Candyce Martin 1999 Irrevocable Trust v. United States (822 F. Supp. 2d 968, 2011)

United States District Court for the Northern District of California 2011-10-06

Internal Revenue Code

Citations

Full opinion text

ORDER DENYING PETITION AND ENTERING FINDINGS OF FACT AND CONCLUSIONS OF LAW

PHYLLIS J. HAMILTON, District Judge.

This matter came on for a court trial on August 22, 23, 25, 26, 29, and 30, 2011. The parties appeared through counsel at trial and filed post-trial proposed findings of fact and conclusions of law on September 9, 2011. Having carefully considered the papers, the evidence presented at trial, the argument of counsel and the relevant legal authority, and good cause appearing, the court hereby DENIES the petition for readjustment of partnership items pursuant to 26 U.S.C. § 6226, and makes the following findings of fact and conclusions of law.

I. FACTUAL BACKGROUND

This action was consolidated on May 22, 2009, with the case of Constance Goodyear 1997 Irrevocable Trust et al. v. United States of America, C-08-5151 (PJH), for all purposes. Petitioners contest the adjustment of certain partnership items proposed by the Internal Revenue Service (“IRS”) in Notices of Final Partnership Administrative Adjustment (“FPAAs”) dated June 19, 2008, issued to First Ship 2000-A, LLC (“2000-A”) for the taxable year 2000, and to First Ship, LLC (“First Ship”) for the taxable year 2001. The court has jurisdiction over this action pursuant to 28 U.S.C. § 1346(e) and 26 U.S.C. § 6226(b)(1). See doe. no. 74, Stipulated Facts set forth in Joint Pretrial Statement, (“Stip”) ¶ 1.

A. The Chronicle Publishing Company

Michael deYoung (“M.H. deYoung”) and his brother, Charles deYoung, founded the San Francisco Chronicle in 1865. Trial Transcript (“Tr.”) at 48:21-23; Stip. ¶ 23. Charles deYoung was shot and killed in his office in the Chronicle in 1880 by a disgruntled politician who shot him over an editorial Charles deYoung had written. Tr. 48:23-25; 307:13-15. At the time of his death, Charles deYoung wasn’t married and had no children, and sole ownership of the San Francisco Chronicle passed to M.H. deYoung. Tr. 48:25-49:1; 307:15-17. In 1906, M.H. deYoung incorporated the Chronicle Publishing Company (“CPC”) as a Nevada corporation. Stip. ¶ 23. M.H. deYoung had five children, one boy, Charles, who died with no children, and four girls, Helen Cameron, who had no children, and Constance Tobin, Phyllis Tucker, and Kathleen Thieriot, each of whom had children. Tr. 49:1-6; 307:15-17. M.H. deYoung placed the ownership of CPC into trust for the benefit of his five children. Tr. 307:20-21. M.H. deYoung ran CPC until his death in 1925. Tr. 49:16.

Upon the death of M.H. deYoung, Helen Cameron’s husband, George Cameron became the C.E.O. or President of CPC, and ran CPC until his death in 1955. Tr. 49:17-24. During his tenure, CPC acquired one of the very first television stations, KRON, and then other properties, including book publishing. Tr. 49:20-23. Upon George Cameron’s death in 1955, Kathleen Thieriot’s son, Charles, took over control of CPC, and ran the company until he died in 1977. Upon his death, his son, Richard, became the C.E.O. Tr. 49:24-50:4. Michael deYoung’s trust for the benefit of his five children did not end until 1988, when his last child, Phyllis Tucker, died. Tr. 307:21-24. Constance Tobin had three children, Patricia, Michael and Consuelo. Tr. 49:6-9. Consuelo Tobin Martin (“CTM”) is the mother of the “Martin siblings:” Candyce Martin, Francis A. Martin, III, Constance Martin Goodyear, Priscilla Martin Tamkin, and Helen Spalding (collectively, the “Martin family”). Tr. 48:10-14.

During Richard Thieriot’s tenure as C.E.O. of CPC, Francis Martin was the head of Chronicle Broadcasting Company. Richard Thieriot’s cousin, Peter Thieriot, was the head of CPC’s Real Estate company. They retained these roles until 1993, when Phyllis Tucker’s sole surviving child, Nan McEvoy, became Chairman of the CPC Board, and brought in John Sias as C.E.O., and together they did some “housecleaning” by firing Richard Thieriot, Francis Martin, Peter Thieriot, and others who had previously held positions at CPC. Tr. 50:14-51:3. The other deYoung family members who were shareholders of CPC, retaliated and, in 1995, Nan McEvoy was fired. She later sued the company for age discrimination and lost. Tr. 51:4-5.

In 1995, CPC, which had before then elected to be treated as a Delaware S Corporation, owned largely four businesses: (a) the newspaper business, including the San Francisco Chronicle, the Worcester paper, and the Pantagraph paper in Illinois; (b) a television business, including television station KRON and a couple of other stations; (c) a cable business; and (d) Chronicle Books. Tr. 49:21-22; 309:24-310:3.

B. The Martin Family Trusts

As of the year 1999, the Martin siblings collectively owned through various trusts or outright, 630,000 shares (or 16.67%) of the stock of CPC. Stip. ¶ 24; Ex. 25. Each of the Martin siblings owned an equal amount of 126,000 CPC shares, either through various trusts or outright. Tr. 54:25-55:10; 313:24-314:1; Ex. 25. Of the 630,000 shares of CPC Stock held by the Martin siblings, 380,500 shares were held in fourteen (14) trusts related to the Martin family (the “14 Martin Family Trusts”). Stip. ¶ 25; Ex. 25. The 14 Martin Family Trusts included five non-grant- or trusts that Consuelo Tobin Martin created in 1988 for the benefit of each of her five children as the income beneficiaries, with her grandchildren as the remainder-men (the “1988 Trusts”). Tr. 52:17-21; Stip. ¶ 5.a; Ex. 25. Consuelo Tobin Martin placed 23,100 shares of CPC stock into each of the five 1988 Trusts. Tr. 53:20-23; 259:17-19; 311:9-13; Ex. 25. The 1988 Trusts included:

a. The CTM Children’s Trust FBO Candyce Martin (1988 Trust);

b. The CTM Children’s Trust FBO Francis Martin, III (1988 Trust);

c. The CTM Children’s Trust FBO Constance Goodyear (1988 Trust);

d. The CTM Children’s Trust FBO Priscilla Tamkin (1988 Trust); and

e. The CTM Children’s Trust FBO Helen Spalding (1988 Trust).

Stip. ¶ 5.a.; Ex. 25.

The 14 Martin Family Trusts also included five grantor trusts that Consuelo Tobin Martin created for the benefit of her five children in 1999 (the “1999 Trusts”). Tr. 54:18-24; 310:22-23; 311:14-16; Stip. ¶ 26. Consuelo Tobin Martin placed 26,-000 shares of CPC stock into each of the five 1999 Trusts. Tr. 54:25-55:2; 259:20-22; 311:15-23; Stip. ¶26; Ex. 25. The 1999 Trusts included:

a. CTM 1999 Trust FBO Margaret Candyce Martin;

b. CTM 1999 Trust FBO Francis Augustus Martin, III;

c. CTM 1999 Trust FBO Constance Martin Goodyear;

d. CTM 1999 Trust FBO Priscilla Martin Tamkin; and

e. CTM 1999 Trust FBO Helen Martin Spalding.

