Partnership Transactions Were Sham, Designed To Generate Tax Loss

Colgate-Palmolive Co. (CP) sold a subsidiary in 1988, resulting in $105 million in capital gain. CP then began looking for ways to reduce or defer that gain. Employees of Merrill Lynch & Co. or its subsidiaries suggested an installment sales transaction through a partnership.

According to the IRS, Merrill's presentation to CP focused on the tax issues and benefits. The transaction would involve the creation of a partnership (ACM), and a "tax-neutral partner" (KNX) that would exit the transaction after a short period of time, recovering its origination costs and some compensation for its lost opportunity costs. The parties agreed that KNX would be exposed to minimal risks and receive the installment-sale gain, leaving the installment sale loss for CP after KNX exited, the IRS alleges. The plan contemplated a total contribution to ACM of $200 million, with $140 million eventually being used to invest in CP's own debt.

The IRS determined that KNX was essentially a lender, rather than a partner. Concluding that the transaction lacked economic substance, the IRS insists that the allocation of installment-sale gain to KNX had no substantial economic effect under section 704(b).

BRIEF FOR RESPONDENT

PRELIMINARY STATEMENT

[1] This case, involving the redetermination of partnership adjustments, was tried before the Honorable David Laro between February 12, 1996 and March 19, 1996. The evidence consists of Stipulations of Fact Nos. 1 to 9, with accompanying exhibits, testimony, and exhibits introduced at trial. The Court ordered simultaneous opening and reply briefs due April 29, 1996 and May 21, 1996, which dates were changed, by Order dated March 22, 1996 to May 2, 1996 and May 22, 1996. Closing arguments are scheduled to be heard in Washington, D.C. on May 30, 1996. A T.C. Rule 155 computation will be required.

QUESTIONS PRESENTED

1. Whether the transactions purportedly financing the purchase and sale of the Citicorp Notes were prearranged sham transactions, devoid of the economic substance necessary for recognition for federal income tax purposes?

a. Whether the purchase and resale of the Citicorp Notes by ACM (or at least the resale on a contingent installment basis) were prearranged sham transactions, devoid of the economic substance necessary for recognition for federal income tax purposes?

b. Whether the sale of the Citicorp Notes by ACM on a contingent installment basis was in substance a sale of a portion of the Citicorp Notes for cash and the remaining portion for LIBOR Notes?

2. Whether Kannex was a partner of ACM or whether Kannex was, in substance, a lender who made a loan and not a capital contribution?

a. If Kannex is determined not to be a partner, then whether the Partnership's proper taxable year is the calendar year pursuant to I.R.C. section 706(b)(1)(B)(i)?

3. Whether the allocation of the installment sale gain lacked substantial economic effect under section 704(b)?

a. If the allocation of the installment sale gain lacked substantial economic effect, whether the installment gain should be allocated, in accordance with the partners' interests in the partnership test of section 704(b), to Southampton and MLCS?

4. Whether the ACM transactions were part of a plan, consisting of certain unnecessary and meaningless transactions, which were focused only on the intended tax result?

[2] RESPONDENT'S REQUEST FOR FINDINGS OF FACT RESPONDENT respectfully requests that the Court find the following facts:

I. MERRILL LYNCH & CO., INC.

1. Merrill Lynch & Co., Inc., ¹ through its subsidiaries and affiliates, provided investment, financing, insurance, and related services. Its principal subsidiary, Merrill Lynch, Pierce, Fenner & Smith Inc., one of the largest securities firms in the world, was a broker in securities, options contracts, commodity and financial futures contracts, and selected insurance products; a dealer in options and in corporate and municipal securities; and an investment banking firm. Stip. paragraph 32; Tr. 547, 639.

2. Merrill's Investment Banking Division had primary responsibility for Merrill's corporate relationships. Merrill's Capital Markets Group was responsible for offering fixed income products to clients. Tr. 508.

3. Merrill Lynch Capital Services, Inc., a major U.S. derivatives dealer wholly owned by Merrill Lynch & Co., is the Merrill subsidiary that acted as a counterparty for Merrill swaps. Ex. 519 (p. 8) (Beder); Tr. 662-63.

4. Merrill takes pride in its ability to deliver on its promises to clients. Tr. 3136.

A. THE SWAP GROUP

5. Macauley Taylor ("Taylor"), a Dartmouth graduate, received a Masters in Business Administration ("MBA") from Harvard and was a certified public accountant. Taylor began working at Merrill in 1986 in the Swaps Department. Tr. 506.

