Michtom v. United States

• Decision Date: 22 March 1978
• Docket Number: No. 253-76.,253-76.
• Citation: 573 F.2d 58
• Parties: Benjamin F. MICHTOM and Hadassah Feil Michtom v. The UNITED STATES.
• Court: U.S. Claims Court

573 F.2d 58

Benjamin F. MICHTOM and Hadassah Feil Michtom v. The UNITED STATES.

No. 253-76.

United States Court of Claims.

March 22, 1978.

Johnnie M. Walters, Washington, D.C., attorney of record, for plaintiff. Hunton & Williams, Washington, D.C., Ross Arnold, and Arnold & Cate, Atlanta, Ga., of counsel.

Joan Seitz Pate, Washington, D.C., with whom was Asst. Atty. Gen. M. Carr Ferguson, Washington, D.C., for defendant. Theodore D. Peyser, Jr., and Donald H. Olson, Washington, D.C., of counsel.

Before DAVIS, KASHIWA and KUNZIG, Judges.

ON PLAINTIFFS' MOTION FOR SUMMARY JUDGMENT AND DEFENDANT'S CROSS MOTION FOR SUMMARY JUDGMENT

KASHIWA, Judge.

This case is before the court on cross motions for summary judgment. The parties have submitted a partial stipulation of facts. The question presented is the proper characterization to be given two losses incurred by the plaintiffs in 1970 and 1974 as a result of entering into a subordination agreement with Hayden Stone Incorporated (hereinafter referred to as Hayden Stone) and subsequently selling preferred stock of H. S. Equities, Inc., Hayden Stone's successor. Having carefully considered the briefs and oral arguments presented, we find that the 1970 loss is properly characterized as an ordinary loss. Due to the parties' failure to stipulate that there was a loss in 1974, we find the assumed¹ 1974 loss to be unripe for summary judgment at this time; so we defer characterizing the assumed 1974 loss until it is factually established that there was a loss.

Benjamin F. and Hadassah Feil Michtom are husband and wife and were husband and wife during 1970 and 1974. Benjamin F. Michtom is a retired industrialist, having retired in 1969. Hadassah Feil Michtom is a housewife and was a housewife during 1970 and 1974.² Neither of the plaintiffs were engaged in the business of being a stockbroker, nor had they ever been so engaged.

Over the years Mr. Michtom had accumulated certain securities and bonds. One of the stockbrokerage houses with which he did business was Hayden Stone, in their White Plains, New York, office. At the solicitation of Hayden Stone, Mr. Michtom entered into a subordination agreement with Hayden Stone on April 11, 1968, effective as of April 30, 1968, under which Hayden Stone could utilize the cash and securities in Mr. Michtom's account to satisfy certain S.E.C. and New York Stock Exchange capital requirements. That agreement was replaced by one dated May 6, 1968, effective as of April 30, 1968. The May 6, 1968, agreement merely increased the minimum-maximum amounts Michtom agreed to subordinate from $55,000-$140,000 to $100,000-$200,000. At that time Michtom placed in the subordinated account cash in the amount of $8,962.62 and securities with a market value of approximately $180,000.

As owner of the cash and securities before entering into the subordination transaction, Mr. Michtom could trade the securities at will; he also received the interest and dividends payable on the securities. After April 30, 1968, under the provisions of the agreement, Mr. Michtom could still trade the securities in his account at will. He also still received the interest and dividends payable on the securities in the account. In addition, he received interest credits monthly on the cash in the account at the rate of 6 percent per annum and on the value of the securities at the rate of 2 percent per annum. Beginning October 1, 1969, these rates were increased to 8 1/2 percent and 3 percent respectively.³

By entering into the subordination agreement, Mr. Michtom increased his income on the assets in the Hayden Stone account. At the time Mr. Michtom entered the agreement, he was realizing through dividends and interest a rate of return of slightly less than 2 percent on the value of the securities in his account. The agreement with Hayden Stone assured him of more than doubling the rate of return on the account. At the time Mr. Michtom originally entered the subordination agreement, he considered Hayden Stone, one of the largest stockbrokerage firms, reliable and financially sound.

Under the agreement, Mr. Michtom agreed to subordinate any claims which he might have against Hayden Stone with respect to his account to the claims of other creditors of Hayden Stone (who were not subordinated lenders). In the event of a determination by certain officials of Hayden Stone that the subordinated accounts were needed to meet the capital requirements of the S.E.C. or the New York Stock Exchange, or to meet maturing obligations of Hayden Stone, or in the event of insolvency of Hayden Stone, or upon the happening of certain events such as the bankruptcy of Hayden Stone, Hayden Stone could liquidate the securities and use the cash in the account as it determined. If such a liquidation occurred pursuant to the agreement, Mr. Michtom was to have a claim against Hayden Stone in an amount equal to the amount realized by Hayden Stone on the sale or liquidation of the securities, less expenses.