Stip. ¶ 26; Ex. 25.

The 14 Martin Family Trusts also included four trusts created by three of Consuelo Tobin Martin’s children for the benefit of their own children, into which they placed a varying number of shares of CPC stock they had previously owned outright. These trusts included the following into which the reflected amounts of shares were contributed:

a. The Francis A. Martin III 1997 Irrevocable Trust, 50,000 CPC shares;

b. The Francis A. Martin III 1998 Irrevocable Trust, 25,000 CPC shares;

c. The Constance M. Goodyear 1997 Irrevocable Trust, 40,000 shares; and

d. The Candyce Martin 1999 Irrevocable Trust, 20,000 shares.

Stip. ¶ 27; Ex. 25; Tr. 310:23-25. In addition to the CPC stock, certain of the 14 Martin Family Trusts also owned, directly or indirectly, stock in Liberty Media Group (“Liberty Media”), AT & T, and TCI Satellite. Stip. ¶ 34.

Peter M. Folger, a management labor lawyer who co-founded the San Francisco law firm Folger, Levin & Kahn, LLP, was appointed to act as trustee of the 14 Martin Family Trusts. Tr. 53:24-54:1; 258:10-20; 258:24-259:12; 318:9-10; 687:15-17; Ex. 25. Mr. Folger had graduated from Stanford University and obtained his law degree from the University of San Francisco law school. Tr. 258:4-8. Mr. Folger had been a long time close family friend of the Martin family. Tr. 54:2-7; 258:22-23; 318:11-15. His parents had been friends of Consuelo Tobin Martin and her husband. Id. Consuelo Tobin Martin wanted someone of her children’s generation with whom she felt comfortable. Tr. 54:15-17. Members of the Martin family testified that Mr. Folger had “some really wonderful personal characteristics that make him a great trustee for everybody. No one feels that he’s closer to and would represent one sibling’s interest over another. He listens to everybody. He takes everybody’s views into account. And that’s really a rare quality.” Tr. 318:15-21. He had a calming influence and relied on a consensus among the beneficiaries. Tr. 91:16-25.

Mr. Folger was also the Trustee of the trusts of Richard Thieriot, including the Richard T. Thieriot 1997 Trust and the Thieriot Family 1999 Irrevocable Trusts. Richard Thieriot was a cousin of the Martin siblings and also a shareholder of CPC. Ex. 25; Tr. 279:18-22.

From 1988 through 1998, Mr. Folger’s position as Trustee required only that he periodically attend CPC’s annual meetings and give stock voting proxies to the Trusts’ beneficiaries. Tr. 259:23-260:7. Mr. Folger generally did not receive a fee for his services as trustee, except for a period when he received compensation at an hourly rate for his time spent dealing with reformation issues surrounding the five 1988 Trusts. Tr. 65:1-3; 259:14-16; 260:17-261:4.

On June 2, 1999, Consuelo Tobin Martin formed LMGA Holdings, Inc. (“LMGA Holdings”) as a Delaware S Corporation. Prior to November 1, 2000, Francis Martin was the director of LMGA Holdings, and Peter Folger was a corporate officer. Tr. 287:23-288:19; Ex. 1 at 110, 111. On November 1, 2000, Francis Martin resigned as President of LMGA Holdings and on November 2, 2000, Peter Folger became President of LMGA Holdings. Tr. 287:23-288:19; Ex. 1 at 110, 111. On June 15, 1999, each of the five 1999 Trusts purchased a 20% share of LMGA Holdings. Stip. ¶¶ 8, 29. On June 15 and June 16, 1999, 4,130,728 shares of Liberty Media stock and $13.8 million in cash were transferred to LMGA Holdings. Stip. ¶ 30.

First Ship was formed as a California limited liability company on March 6, 2000, and remains in existence today. Stip. ¶¶ 3, 15; Stip. Ex. 1. First Ship’s members (or partners, for tax purposes) were the 14 Martin Family Trusts. Stip. ¶ 4; Stip. Ex. 2. On October 10, 2000, 2000-A was formed as a California limited liability company. Stip. ¶ 6, Stip. Ex. 3 (Articles of Organization of 2000-A). 2000-A had three partners with the following percentage holdings: First Ship (77.03%); Fourth Ship, LLC (“Fourth Ship”) (22.22%); and LMGA Holdings (0.75%). Stip. ¶ 6; Stip. Ex. 4 (Operating Agreement of 2000-A).

LMGA Holdings was the managing member of 2000-A. Stip. Ex. 4. As President of LMGA Holdings, Mr. Folger had the authority to act as the managing member of 2000-A. Fourth Ship was formed as a California limited liability company on October 12, 2000. Fourth Ship had nine partners: (1) the five 1988 Trusts; (2) the Francis Martin 1997 Trust; (3) the Francis Martin 1998 Trust; (4) the Constance Goodyear 1997 Trust; and (5) the Candyce Martin 1999 Trust. Stip. ¶ 7.

C. Sale of the Chronicle Publishing Company

After a great deal of turmoil among the CPC owners caused the deYoung family’s relations to deteriorate to such an extent that no one could get along, on June 16, 1999, CPC’s board of directors announced its decision to accept bids for the sale of all of CPC’s assets. Tr. 52:2-7; 308:19-21; Stip. ¶ 31. At this time, Helen Spalding was a member of the CPC board of directors. She had been on the board since 1994, and remained a board member until the final liquidation of CPC. Tr. 51:16-24; 694:14-23. CPC completed the sale of substantially all of its business assets in 1999 and 2000. Stip. ¶ 31. The total final sales price for all of the CPC assets was $2,119,955,144, comprised of cash equal to $479 per share of CPC stock, and shares of Young Broadcasting, Inc. stock. Id. CPC made large distributions of cash and securities to its shareholders. Id. After the sale of CPC’s assets and distribution of the proceeds to its shareholders, the 14 Martin Family Trusts held the following assets:

Number of Asset Shares Value as of 11/8/00

Cash NA $121,452,146

Cash in Escrow NA $ 3,019,841

Liberty Media 5,435,370 $ 97,496,949

Young Broadcasting 391,444 $ 11,376,341

AT & T 267,533 $ 55,885,726

TCI Satellite 33,785 $ 221,714

Total $239,452,518

Stip. ¶ 34.

In the midst of the efforts to sell CPC’s assets, its board of directors realized that there were certain types of liabilities that might arise after the proceeds from the sale of CPC’s assets had been distributed to its shareholders, and that the responsibility to cover such liabilities could fall first and foremost to the board of directors as individuals to personally cover the liabilities and that such liabilities might be unlimited. Tr. 57:8-58:22; 696:4-10. These potential future liabilities included but were not limited to contractual matters, buyer’s remorse, union or worker’s contract issues, environmental issues, and CPC’s status as a Subchapter S corporation, and it was feared that these potential liabilities could exist long into the future. Tr. 57:8-58:22; 309:10-19; 314:12-315:9; 597:20-598:9.

As a director, Ms. Spalding understood that her potential exposure for CPC liabilities was unlimited and it was therefore very important that there be some mechanism whereby all shareholders would share these possible responsibilities equitably. Tr. 696:4-10. In order to more equitably share the responsibility for these potential future liabilities amongst the CPC shareholders, the board of directors discussed with the shareholders and ultimately caused to be prepared “The Chronicle Publishing Company Recontribution Agreement” (the “Recontribution Agreement”), which governed shareholder responsibility for potential future CPC debts or liabilities. Ex. 25; Tr. 54:24-55:2; 56:6-10, 12-17; 62:11-19. The Recontribution Agreement provided that CPC shareholders would contribute on a pro rata basis funds to cover any excess liabilities incurred by CPC, and would indemnify CPC and other shareholders at least to the extent of the distributions they had received, and possibly beyond the extent of their distributions. Ex. 25; Tr. 136:4-5; 351:11-22.

