be liable for the obligation to return the treasury notes that had been borrowed from the brokerage to execute the short sale.
After the transfer to Partnership A, the client would contribute its limited partnership interest in Partnership A to a second partnership ("Partnership B"). In return, the client would receive a limited partnership interest in Partnership B. Thus, the client would own a partnership interest in Partnership B, which owned a partnership interest in Partnership A, which owned the brokerage account consisting of cash and the obligation to return the property in the form of treasury notes.
Following these transactions, Partnership B would sell its interest in Partnership A to a third party. The third party, thus, would own Partnership A, including the resulting brokerage account with the total amount of cash and the obligation to return the property in the form of treasury notes. The third party would then use the cash from the brokerage account to close the short sale by buying the treasury notes necessary to return them to the brokerage. The third party would then have a profit or loss depending on the fluctuation of the treasury notes which had been sold short.
Defendants' First Amended Updated Proposed Findings of Fact and Conclusions of Law ("Defendants' Proposed Amended Findings and Conclusions"), docket no. 564, at pp. 14-15. See also P.Ex. 73; Testimony of Czerwinski (1/16/09) 22:2-27:21.
According to the Defendants, the tax treatment that Heritage and its Chief Executive Officer, Gary M. Kornman ("Kornman"), believed to be appropriate for a 752 Transaction is generally described as follows:
1. Partnership B has an outside basis in its purchase of Partnership A in the amount that it paid for the interest (the value of the cash in the brokerage account that was Partnership A's only asset).
2. Partnership B sells its interest in Partnership A to the third party, and its basis is the entirety of the amount that it paid for the Partnership A interest, less the amount paid by the third party. Partnership B does not have to offset its basis by the amount necessary to close the short sale and return the property in the form of treasury notes.
3. Partnership B's outside basis in Partnership A would normally have to be adjusted for any liability that is contained with Partnership A— i.e., the obligation to return the property in the form of treasury notes. But Partnership A's obligation was not ascertainable at the time of the sale to the third party. Since the transaction had not yet closed, the amount of the obligation was not ascertainable. See I.R.C. Sec. 12334. Therefore, Partnership A's obligation is a "contingent liability" and is not a "liability" for purposes of Section 752. Since it is not a liability, Partnership B does not have to take the liability into account in computing outside basis under that section of the Code.5
4. As a result, the outside basis for Partnership B is a great deal larger than the amount it receives from the third party. The net effect is a tax loss for Partnership B that it can then use to offset capital gains in that tax year and in subsequent years.
Defendants' Proposed Amended Findings and Conclusions, at pp. 15-16.
The tax returns of many of Heritage's clients who had implemented a 752 Transaction were either audited by the Internal Revenue Service ("IRS") or the clients chose to "unwind" the transactions and settle with the IRS by paying the taxes owed, together with interest and penalties on the unpaid taxes. As a result of the failure of the 752 Transactions (or other strategies) to achieve the desired tax savings (and certain other alleged actions or inactions by Heritage), a number of Heritage's former clients asserted claims against Heritage in the Case (the "Client Claimants").
On the motion of Ralph Canada ("Canada"), a former Heritage employee, and after notice and a hearing, the Court ordered the appointment of a Chapter 11 trustee in the Case. See docket no. 151 in 04-35574-BJH-11. On August 16, 2004, the U.S. Trustee appointed Dennis S. Faulkner as the Chapter 11 trustee of Heritage (the "Trustee"), which...
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