6. In 1989, Taylor became a managing director, responsible for the Structured Derivative Financing Group of Merrill's Swap Group. Taylor developed transactions to solve tax, accounting, business or other economic problems for corporations. Tr. 506-07, 814; Stip. paragraph 34.

7. Taylor accessed corporate clients through Merrill's Investment Banking Division and Capital Markets Desk. Tr. 507-08; Stip. paragraph 34.

8. In 1989, Taylor's group consisted of James Fields ("Fields"), a tax attorney, Paul Pepe ("Pepe") and Steve Dymant. Tr. 507; Stip. paragraph 34.

9. Fields, a Wesleyan and Stanford graduate with a JD (1982) and a Ph.D. in economics (1984), was hired by Merrill to become a member of Taylor's group because Taylor wanted his group to have additional tax expertise in developing products for clients. Tr. 697, 809.

10. Fields worked at the Internal Revenue Service ("IRS" or "the Service") from 1984 to 1986 as an attorney advisor and then as a principal technical assistant to the then Chief Counsel Fred Goldberg. Tr. 869. He was a tax associate at Skadden Arps working in structured finance from 1986 to 1988. Tr. 810, 813.

11. Fields' work at Merrill related to servicing the Capital Markets and the Swap desks. He acted as internal counsel advising clients on tax consequences relating to interest rate swaps and debt. Tr. 814.

12. Pepe received an MBA in 1987 from the Wharton Business School and spent his first five months at Merrill in the mortgage backed securities area. Pepe then began working in Merrill's Swap Group, and in 1995, he became a Managing Director. Tr. 1242-43.

13. Since Pepe entered the Swap Group, he worked for Taylor, who prepared Pepe's evaluations. Tr. 698, 1242-43, 1293.

B. INSTALLMENT SALES TRANSACTION FOR TAX BENEFITS

14. At the end of 1987 or beginning of 1988, Taylor became involved in installment sales of foreign currency or private placements for cash and LIBOR notes. Tr. 703-04.

15. In the early installment sale transactions, Taylor found a purchaser who would pay for foreign currency with cash and a LIBOR note and arranged swaps with that issuer. Tr. 704-05.

16. Taylor understood that tax benefits were one of the benefits of these transactions. Taylor understood that the installment sale was used by the sellers to accelerate income to offset expiring capital losses. Tr. 704-05.

17. In 1989, Fields and Taylor discussed partnership transactions designed to create tax benefits from contingent payment installment sales. Tr. 705-07.

18. To assist Taylor in developing a transaction that could help a company utilize an expiring capital loss, Fields presented Taylor with the concept of an installment sale within a partnership. Tr. 543.

19. The initial appeal of the installment sale in a partnership concept was the tax benefits. Tr. 544.

20. The concept was explored as a way for a United States (U.S.) corporation to refresh capital losses or convert capital losses to ordinary losses. In such transactions, the majority interest partner would be the U.S. corporation who would take the acceleration of income. Tr. 705-06.

21. As Taylor and Fields played around with the boxes to designate participants in the deal, the different participants had different tax results. The concept was explored as a way for a U.S. corporation to defer or offset capital gains. Tr. 543-44, 705-06; Exs. AYR, AYX.

22. At about the same time that Taylor and Fields were discussing the partnership installment sale concept in early 1989, Taylor discussed the generic concept of an installment sale within a partnership with Johannes Willem (Hans) den Baas ("den Baas"), using den Baas as a sounding board for the idea. Tr. 711-12.

23. During 1989, and using schematics, Taylor approached companies with the conceptual idea of forming a partnership which would enter into an installment sale transaction. Tr. 707.

24. Taylor contacted Henry Yordan ("Yordan") for leads on companies that might be interested in the transaction. Yordan, a managing director on Merrill's Capital Markets Desk, was a Princeton graduate with a Stanford MBA. Tr. 509, 699, 3082, 3085; Stip. paragraph 34.

II. COLGATE-PALMOLIVE COMPANY

25. Colgate-Palmolive Company ("CP"), incorporated in Delaware and headquartered in New York, is a leading global consumer products company whose products include Colgate toothpaste, Palmolive dishwashing liquid, Fab laundry detergent, Ajax cleaner, and Irish Spring soap. During the years 1987 through 1992, CP had annual net sales: of between $5.6 billion and $7.0 billion. Stip. paragraph 8.