On August 10, 2000, as a prerequisite to receiving a distribution of the CPC sales proceeds and securities, each CPC shareholder, including the 14 Martin Family Trusts, was required to sign the Recontribution Agreement. Ex. 25; Tr. 54:24-55:2; 56:6-10, 12-17; 350:1-4. The Re-contribution Agreement gave rise to a concern among the Martin family and the 14 Martin Family Trusts about ongoing potential exposure to excess CPC liabilities faced by its shareholders pursuant to the Recontribution Agreement. The Martin family was concerned that potential future CPC liabilities would extend many years into the future, until various state and federal statutes of limitation had expired. Tr. 87:18-88:11.

One of the major issues that could have caused a recontribution of assets by the CPC shareholders was a possible revocation of CPC’s “Subchapter S” status. Tr. 79:15-19; 80:11-13. Subchapter S of the Internal Revenue Code, 26 U.S.C. §§ 1361 to 1379, allows a single tax on the shareholders of a corporation upon the distribution of income, as opposed to the double taxation possible with a “C” corporation, first at the corporate level and then again at the shareholder level. Tr. 79:15-19; 137:15-19; 137:25-138:6. There are certain eligibility requirements in order to elect and maintain “Subchapter S” status, and problems as to eligibility might not surface for years. Tr. 79:19-80:7; 138:12-139:10; 271:8-17; 314:19-315:25. For example, CPC’s Subchapter S status could have been revoked: (a) if a non-US citizen acquired shares; (b) if the maximum number of shareholders were exceeded through the death of one of the living shareholders who had a large number of children; or (c) if the wrong kinds of trusts were shareholders. Tr. 314:12-315:6; 353:1-8. If CPC’s Subchapter S status had been revoked for any of these reasons, the IRS could have gone back and taxed CPC as a C corporation and then taxed the shareholders again as recipients of dividends and the sale proceeds. Tr. 80:14-20; 137:15-19; 135:25-138:6; 315:6-14.

The Martin family and the 14 Martin Family Trusts had no way of knowing or controlling what other CPC shareholders might have done to affect CPC’s eligibility for Subchapter S status, yet could become jointly and severally liable for a potentially colossal tax owing at the corporate level at a time when CPC no longer had the assets. Tr. 138:12-139:10; 314:15-18. Given CPC’s $2 billion value at the time of sale, the extent of this additional tax liability just on the sale alone could have been more than $800 million. Tr. 352:5-13. Concerned about possible revocation of CPC’s Subchapter S status, the Martin family and the 14 Martin Family Trusts determined to preserve a portion of their distributions and hold them in a pooled fashion until after the statute of limitations on the Subchapter S issue had expired. Ex. 25; Tr. 54:24-55:2; 56:6-10, 12-17; 62:11-19; 135:13-24; 139:12-21; 271:13-17; 352:20-22.

Besides the possible exposure to liability under the Recontribution Agreement, the Martin family and the 14 Martin Family Trusts shared other concerns following the sale of CPC. They were also concerned about dealing with and reforming the ambiguous distribution provisions of the five 1988 trusts, which held a large percentage of the Martin family’s assets. There was an urgent need to clarify the terms of distribution to beneficiaries upon the death of one of the Martin siblings. The remaindermen of the trusts were comprised of the 10 grandchildren of Consuelo Tobin Martin and the five 1988 Trusts provided that they receive equally on a pro rata instead of per stirpes basis. This was not a problem while the Trusts simply held CPC shares. But, when those shares were converted to cash upon the sale of CPC, distribution under the Trusts in their then current form became extremely difficult. Tr. 75:12-16; 76:2-9; 136:12-137:10; 270:24-271:7; 312:3-8; 316:9-318:5.

In 1998 or 1999, the five 1988 Trusts had previously been revised in order to eliminate a provision that prohibited inheritance by an adopted child. Richard Sideman, a Harvard Law School Graduate, a holder of a Masters in Tax from NYU, and a co-founder of the San Francisco law firm Sideman & Bancroft, LLP, who had been hired by Consuelo Tobin Martin in 1991 with respect to a gift tax issue, was hired again in 1998 or 1999 to assist the Martin family in this first revision. Tr. 53:4-16; 80:25-81:71; 123:3-5; 123:24-124:1; 127:7-16; 128:13-18. Reformation of the trusts was a complicated and time consuming process requiring extensive analysis as to potential beneficiary scenarios, and obtaining a probate court order and an IRS private letter ruling, all of which finally concluded in 2005. Tr. 142:24-143:1; 161:21-163:24; Exs. 322, 323, 324, 325.

The uncertain status of these trusts in the interim affected the Martin family’s and the 14 Martin Family Trusts’ investment decisions. In particular, given the complicated legal tontine created by the Trusts’ provisions, and to eliminate the possibility of a conflict of interest between the trustee and unexpected beneficiaries, all of the 1988 Trusts had to be managed as a unit. In addition, trust assets needed to be completely pooled in order to assure there would be total equality for known and potentially unknown beneficiaries until the 1988 trusts could be clarified. Tr. 53:4-10; 75:12-16; 76:2-9; 136:12-137:10; 142:9-11; 270:24-271:7; 275:13-21; 335:8-11.

The third concern shared by the Martin family and the 14 Martin Family Trusts was the volatility of the Martin family’s and the 14 Martin Family Trusts’ investments. The Martin family and the 14 Martin Family Trusts had received a large amount of cash and stock from the sale of CPC’s assets. These assets were held by the trusts and there were interests of both income beneficiaries and remaindermen to be addressed. The Martin family and Mr. Folger as trustee of the 14 Martin Family Trusts considered proposals for investing the assets because keeping the funds in cash would not protect the interests of the remaindermen in light of inflation or altered markets. Tr. 140:20-142:11.

D. Development of the Joint Investment Transaction

1. Arthur Andersen Proposal

In late 1998 or 1999, in anticipation of the CPC sale, Arthur Andersen, LLP (“AA”), at that time the public accounting firm for both CPC and the Martin Family and their various trusts, approached Francis Martin with a proposal that addressed the liabilities concerns and also potentially had some tax benefits. Tr. 127:24-128:4; 129:24-130:11; 130:7-11; 130:19-22; 320:5-11; 598:11-16. The Arthur Andersen transaction was also proposed to the cousins of the Martin family, the Theriots, who also faced large gains from the sale of the Chronicle. Peter Folger was also the decision maker for the Theriot family trusts. Ex. 101 at RTS 176.

