Southgate Master Fund ex rel. Montgomery v. U.S., Civil Action No. 3:06-CV-2335-K.

• Decision Date: 18 August 2009
• Docket Number: Civil Action No. 3:06-CV-2335-K.
• Citation: 651 F.Supp.2d 596
• Parties: SOUTHGATE MASTER FUND, LLC, by and through MONTGOMERY CAPITAL ADVISORS, LLC, its Tax Matters Partner, Plaintiff, v. UNITED STATES of America, Defendant.
• Court: U.S. District Court — Northern District of Texas

651 F.Supp.2d 596

SOUTHGATE MASTER FUND, LLC, by and through MONTGOMERY CAPITAL ADVISORS, LLC, its Tax Matters Partner, Plaintiff, v. UNITED STATES of America, Defendant.

Civil Action No. 3:06-CV-2335-K.

United States District Court, N.D. Texas, Dallas Division.

August 18, 2009.

COPYRIGHT MATERIAL OMITTED

M. Todd Welty, Claire Irene Wade, Sonnenschein Nath & Rosenthal LLP, Daniel H. Charest, Kenneth E. Gardner, Terrell W. Oxford, Susman Godfrey LLP, Dallas, TX, Justin Kattan, Sonnenschein Nath & Rosenthal LLP, New York, NY, Steven Merouse, Sonnenschein Nath & Rosenthal LLP, Chicago, IL, for Plaintiff.

Richard G. Jacobus, Justin S. Kim, Robert J. Kovacev, Washington, DC, David G. Adams, U.S. Department of Justice, Michael C. Prindible, Internal Revenue Service, Dallas, TX, for Defendant.

FINDINGS OF FACT AND CONCLUSIONS OF LAW

ED KINKEADE, District Judge.

This case is a tax dispute between Plaintiff Southgate Master Fund, LLC ("Southgate") and the United States of America (the "Government"). It is a civil action by the Plaintiff against the United States under 26 U.S.C. § 6226 for readjustment of partnership items. Based on the findings and conclusions set forth today, the Court holds that although Southgate's claimed capital loss appeared to fall within the literal terms of the statute, the transaction that created the high basis in the stock lacked economic substance and therefore must be disregarded for tax purposes. Consequently, the Internal Revenue Service correctly determined Plaintiffs reported loss was invalid. The Court further holds that because the calculation of taxes was done in good faith and with reasonable cause and the penalties assessed are otherwise inapplicable, the Plaintiff is not liable for the penalties sought by the Government.

In December 2008 and January 2009, the Court conducted a fifteen-day bench trial on this matter. The Court additionally asked the parties for extensive post-trial briefing and allowed the parties to file evidence. Thus, the Court, having heard the testimony of witnesses and the argument of counsel, hereby renders the following Findings of Fact and Conclusions of Law as permitted by Federal Rule of Civil Procedure 52(a).

I. Findings of Fact

A. Andrew Beal and Beal Bank's Business of Acquiring "Stressed Debt"

1. This case centers around banker D. Andrew Beal ("Beal"), and his participation

in a partnership transaction involving Chinese non-performing loans ("NPLs"), by which he claimed $1.1 billion in tax losses on his personal income tax returns across the years 2002-2004 based on an economic loss the Government estimates at about $10 million. Beal is Southgate's primary United States investor, and the person whose tax liability is ultimately at issue in this action. Beal is the founder, Chief Executive Officer, and 100 percent shareholder of Beal Financial Corporation ("BFC"), a Texas corporation and S-corporation for federal tax purposes, and its subsidiary Beal Bank, which in turn owns Beal Capital Markets, Inc.(collectively the "Bank"). Although Beal is a highly sophisticated and experienced banker, he has no professional or educational background in tax law. Beal is a Texas resident.

2. Beal Bank, a S-corporation, has been operating under the scrutiny of regulators since its inception in 1988. During that time, Beal Bank has been given "exemplary" ratings from its regulators.

3. Over the past twenty years, Beal and the Bank have been highly profitable, and have achieved significant returns on distressed assets originated by other financial institutions. The Bank's primary business is acquiring "stress debt," which Beal describes as "debt that has some issue with it . . . performing loans that are out of favor . . . or where the industries are stressed."

4. In its 2002 Report of Examination of Beal Bank, the Federal Deposit Insurance Corporation ("FDIC") confirmed Beal Bank's success, and the Bank's primary focus on acquiring distressed loans: "[Beal Bank's] earnings remain strong and well in excess of peer levels. Management is competent and skilled in the bank's primary business activity of acquiring distressed loan packages at a discount."