26. CP's total current assets, in 1989, totalled nearly $1.9 billion, and cash and cash equivalents plus marketable securities totalled $524 million. Exs. 12-L (p. 27), AZF (p. 29).

27. At all pertinent times, Colgate was rated A+ by Standard & Poors. Ex. AZI (p. 59).

A. COLGATE'S SALE OF KENDALL

28. On October 31, 1988, CP sold its wholly owned subsidiary, Kendall, and related assets. The consideration at closing included $901.7 million of cash and a note for $50 million. This sale created an approximately $105 million capital gain for CP. Tr. 902, 905; Ex. 40-AN; Stip. paragraph 18.

29. For 1988, CP reported $104,743,250 of net long-term capital gain, which included the capital gain from Kendall of approximately $105 million. Ex. 41-AO; Stip. paragraph 19.

30. Once CP's tax department realized the magnitude of the capital gain from the Kendall sale, CP began to look at alternative kinds of structures or transactions to either reduce or defer the gain, analyzing many different tax-advantaged transactions. Tr. 903- 04; Ex. 419-AAR.

31. As Vice President Taxation, Steven R. Belasco ("Belasco") was in charge of CP's tax department which was staffed by about 20 accountants and attorneys. Tr. 898-900; Stip. paragraph 9.

32. The Vice President Taxation was the senior-most tax position at CP and Belasco was the chief tax advisor to CP's senior management providing tax advice, dealing with mergers and acquisitions, advising the board on current issues, and setting the direction of the tax department on other than day-to-day issues such as compliance. Tr. 898-99.

33. As Tax Counsel, Judith A. Jacobson ("Jacobson") was part of the tax department reporting to Belasco. Tr. 1453; Stip. paragraph 9.

34. In trying to address the Kendall capital gain, Belasco worked principally with Jacobson, and Hans Pohlschroeder ("Pohlschroeder") from CP's Treasury Department. Tr. 904; Stip paragraph 9.

35. CP's Treasury Department had fairly typical functions for a large corporation. Its tasks included raising capital on the most advantageous terms; managing risks; managing CP's cash and investments; and insurance responsibilities. Tr. 75-77.

36. In the summer of 1988, Pohlschroeder was considering alternatives for sheltering the Kendall gain with investment bankers. Tr. 94-95.

37. On August 22, 1988, Pohlschroeder wrote a memorandum to Belasco regarding potential methods of sheltering the Kendall gain, one of which was an installment sale. Ex. 419-AAR.

38. In October 1988, CP considered restructuring the purchase price of Kendall with the purchaser in order to realize after-tax benefits through an installment sale. Brian J. Heidtke ("Heidtke"), Vice President Finance and Corporate Treasurer, reported to the Finance Committee about the tax benefits that could be achieved through obtaining installment sales treatment on the sale of the Kendall business. Ex. 437-AVO.

39. The purchase price was not restructured with the Kendall purchaser. Tr. 95.

B. MAY 15, 1989 MERRILL PRESENTATION TO COLGATE

40. Prior to May 15, 1989, Taylor discussed the concept of an installment sale transaction in a partnership context with Yordan and told him it might be of interest to a client with significant capital gain. Tr. 699-700, 3085; PF ² 45.

41. Yordan's basic responsibilities were to advise U.S. corporations about potential activities in the debt markets, issuance of new debt, retirement of debt, debt management matters, interest rate swaps, and issues dealing with fixed income matters. Tr. 3082.

42. Yordan was Merrill's key account officer for CP in the capital markets area and Pohlschroeder and Heidtke were Yordan's CP contacts. Tr. 245, 357, 3083. Pohlschroeder spoke to Yordan about debt markets and how CP's debt was trading frequently, on at least a weekly basis. Tr. 245, 248, 357-58.

43. In the Spring of 1989, Yordan contacted Pohlschroeder and told him that Merrill's Swap Group had an idea of how CP could deal with the Kendall capital gain. Tr. 245.

44. Yordan arranged for Pohlschroeder to meet with members of the Merrill Swap Group. Tr. 245.

1. THE PRESENTATION

45. On May 15, 1989, Yordan, Fields, Taylor, Pepe and James W. Simpson ("Simpson"), Merrill's CP relationship banker, met with Pohlschroeder. Taylor and Fields made a presentation proposing that CP engage in an installment sales transaction through a partnership (an "investment partnership") . Tr. 246, 699-700, 1244; Ex. 378-WY; Stip. paragraph 316.