Because of their prior work for Consuelo Tobin Martin and their work on the first reformation of the five 1988 Trusts, Richard Sideman and his firm, Sideman & Bancroft, LLP, were well known to the Martin family. Tr. 53:4-16; 67:24-68:4; 80:25-81:71; 127:7-16; 128:13-18; 598:19-22. As such, at the request of his siblings, Francis Martin engaged Sideman, briefed him about the family’s many concerns, and requested that he meet with AA in order to learn about and independently review its proposal. Tr. 59:6-24; 63:11-15; 127:24-128:4; 129:24-130:11; 130:19-131:1; 262:18-22; 319:4-9; 589:11-16; 597:9-600:14. Mr. Sideman’s job was to look at AA’s proposal and give independent advice to the Martin family and Mr. Folger as trustee of the 14 Martin Family Trusts. Tr. 130:24-131:1; 270:20-23. He was also to address the family’s many concerns arising from the CPC sale and to find a way to help them manage and potentially mitigate their potential exposure under the Recontribution Agreement. Tr. 319:11-16; 598:11-16. Mr. Sideman had not known Mr. Folger prior to this time, but came to learn that he was a contemporary of the Martin siblings, and a childhood friend of Mr. Martin. Tr. 131:3-14.

In January and February 2000, Mr. Sideman and his partner, Kristina Harrigan, of the Sideman firm had discussions with Arthur Andersen about the terms under which tax attorney R. J. Ruble of the Brown and Wood law firm would issue an opinion letter concerning an investment strategy for Francis Martin. Mr. Ruble had been asked by Arthur Andersen to provide a tax opinion with respect to the proposed transaction for the Martin Family. Tr. 132:19-25. On January 29, 2000, John Mullen from Arthur Andersen stated, “R.J. [Ruble] does know all the facts. He knows that the trustee will contribute the proceeds of CPC to the Corporation.” Ex. 218.

On February 24, 2000, the Sideman firm and AA discussed competitive pricing of shelter strategies. John Mullen of AA said that the AA strategy was a proprietary strategy that AA could only market jointly with AIG; thus AA could not carry it out with JP Morgan (the Martin Family’s financial advisor and private bank) instead of AIG. John Mullen told the Sideman firm that AA did not want to share any information on the AA strategy with JP Morgan because JP Morgan was a competitor of AA in that type of product. Ex. 127.

On February 25, 2000, the Sideman firm sent a memo to trustee Peter Folger describing the AA shelter strategy. Ex. 98. In that memo, Ms. Harrigan explained the mechanics of the Son of BOSS transaction as follows:

Why does this work to help with Rani[’]s problem? When you contribute assets to an entity, your basis in the entity reflects the basis of the assets you put in, less any liabilities the entity takes off your hands in the process. Here, you are contributing an asset — the call that you BOUGHT — with basis of $30, which is the price you paid for the call exercisable at $70. While the entity will also assume your obligations under the call that you SOLD, for which you received $50 premium, that liability is contingent in the eyes of the Tax Code, and ignored for purposes of computing your basis in the entity. The net effect is to create $30 of basis for the call that you BOUGHT, and another $20 basis for the net cash that you kept in Step Two above. Although this $20 basis (and the cash that goes with it) is going to disappear if the market value of the baskets is $70 or more on the 180th day, you have still created $30 of basis where there was none before. If the volume of these calls is large enough, this basis will be large enough to equal the missing basis of other valuable assets that you contribute to the entity, e.g., LMGA stock, AT & T stock.

Ex. 98 at RTS 000148-149 (emphasis added). After seeing this memo, Mr. Mullen expressed concern to the Sideman firm because it had been Sideman’s counsel not to have anything in the files that detailed the tax aspects of the transaction. Ex. 98 at RTS000151. Mr. Mullen suggested that another memo, provided earlier to the Theriots, be sent to Folger for his files. Id.

On March 2, 2000, Peter Folger faxed Richard Sideman an engagement letter signed by R.J. Ruble, hiring Mr. Ruble to act as special tax counsel to the Martin Family Trusts for the AA shelter strategy. Ex. 100. On March 2, 2000, Francis Martin called Richard Sideman to say that he wanted to go forward with the AA shelter strategy without waiting for the Ruble opinion letter, while his sisters preferred to wait until Mr. Sideman had reviewed R.J. Ruble’s opinion letter. Ex. 101 at RTS 176.

On March 8, 2000, John Mullen of AA faxed Peter Folger a representation letter concerning the options portion of the AA proposed shelter transaction, which AIG requested Mr. Folger complete and return. Ex. 102. On March 15, 2000, AA provided the Sideman firm with a list of “competitors pricing” of tax shelter products sold by Ernst & Young (COBRA), PWC, KPMG, UBS, and Presidio. Ex. 222. Mr. Sideman testified that he was not aware that this was a list of tax shelters. Tr. 188:6-8.

On March 16, 2000, the Sideman firm faxed a list of the steps of the AA shelter transaction to Owen Harper of JP Morgan. This document showed the various steps of the contemplated tax shelter to be part of a single integrated transaction. Ex. 255. On April 5, 2000, Richard Sideman faxed to R.J. Ruble his comments on Ruble’s draft opinion letter for the AA shelter transaction. Ex. 224. On April 19, 2000, AA sent Peter Folger and Richard Sideman engagement letters dated March 17, 2000 and signed by R.J. Ruble, hiring Mr. Ruble to act as special tax counsel to the Martin Family Trusts for the AA shelter strategy. Mr. Ruble’s fee was $700,000. Ex. 103. On or about April 24, 2000, Arthur Andersen sent to the Sideman firm a draft Ruble opinion letter entitled “Investment in Foreign Currency,” on which the Sideman firm made substantial editorial comments. Ex. 227.

On June 6, 2000, Richard Sideman sent AA and R.J. Ruble a memo prepared by the Sideman firm comparing the pricing of competing shelter transaction proposals made by AIG and Lehman Brothers. Ex. 230. The Martin family’s fees for the AIG proposal were $17.5 million if the options contracts had a 90-day term or $139.5 million if the options contracts had a 12-month term. The Martin family’s fees for the Lehman Brothers proposal (taking into account the adjusted notional amount because the Lehman proposal was blind) were $4.7 million if the options contracts had a 90-day term or $18.9 million if the options contracts had a 12-month term. Ex. 230.

Sometime after meeting with AA and reviewing its proposal, Mr. Sideman and Ms. Harrigan recommended against it. Tr. 132:2-13; 273:9-12. They had come to the conclusion that there had been misleading statements by AA that were material and important. Tr. 247:2-8. Mr. Sideman and Mr. Folger found the proposal inappropriate, unworkable, and not economically viable. Tr. 320:15-23; 324:21-22; 462:17-19. The AA proposal was never close to completion. Tr. 215:24-216:1. Ultimately, the family lost confidence in AA and on June 28, 2000, Francis Martin terminated AA’s services as the Martin Family’s accountant. Ex. 105. By letter dated July 7, 2000, Mr. Folger as trustee for the 14 Martin Family Trusts, terminated AA’s services for the Trusts. Tr. 133:15-16; 285:12-23; 321:4-14; Ex. 105.

On June 9, 2000, AA informed AIG that the Martin Family would not be engaging in any shelter transaction with AIG. In response, AIG requested that all proprietary information concerning its shelter proposals be returned to AIG. By letter dated June 21, 2000, the Sideman firm declined to return any such information to AIG (explaining that the information is not proprietary because the firm is required to maintain a client list of firms that participate in tax motivated transactions under the “listed transaction regulations.”) Exs. 45; 51.