5. Both before and after founding Beal Bank, Beal individually (as opposed to on behalf of Beal Bank) had a long and, for the most part, successful history investing in distressed assets.

6. In many instances, Beal would purchase these assets based on limited research—including one instance where he acquired over 100,000 loans with a face value of approximately $20 million based on two days of investigation—if "the price was right."

B. Thomas Montgomery and His Experience with Stressed Debt

7. Thomas Montgomery ("Montgomery") is a certified public accountant with significant experience in venture capital transactions. In 2001, Beal Capital Markets, Inc. hired Montgomery to start a new capital markets group. The group's specific focus was identifying investment markets and opportunities where there existed a so-called "market disconnect" between the quality of assets and the price at which those assets were trading, as well as opportunities in distressed debt generally. Excluding investments in China, Beal's companies invested several billion dollars at the recommendation of the Beal Capital Markets group since 2001.

8. Montgomery had been involved in, or had knowledge of, some of Beal's and the Bank's investments in distressed assets, especially non-performing loans. Some of these included: (a) domestic investments in a pool of over 100,000 loans sold by the FDIC with a face value of approximately $20 million, purchased for about $1.4 million or roughly seven cents on the dollar; (b) numerous investments in airline bonds following September 11, 2001, totaling several hundred million dollars; (c) investments in distressed hotel and casino bonds; and (d) investments in power company bonds of more than $1 billion following the Enron and Dynegy frauds and the California rolling blackouts.

9. Like Beal, Montgomery worked on deals that would be researched quickly before an offer was made, sometimes in a matter of days or hours. Montgomery stated that his and Beal's investment philosophy is "to go where nobody else is going and do it quickly" to beat other investors looking for high profit potential "market misconnects."

10. When Beal Capital Markets, Inc. hired Montgomery, Beal defined the pursuit of investments in foreign-based non-performing loans as one of Montgomery's primary business duties. He increasingly sought such foreign opportunities as Beal's and the Bank's potential for "upside returns" on traditional investment targets became more limited within the United States. Beal and Montgomery turned to investing in the "inefficiencies" of foreign markets that allowed greater leverage. Inefficient markets are generally those that have yet to be fully understood by investors at large, leaving opportunities for pioneer investors willing to take some risk of not having complete knowledge of all the pitfalls of that market.

11. Montgomery was involved with and aware of Beal's and the Bank's investments (or attempted investments) in foreign-based non-performing loans and other assets, including a $23 million acquisition of approximately 25,000 non-performing loans with a face value of $460 million originated in Jamaica in early 2002, as well as investments in Estonia, Mexico, Slovakia, Nicaragua, and several other countries.

12. In the Jamaica transaction, Beal and Montgomery relied on the due diligence of their loan servicer. For unsecured loans in the Jamaica transaction, there was little review; what review was done was based on a small statistical sample "just to make sure that [the loans] were . . . valid, legally enforceable." Beal Bank ultimately doubled its investment in the Jamaican transaction. Although the Jamaican transaction was not structured for tax benefits, Montgomery realized toward the end of the transaction that, if it had been structured differently, there may have been tax benefits available.

13. In September 2003, Montgomery left Beal's employment and rejoined his accounting firm, known as Montgomery Coscia Greilich LLP ("MCG"), where he currently is the managing partner. MCG provides accounting services and prepares tax returns for Beal and the companies he owns, including BFC and Beal Bank.

C. The Emergence of the Non-Performing Loan Market in China

14. The non-performing loan business has its roots in the United States Government's response to the savings and loan crisis in the 1980s-1990s. During the crisis, the United States Government established the Resolution Trust Corporation ("RTC"), a government-owned asset management company whose mandate was to liquidate the savings and loans' non-performing loans and other distressed assets. As the RTC sold off its inventory of non-performing loans, best practices were established with respect to sales processes, and specialist non-performing loan investors emerged.

15. Other countries drew upon the United States' RTC model to handle their financial institutions' distressed assets, and non-performing loan markets emerged worldwide. By the time non-performing loan markets developed in Asia in the wake of the late-1990s financial crisis, non-performing loan investing operated under a set of generally recognized guidelines.

16. The non-performing loan market started to develop in China in or around 1999-2000. At that time, China was looking to join the World Trade Organization ("WTO"). To do so, the Chinese government sought to reform its State-owned commercial banks ("SOCBs") and turn them into more modern institutions. Responding to concerns about the continued solvency of its banks, and to prevent financial crises, the Chinese government took several steps to reform its ailing banking system, including (1) reduced government interference in bank operations, (2) recapitalized State banks, and (3) created and transferred NPLs...