The term of the subordination agreement was indefinite, but the agreement could be terminated by either party by delivery of a written demand. If Mr. Michtom elected to terminate, the agreement ended six months after the end of the month in which the notice was given. If Hayden Stone elected to terminate, the agreement ended two months after the end of the month of such notice.

On April 23, 1970, Michtom notified Hayden Stone of his desire to terminate the agreement and receive back the cash and securities in his account. On July 10, 1970, Hayden Stone notified Michtom that it had sold the securities in all subordinated accounts and that Michtom then had an interest-bearing claim against Hayden Stone for the amount represented by the proceeds from the sale of the securities, less expenses, in the amount of $112,774.04. The amount of the interest-bearing claim ultimately rose to $127,764.55.

In the summer of 1970 Hayden Stone found itself in an impossible financial position. Because of its difficult financial position, Hayden Stone negotiated the sale of most of its business operations and the name "Hayden Stone" to Cogan, Berlind, Weill & Levitt, Inc., another stockbrokerage firm.⁴ To consummate the proposed transaction, however, it was necessary to obtain the agreement of 108 subordinated lenders to withhold exercise of any claims until such time as Hayden Stone arranged for payment of all public customers and, further, to subordinate their claims to that of Cogan, Berlind, Weill & Levitt, Inc. Consequently, Hayden Stone, together with the "Committee of Subordinated Lenders," recommended that all subordinated lenders agree to the proposed transaction with Cogan, Berlind, Weill & Levitt, Inc., to withhold exercising their claims and, further, to accept one share of $6 Senior Preferred Stock in H. S. Equities, Inc., for each $100 aggregate principal amount of all outstanding indebtedness of the corporation to the undersigned as a subordinated lender to the corporation in exchange for and in lieu of all the claims of the undersigned against the corporation. Pursuant to this arrangement, Michtom signed the agreement and consent and exchanged his claim against Hayden Stone for 1,277.65 shares of the $6 Senior Preferred Stock. Michtom held the preferred stock until 1974 when he sold his shares to an unrelated party for $2,500 cash.

On their 1970 joint federal income tax return, plaintiffs claimed an ordinary loss deduction for the difference between Mr. Michtom's tax basis for the securities in his subordinated account and the fair market value of the preferred stock of H. S. Equities, Inc., he received in exchange for claims against Hayden Stone. On audit of that return, the Internal Revenue Service disallowed the ordinary loss deduction, contending that the loss was a capital loss with only $1,000 deductible against ordinary income in 1970. As a result, the Internal Revenue Service issued a deficiency notice for additional income tax due, interest, and penalty. Plaintiffs paid the amounts assessed and filed a timely claim for refund.

On their 1974 joint federal income tax return, plaintiffs claimed a long-term capital loss for the difference between the $2,500 cash received upon the sale of the 1,277.65 shares of $6 Senior Preferred Stock in H. S. Equities and the value of the preferred stock shown on the 1970 return. The plaintiffs later claimed that this loss was ordinary rather than capital and, accordingly, filed a timely claim for refund for overpayment of their 1974 income taxes.

Six months passed and the Internal Revenue Service failed to act upon either of the refund claims. Therefore, plaintiffs filed this suit seeking refund.

The parties agree that the subordination agreement involved herein was a transaction entered into for profit. They also agree that plaintiffs realized a loss in calendar year 1970 as a result of entering into the subordination agreement.⁵ The parties differ upon how the 1970 loss should be treated under the tax code. Plaintiffs maintain that the 1970 loss is deductible as an ordinary loss under Internal Revenue Code⁶ § 165(a) and (c)(2). Defendant contends that, although the 1970 loss is deductible under I.R.C. § 165(a) and (c)(2), the amount of the deduction is further limited by I.R.C. § 165(f) because the 1970 loss is a capital loss.⁷ Alternatively, defendant contends the 1970 loss should be deducted as a bad debt under I.R.C. § 166. If that is done, the amount deductible by plaintiff is again limited by the limitations placed upon the deduction of capital losses, I.R.C. §§ 1211(b) and 1212, because I.R.C. § 166(d) is applicable to the 1970 loss for it is a nonbusiness bad debt.⁸

Both parties argued this case assuming that plaintiffs had incurred a loss in calendar year 1974.⁹ They agree that if there was such a loss, it is deductible under I.R.C. § 165(a) and (c)(2). Defendant again contends, however, that the amount of the 1974 loss deduction is...