2. Dr. Rubinstein

One component of the AA proposal had been a purported hedging transaction. A hedge was of some interest to the Martin family and the 14 Martin Family Trusts, as they already had a large portfolio of stock in the market and had been further advised by JP Morgan, their long time investment bankers, to invest the large amount of the cash distributions they had received or expected to receive from the CPC sale into the equity market. Tr. 90:2-11; 326:4-8; 462:17-23; 464:4-8; 605:25-606:1; 607:19-22. They were interested in maximizing the benefits from potential increases in the market while at the same time insuring themselves against a possible decrease in the market. Tr. 144:4-19; 489:15-490:16; 606:9-607:14. Mr. Sideman sought an expert in economic modeling to design or approve an economically viable options transaction that would both maximize the potential upsides and mitigate the potential downsides in the market. Tr. 143:8-144:19; 189:8-10; 236:10-11; 248:17-249:24; 462:17-19.

Mr. Sideman was directed by Mukesh Bajaj, an economics and financial expert with whom he’d previously worked, to Mark Rubinstein, an Economics Professor at the Haas School of Business at the University of California, Berkeley, who has an economics degree from Harvard University, an MBA from Stanford University, a PhD in Finance from UCLA. Dr. Rubinstein, an expert on derivatives and portfolio structures, is considered by investment banks to be the “godfather of derivatives,” and with two other professors developed the “binomial option pricing model,” which is widely used to value options. Tr. 82:25-83:9; 143:15-144:1; 150:24; 385:23-386:5; 703:7-23; 704:15-705:22.

On April 11, 2000, Mr. Sideman engaged Dr. Rubinstein under a Kovel agreement to provide independent advice only with respect to the options portion of the transaction that purportedly would enable the Martin family and the 14 Martin Family Trusts to maximize the potential upsides in the market while mitigating their potential downside risk and to otherwise address their business and financial objectives. Tr. 143:8-144:19; 189:8-10; 236:10-11; 248:17-249:24; 326:9-17; 462:17-19; Ex. 39. Dr. Rubinstein understood his task was to analyze the options transaction to determine whether there “could” be a business purpose to the transaction, that is, whether a rational risk-averse investor would want to engage in the transaction to improve his position. This determination was not based on any forward-looking view of the market, as to whether a particular investor expected the market to go up or down. Tr. 707:18-709:2; 731:20-22; 791: 4-8. Dr. Rubinstein was not asked to consider tax implications of the transaction.

3. Pricewaterhouse Coopers

On June 14, 2000, Mr. Sideman formally engaged the global accounting and consulting firm Pricewaterhouse Coopers (“PWC”) to design a joint investment structure to meet the objectives of the Martin family and the 14 Martin Family Trusts of risk management, asset conservation, flexible and prudent investment, maximization of returns, and equitable allocation amongst the trusts of the attendant risks and rewards. Tr. 142:16-19; 145:10-16: 188:22-189:2; 322:21-25; Ex. 125. On June 19, 2000, Roger Feusier of PWC sent Sideman a list of requests, including a request for “[a] more detailed description of the specific mechanics of the hedging transaction and the commercial reasons for undertaking it.” Ex. 129 at Priv Log 3888.

Having terminated AA as its accountant and tax return preparer, the Martin family and the 14 Martin Family Trusts separately engaged PWC to handle the family’s and Trusts’ accounting and tax return preparation needs. Tr. 170:10-171:8; Exs. 300, 301. Over several months, PWC gathered information about the CPC sale, the Martin family and the 14 Martin Family Trusts, and their objectives. Tr. 179:11-23; Ex. 129. Mr. Sideman and his Sideman & Bancroft colleagues, Ms. Harrigan and C. Jean Ryan, worked closely on the project with PWC and its partners and employees, principally Roger Feusier, a Certified Public Accountant with a Masters in Tax Law, and Duane Pellervo, a lawyer with a Masters in Tax Law from Georgetown University, speaking almost everyday and providing PWC anything it requested in order to do its work. Tr. 180:2-6.

On June 19, 2000, Duane Pellervo and Roger Feusier, both PWC partners, investigated and discussed the reputation of R.J. Ruble in the tax shelter area. This investigation revealed Mr. Ruble’s reputation as very aggressive, and that he had gained much financial success from writing tax opinions. Tr. 366:22-24. Because of his aggressive reputation, PWC felt that his opinion letter should be fully evaluated for accuracy. Tr. 367:11-17.

At Ruble’s recommendation, Sideman decided to bring Lehman Brothers into the transaction. Tr. 150:10-15. On July 11, 2000, Richard Sideman faxed to Roger Feusier a draft engagement letter with regard to Lehman Brothers. Ex 132; Tr. 400:8-19. In September 2000, the Sideman firm solicited proposals for the Martin family from both Lehman Brothers and JP Morgan.

4. Notice 2000-44

On August 11, 2000, PWC sent the Sideman firm a copy of IRS Notice 2000-44, as well as some news articles about the government’s efforts to combat the Son of BOSS tax shelter. At trial, Mr. Sideman testified about his understanding, at the time that Notice 2000-44 was issued, that the IRS took the position that transactions similar to the one being proposed for the Martin family were abusive tax shelters, but that the Notice had no binding effect at all.

On August 14, 2000, Mr. Pellervo of PWC informed the Sideman firm that R.J. Ruble was still willing to provide an opinion letter for the Martin Family Trusts’ shelter transaction, proposed by Lehman Brothers, notwithstanding the issuance of Notice 2000-44. Mr. Pellervo was interested in Mr. Ruble’s rationale for “what seems to be a very optimistic position in the face of the notice.” Ex. 168.

5. Presentation to the Martin Family

PWC prepared and put on several iterative presentations of a proposed joint investment structure it had designed to members of the Martin family, Mr. Folger as the Trustee of the 14 Martin Family Trusts, Mr. Sideman, and Ms. Ryan. These presentations described the various concerns and objectives that the joint investment structure was intended to address and achieve and the components of a proposed joint investment structure. Tr. 147:2-10; 153:1-24; 176:6-15; 323:1-22; Tr. 348:20-349:18; 372:6-373:4; 454:8-455:16; 533:17-536:18; Exs. 30, 120, 309. The tax ramifications of the transaction were clearly described to the Martin Family, as well as the potential for IRS examination, because of the issuance of IRS Notice 2000-44. Tr. 359:16-360:16.

At these meetings, Mr. Folger asked a lot of questions. He saw it as his role to understand and vet the proposed joint investment structure. In the course of this process, while he listened and might defer to the Martin family, it was ultimately his decision, based on the advice of Mr. Sideman, Ms. Ryan, and PWC, as to whether to approve and finally recommend the joint investment structure to the Martin family and to allow its implementation by the 14 Martin Family Trusts. Tr. 233:12-20; 323:23-324:5; 324:14-15; 335:17-19. In addition to attending the PWC meetings, Mr. Folger also frequently met and talked with Mr. Sideman separately about the proposed joint investment structure and met with the Trusts’ beneficiaries. Tr. 154:9-158:4; 266:8-18; 267:18-23; 268:7-12; 273:16-274:20; 325:21-25; 454:1-22.

At the same time that PWC was working to design a joint investment structure, Dr. Rubinstein had been evaluating and rejecting various options transactions proposed by Lehman Brothers and JP Morgan. Over the course of several months, he communicated with Sideman & Bancroft his various concerns with respect to the rejected proposed options transactions. Tr. 173:1-10; 733:18-25; Exs. 40, 47, 49, 50. After extensive analysis and consultation with Dr. Rubinstein, JP Morgan finally designed an options transaction that Dr. Rubinstein deemed could have economic purpose, to achieve the business and financial objectives as understood by Dr. Rubinstein. Tr. 173:1-10; 733:18-25; 769:18-23; Exs. 51, 52. Once Dr. Rubinstein approved the last JP Morgan proposed options transaction, Mr. Sideman also agreed to approve the options transaction as a component of the joint investment transaction. Tr. 173:3-13. Mr. Sideman would not have recommended or approved an options transaction that was not approved by Dr. Rubinstein. Tr. 225:11-15.

On September 20, 2000, the Sideman firm and PWC made a presentation to the Martin family in regards to the Lehman Brothers proposal. The family briefing document for this presentation was titled “Martin Family Presentation, Joint Investment and Management Proposal.” Ex. 30. The presentation included an explanation of the tax ramifications and tax risks of the proposal. Ex. 30 at Priv. Log. 3564; Tr. 444:20-445:10; Ex. 309. This presentation was attended by the Martin family (either in person or by phone), Folger, and representatives from PWC and the Sideman firm. Tr. 407:8-408:4; Tr. 543: 16-24.

At that presentation, the proposed transaction was described to the Martin family as having “the same basic mechanics” as the transaction described by the IRS in Notice 2000-44. Ex 30 at Priv. Log. 3577. The proposed transaction was presented to the Martin family as one that could completely eliminate their taxable gain on the sale of CPC. Ex 30 at Priv Log 3620. The written proposal states, “the joint investment management proposal may yield through the hedging component of the overall proposal significant tax benefit in the form of large capital loss.” Ex. 30 at Priv. Log. 3571. At that presentation, the Martin family was informed of what rate of return they would need to achieve on the investment of their tax savings in order to be indifferent to an IRS examination and ultimate repayment of the tax, plus interest and penalties. Ex 30 at Priv. Log. 3622; Tr. 405:8-25. The tax aspects of the transaction were explained to the Martin family at the presentation, with questions asked by the Martin family and answered by Roger Feusier and Richard Sideman. Tr. 408:24-409:20.

The written proposal discusses the importance of the IRS Notice 2000-44:

Also it is important to note that on August 11, 2000 the IRS announced in Notice 2000-44 that transactions involving the same basic mechanics as the instant one did not give rise to the intended capital loss.... As consequence, the Martin family should expect to incur significant litigation expenses in defending any capital loss resulting from the contemplated transaction.

Ex. 30 at Priv. Log. 3577. The written proposal also discusses the importance of the Ruble opinion letter to avoid IRS penalties. Ex. 30 at Priv. Log. 3577. In the section titled “Non-Tax Financial Considerations,” the written proposal states, “If the Parent LLCs were to be eliminated shortly after the short term assets were disposed of or if it distributed substantially all of its assets to its shareholders shortly thereafter the intended tax benefits of the transaction would be seriously jeopardized.” Ex. 30 at Priv. Log. 3577.

As part of the presentation, PWC prepared a spreadsheet that showed the effect of the proposed transaction on the Martin family income. This spreadsheet shows that expected tax loss would completely eliminate all gains from the sale of CPC. Ex. 30 at Priv. Log 3620. The mechanics and structure of the tax shelter portion of the transaction presented in the Martin family briefing document were identical to the abandoned Arthur Andersen proposal. Tr. 218:18-20.

On September 27, 2000, Lehman Brothers made a new proposal to the Sideman firm. The Sideman firm solicited the views of Dr. Rubinstein, PWC, and JP Morgan, on the proposal. Ex. 49. On September 29, 2000, R.J. Ruble provided to the Sideman firm a new draft opinion letter for the Martin Family Trusts’ shelter transaction. Ex. 179. PWC and Jean Ryan of the Sideman firm provided comments on the opinion letters written by R.J. Ruble for the Martin Family Trusts. Tr. 428:25-429:6; 522: 24-25; 458:7-15; Ex. 214 at Priv Log 5341. On September 29, 2000, Dr. Rubinstein informed the Sideman firm that the Lehman Brothers options strategy did not make sense, the pricing and payoff structure was strange, and the options were still too expensive. Ex. 50. The Lehman Brothers proposals were rejected as too expensive. Ex. 50.

In October 2000, the Sideman firm, PWC, and JP Morgan continued working together on a proposed shelter transaction for the Martin family. Throughout the month of October, JP Morgan made a variety of updated transaction proposals to the Sideman firm with respect to the Martin family. On October 6, 2000, another draft Ruble opinion letter, also entitled “Investment in Foreign Currency,” was sent from Sideman to Folger with a cover memo that states, “If the transaction occurs, we expect to close next week.” Ex. 235.

On October 16, 2000, Dr. Rubinstein told Richard Sideman that he was even more troubled by the JP Morgan options proposal than he was with the prior proposals from Lehman Brothers. He characterized the only possible argument for business purpose for this proposal as “a bit shakey [sic].” Ex. 51 at First Ship Summons 0736. On October 16, 2000, Mr. Sideman informed Francis Martin of Dr. Rubinstein’s concerns about the JP Morgan shelter proposal, and also informed Mr. Martin that the cost of the JP Morgan transaction was $10 million, rather than $9 million. Ex. 123. On October 21, 2000, Francis Martin called Mr. Sideman and told him that he disagreed with Dr. Rubinstein’s concerns and wanted to proceed with the proposed transaction anyway. Ex. 143. On October 24, 2000, Dr. Rubinstein told the Sideman firm that the options as proposed by JP Morgan were overpriced by $7 million, but later accepted JP Morgan’s explanation for its fees to account for the risk it was assuming for hedging this transaction. Ex. 51 at First Ship Summons 0745; Tr. 751-753. On October 27, 2000, Mr. Sideman provided the Martin family with a description of the transaction proposed by JP Morgan. Tr. 81:19-82:15.

PWC gave a final presentation to the Martin family, Mr. Folger, Mr. Sideman and Ms. Ryan in late October or early November, 2000. Tr. 372:6-373:4; 454:8-455:5; 543:16-544:3; Ex. 309. Following this presentation, the Martin family and Mr. Folger on behalf of the 14 Martin Family Trusts determined to go forward with a joint investment structure and the hedging transaction. Mr. Folger, on behalf of 2000-A and the 14 Martin Family Trusts, and the Martin family relied on Sideman & Bancroft and PWC to provide them with advice as to whether to enter into the joint investment transaction and its propriety. Tr. 151:18-22; 172:21-173:10; 264:3-10; 267:21-23; 268:7-23; 473:4-6; 477:9-16; 324:23-25; 325:1-10; 543:23-544:3. The Martin family understood that the transaction had a tax component as well as the business objectives of risk management, asset conservation, flexible and prudent investment, maximization of returns, and equitable allocation amongst the trusts of the attendant risks and rewards. Tr. 62:5-10; 323:1-11; 450:13-15; 651:13-17.

E. LLC Structure

The Martin Family Trusts formed several limited liability companies to implement the joint investment structure. See Ex. 30 (Joint Investment and Management Proposal); Ex. 6 (Ruble opinion letter). The implementation of the LLC structure, contemplated in November 2000, was completed in 2001. The Parent LLCs formed multiple lower tier LLCs (11 in all) to hold specific pools of assets, with those pools further divided into “Discretionary Investments” and “Common Investments.” In general, assets held by the Parent LLCs at the close of 2000 were not distributed to the ultimate owners but, rather, were invested within the structure. Each owner of a Parent LLC indirectly owned interests in those two categories of investments. Discretionary Investments were intended to provide a degree of investment flexibility to individual Martin family members, whereas Common Investments were intended to consist of conservative and uniform investments that were jointly agreed to by the family members, in order to facilitate the objective of maintaining a relatively stable pool of assets to cover the various exposures described above. Tr. 161:6-20; 374:10-375:14; 479:2-10; 482:3-16; 536:1-18; 575:21-24; Exs. 198, 266, 310. The joint investment structure stayed in place until 2006, when the reasons for its implementation were no longer of consequence. Tr. 87:13-88:15; 476:20-478:9.

The LLC structure and partnership at issue here involves the 2000-A partnership.

On June 2, 1999, LMGA Holdings was formed as a California C corporation. The five 1999 Trusts were each 20 percent shareholders in LMGA. Stip. ¶ 8. On June 15, 1999, and June 16, 1999, the 1999 Trusts transferred 4,130,728 shares of Liberty Media Group (LMGA) Stock and $13.8 million in cash to LMGA Holdings. Stip. ¶ 30.

On March 6, 2000, First Ship, LLC was formed as a California limited liability company. Stip. ¶ 3. The 14 Martin Family Trusts were the partners of First Ship, with petitioners Constance M. Goodyear 1997 Irrevocable Trust and Candyce Martin 1999 Irrevocable Trust having partnership interests of 7.13% and 3.40%, respectively. Stip. ¶ 4 and Ex. 6 (First Ship’s Form 1065 for tax year ended Dec. 31, 2000).

On October 10, 2000, First Ship 2000-A, LLC (“2000-A”) was formed as a California limited liability company with three partners: First Ship (77.03%); Fourth Ship LLC (22.22%); and LMGA Holdings, Inc. (0.75%). Stip. ¶ 6.

On October 12, 2000, Fourth Ship LLC was formed as a California limited liability corporation with nine partners: the five 1988 Trusts; the Francis Martin 1997 Trust; the Francis Martin 1998 trust; the Constance Goodyear 1997 Irrevocable Trust; and the Candyce Martin 1999 Irrevocable Trust. Stip. ¶ 7.

F. Implementation of the Joint Investment Transaction

The steps for implementing the joint investment transaction were outlined in the “Joint Investment and Management Proposal” briefing document prepared by PWC, and are described below. Ex. 30.

1. Step One: Consolidation of Assets in Martin Family Trusts

On November 9, 2000, LMGA Holdings distributed back to the five 1999 Trusts all of its Liberty Media shares (4,130,728 shares) along with $12.5 million of the $13.8 million in cash that LMGA then held. Stip. ¶ 30; Ex. 1 at MTCB 00116-00121. On that same date, based on the advice of JP Morgan, $121,452,146 in cash held by the 14 Martin Family Trusts and $1 million of cash retained by LMGA Holdings was invested in Standard & Poor’s Depositary Receipts (“SPDRs”), an investment unit that tracks the S & P 500. Stip. ¶ 36. Investing in SPDRs purportedly permitted the Trusts to quickly and conveniently convert the CPC proceeds into an investment that was intended to perform in a manner similar to, and that promised a return measured by, S & P 500 equities to which the SPDRs were later converted. Tr. 464:4-16; Exs. 30,120, 309.

2. Step Two: Purchase SPDRs

Each of the 14 Martin Family Trusts then invested its cash proceeds into S & P Depository Receipts (“SPDRs”). On November 9, 2000, the Martin Family Trusts invested most of their cash, $121,452,146, in SPDRs, an exchange-traded fund (“ETF”) that tracks the performance of the S & P 500. Stip. ¶ 36.

3. Step Three: Options

Concurrently with Step Two, the Martin Family Trusts entered into a set of options transactions with JP Morgan. The options were European-style options written against a notional portfolio (the “option notional portfolio”) that was virtually identical to the assets owned by the Trusts after the purchase of the SPDRs. Instead of SPDRs, the option notional portfolio included units of the S & P 500 index (86,230 shares). The number of shares of Liberty Media, Young Broadcasting, AT & T, and TCI Satellite included in the portfolio were exactly the same as the Trusts owned (i.e., 267,533 shares of AT & T, 5,435,370 shares of Liberty Media Group, 33,785 shares of TCI Satellite, and 391,444 shares of Young Broadcasting). Based on the initial stock prices and the initial level of the S & P 500 index used to value the portfolio, its initial value (the “notional value”) was $226.3 million. Ex. 3; Stip. ¶¶ 37, 40.

On November 10, 2000, the 14 Martin Family Trusts purchased six European-style option contracts (the long options) from JP Morgan for premiums paid totaling $315,781,658.59. Ex. 332 at US011130. Also on November 10, 2000, the 14 Martin Family Trusts sold (or wrote) five European style option contracts (the short options) to JP Morgan for premiums received totaling $314,885,515.96. Ex. 332 at US011150. The Martin Family Trusts paid JP Morgan a net up-front premium payment of $896,142.64, which amount is the difference between the premiums paid on the long options and the premiums received on the short options. Stip. ¶ 37; Tr. 937:4-25; 938:1-939:5; Ex. 6 at 5-6; Ex. 3 at MTCB00578-MTCB00830.

The trusts entered into a total of eleven options contracts: six purchased options, consisting of five calls and one put, and five sold or written options, consisting of four calls and one put:

Purchased Options SoldfWritten Options

Option Type Exercise Price * Scale Parameter ** Option Type Exercise Price Scale Parameter **

Call 80.50% 2.7 Call 83.5% 3.7

Call 86.75% 1.0 Call 88.25% 1.0

Call 91.50% 1.0 Call 93.00% 1.0

Call 96.25% 1.0

Put 119.00% 2.684 Call 119.00% 2.684

Call 119.65% 2.684 Put 119.65% 2.684

* Percentages are derived by dividing the call strike price by the Initial Notional Amount.

* * The scale parameter scales the notional portfolio on which the option is written.

Ex. 332 at US011129-31; US011149-51.

The put-call pairs with exercise prices of 119.00% and 119.65% (and an identical multiplicative factor of 2.684) collectively constituted a “box-spread,” which has a fixed dollar payoff at expiration. The combined effect of these four options was that the 14 Martin Family Trusts would pay JP Morgan an incremental $3.95 million embedded within the options at expiration, regardless of the value of the underlying portfolio in exchange for a smaller up-front premium. Tr. 995:1-16; 1075:23-1077:22.

The options expired on December 29, 2000. Stip. ¶ 37. The options were ordinary European-style options in all but one respect: the payoffs on the options did not depend on the value of the option notional portfolio at expiration. Rather, the payoffs depended on the average value of the options over three days leading up to and including expiration — that is, the option payoffs depended on the average value of the portfolio as of the market close on December 27, 28, and 29, 2000. Dr. Rubinstein testified that this feature of the options effectively prevented any attempt by JP Morgan to control the option payoffs. Tr. 773:19-774:8; Ex. 332 at US011129.

a. The Long Options

The Martin family entered into a long call-spread with a lower exercise price of 80.5% and an upper exercise price of 83.5%. Ex. 332 at US011129-31, US011149-51. The six long (purchased) options bought were as follows:

Type Premium Strike Price Multiplier

Call Strike 1 $123,805,727.02 $182,170,411.18 2.7

Call Strike 2 $ 33,729,813.40 $196,314,076.64 1.0

Call Strike 3 $ 24,935,847.96 $207,063,262.40 1.0

Call Strike 4 $ 17,520,041.28 $217,812,448.15 1.0

Call Strike 5 $ 2,998,457.08 $270,766,331.65 2.684

Put Strike 1 $112,791,772.85 $269,295,390.44 2.684

Total $315,781,658.59

Ex. 332 at US011130-31.

For the call options, if the final notional amount of the portfolio on December 29, 2000, was greater than the call strike price, JP Morgan was required to pay the Martin Family Trusts the difference between such amount and the call strike price, multiplied by the 2.684 multiplier. If the final notional amount was below the call strike price, no payments or settlements were due from either party. The final notional amount of the portfolio could trigger payments on more than one of the call options. Ex. 332 at US011131.

For the put option, if the final notional amount of the portfolio on December 29, 2000, was below the put strike price, JP Morgan was required to pay the Martin Family Trusts the difference between such amount and the put strike price, multiplied by the above multiplier. If the final notional amount was greater than the put strike price, no payments or settlements were due from either'party. Ex. 332 at US011131.

b. The Short Options

The Martin family entered into three short call-spreads with the following non-overlapping exercise prices:

Upper Exercised Lower Exercise Price Price (purchased (sold call) call)

83.50% 86.75%

88.25% 91.50%

93.00% 96.25%

Ex. 332 at US011129-31; US011144-51.

The terms of the five sold options were as follows:

Type Premium Strike Price Multiplier

$145,235,838.80 $188,959,370.60 Call Strike 1 3.7

Call Strike 2 $ 29,160,843.71 $199,708,556.35 1.0

Call Strike 3 $ 20,760,637.91 $210,457,742.11 1.0

Call Strike 4 $ 3,297,171.29 $269,295,340.44 2.684

Put Strike 1 $116,408,024.24 $270,766,331.65 2.684

Total $314,885,516.96

Ex. 332 at US011150-51.

For the call options, if the final notional amount of the portfolio on December 29, 2000, was greater than the call strike price, the Martin Family Trusts were required to pay JP Morgan the difference between such amount and the call strike price, multiplied by the above multiplier. Ex. 332 at US011151. If the notional amount was below the call strike price, no payments or settlements were due from either party. The final notional amount of the portfolio could trigger payments on more than one of the call options. Id.

For the put option, if the final notional amount on December 29, 2000, was below the put strike price, the Martin Trusts were required to pay JP Morgan the difference between such amount and the put strike price multiplied by the above multiplier. Ex. 332 at US011151. If the final notional amount was greater than the put strike price, no payments or settlements were due from either party. Id.

c. Underlying Basket of Stocks

The payouts on the option contracts were based upon the average closing price of the company stock owned by the Martin Family Trusts in an “underlying basket” or “notional portfolio” of stocks for the three business days leading up to and including December 29, 2000. Ex. 3 at MTCB00578-MTCB00830. The option notional portfolio was virtually identical to the asset portfolio owned by the Martin Family Trusts after the purchase of the SPDRs. Instead of SPDRs, the option notional portfolio included units of the S & P 500 index. The number of shares of Liberty Media, Young Broadcasting, AT & T, and TCI Satellite included in the portfolio were exactly the same as the trusts owned. These stock positions remained unchanged throughout the entire transaction, and continued even after it ended. Tr. 941:1^4. Based on the initial stock prices and the initial level of the S & P 500 index used to value the portfolio, its initial value (the “notional value”) was $226.3 million. Specifically, the underlying basket of stocks, as of November 8, 2000 (at or before the date the options contracts were about to be entered into) was as follows:

Company Number of Shares Initial Notional Initial Share Price Amount

AT&T 267,533 $ 21.1614 $ 5,661,372.83

Liberty Media 5,435,370 $ 16.4766 $ 89,556,417.34

TCI Satellite 33,785 $ 5.6250 $ 190,040.63

$ 26.8003 $ 10,490,816.63 Young Broadcasting 391,444

S & P 500 Index 86,230 $ 1,396.2620 $120,399,672.26

Total $226,298,319.69

Ex. 6; Tr. 940:16-941:10.

4. Step Four: Contributions to Parent LLCs

The next step of the transaction was to have the Martin Family Trusts contribute their assets, including the long and short options, to their first-tier partnerships, First Ship and Fourth Ship, referred to as the “parent LLCs.” Ex. 6 at US006475-76. On or about November 17, 2000, the Martin Family Trusts purportedly contributed $485 million to First Ship as follows:

Description Fair Market Value ($)

650,066 SPDRs 90,725,160

391,444 shares of Young Broadcasting 10,813,617

4,130,730 shares of Liberty Media Group 64,542,655

33,785 shares of TCI Satellite 162,575

KRON Holdback 3,019,838

Long Option Positions 315,781,636_

Total $ 485,045,481

Stip. Ex. 2 at PWC02784-89; Ex. 37 at Priv Log 5434; Ex. 6 at 5-6; Ex. 3 at MTCB00839-MTCB00850, MTCB00870-MTCB00875.

As reflected in the table above, the amount of the purported contributions to First Ship included the premiums on the long options totaling $315,781,658.59, unreduced by the premiums on the short options totaling $314,885,515.96, although the Martin Family Trusts only paid $896,142.64 net premium to enter into the option agreements. The transfer of the purchased and sold options to the partnership caused a purported increase in the Trusts’ bases in First Ship, as the Martin Family Trusts did not treat the short position on the sold options as a liability in computing the basis for the partnership.

Also on or about November 17, 2000, the five 1988 Martin Family Trusts and the Francis Martin 1997 Irrevocable Trust, the Francis Martin 1998 Irrevocable Trust, the Constance Goodyear 1997 Irrevocable Trust, and the Candyce Martin 1999 Irrevocable Trust contributed 210,880 SPDRs with a fair market value of $29.4 million to Fourth Ship. Ex. 3 at MTCB 00859-00867; Ex. 37 at Priv Log 5437.

5. Step Five: Contributions to 2000-A

The next step of the transaction was to transfer the assets from the first-tier partnerships, First Ship and Fourth Ship, to the second-tier partnership, 2000-A. On November 27, 2000, First Ship purportedly contributed over $415 million to 2000-A as follows:

Description Fair Market Value ($)

650,066 SPDRs $ 88,368,347

391,444 shares of Young Broadcasting, Inc. 11,033,828

Long Option Positions Purchased from JP Morgan 315,781,636_

Total $ 415,183,811

Ex. 37 at Priv Log 5433; Ex. 3 at MTCB00879-87. 2000-A also took on First Ship’s obligations under the short options.

Also on November 27, 2000, Fourth Ship contributed its 210,880 SPDRs, with a fair market value of $28,666,500, to 2000-A. On the same date, LMGA Holdings contributed its 7,151 SPDRs, with a fair market value of $972,089, to 2000-A. As of November 27, 2000, 2000-A held all of the 868,111 SPDRs that the 14 Martin Family Trusts and LMGA Holdings had purchased. Ex. 3 at MTCB 00886-88. First Ship continued to hold its shares of Liberty Media stock, its shares of TCI Satellite stock, and the KRON Holdback of $3,019,838. Ex. 37 at Priv Log 5434.

6. Step Six: Sale of 2000-A Assets

Immediately after the transfer of the SPDRs to 2000-A, JP Morgan directed the reinvestment of the SPDRs in stock of S & P companies. On November 29, 2000, 2000-A sold the SPDRs for $116 million, resulting in a lost of approximately $5.4 million. On or about December 1, 2000, 2000-A u