46. Merrill brought blue-bound and poster-board size generic flip-charts to the May 15, 1989 meeting with CP and, using a balanced approach, Taylor and Fields presented the concept of an investment partnership. Tr. 246, 363, 818, 867, 1244, 1291.

47. The first part of the flip chart used in Merrill's presentation at the May 15, 1989 meeting described an I.R.C. section 453 contingent installment sale and the second part had two or three pages of boxes and arrows that dealt with an investment partnership. Tr. 819-20.

48. Fields first focused on tax issues involving investment partnerships, discussing the contingent installment sales regulations and explaining how they worked to Pohlschroeder. Tr. 821-22, 848.

49. In explaining the calculation of capital gain and loss in an I.R.C. section 453 contingent installment sale transaction at the May 15, 1989 meeting, Merrill used a document similar to "Contingent Payment Installment Sale Section 453" which laid out the cash flows of a contingent installment sale transaction. Tr. 360-61, 608; Ex. 84-CH.

50. Merrill's presentation, as laid out in "Contingent Payment Installment Sale Section 453", reflected a hypothetical transaction involving the sale of $100 million (fair market value and tax basis) of short term notes for $70 million in cash and four years of contingent payment notes, with a discounted value of $30 million. In this transaction, the partnership's cash flows net out to zero. There was $50 million of capital gain in 1989 and $50 million of capital loss in 1993. Ex. 84-CH (third page "Contingent Payment Installment Sale").

51. In the May 15, 1989 presentation to Pohlschroeder, Fields described an investment partnership with a sophisticated partner, and how the contingent installment sale regulations fit in the context of the investment partnership. Tr. 822-23.

52. Fields told CP that a transaction, using the contingent installment sale regulations, would produce a significant tax advantage. Tr. 822.

53. Taylor explained the types of partners and investments that might be interesting to CP. Tr. 822-23.

54. Taylor and Fields explained that the transaction would involve a tax-neutral partner who would be allocated the installment sale gain in the first year of the transaction and that the installment sale loss would be realized by CP or a CP subsidiary after the large partner exited the partnership at a later point in time. Tr. 363-64, 700-01.

55. The schematics used at the May 15, 1989 presentation reflected the majority interest partner exiting the partnership in two years. Tr. 701.

56. In the May 15, 1989 presentation to Pohlschroeder, Taylor indicated that if CP were interested in a particular type of investment, Merrill could tailor the investments of the partnership to that area, by arranging for a partner with expertise in the area of CP's interest. Tr. 823.

2. COLGATE'S REACTION TO MAY 15, 1989 PRESENTATION

57. Merrill's proposal at the May 15, 1989 meeting contemplated the partnership buying investment assets. Tr. 820.

58. CP used a portion of the cash proceeds from the 1988 Kendall sale to pay off existing debt. CP anticipated using remaining cash proceeds from the Kendall sale for acquisitions and had given the cash to J.P. Morgan to invest. Tr. 93, 232.

59. Certain cash reflected on CP's balance sheet was blocked for foreign transactions. Tr. 247-48.

60. Pohlschroeder testified that he told Merrill that CP did not have unblocked cash available to invest in investment assets. Tr. 247-48.

61. It was Pepe's impression that Pohlschroeder was preliminarily interested in the transaction but Pohlschroeder did not see the fit with CP's asset and liability structure. Tr. 1245.

62. Pohlschroeder briefed Belasco on his May 15, 1989 meeting with Merrill, explaining to Belasco the tax aspects of the transaction presented by Merrill. Tr. 906, 956.

63. Belasco understood that Merrill's proposal involved the installment sale regulations and could provide CP with a large capital loss to offset the Kendall gain. Tr. 906.

64. Belasco believed that while the investment partnership transaction proposed by Merrill had a potentially good tax effect, it did not, on its face, serve the business needs of CP. Tr. 907.

65. As a tax professional, Belasco was concerned that the transaction might be viewed as a transaction without economic substance. Tr. 922.

66. Referring to the transaction described in the September 20, 1989 schematics, Belasco testified that the transaction was naked because it did not do anything in terms of accomplishing something that CP would want to do. Tr. 924; Ex. 81-CE.

67. During the period CP considered the transaction, Belasco expressed his concerns to Robert M. Agate ("Agate"), CP's Chief Financial Officer ("CFO"), members of CP's tax department and CP's "treasury folks". Tr. 922-23.

68. Belasco became comfortable with his concerns as a result of the treasury aspects of ACM Partnership ("ACM" or "the Partnership"). Tr. 926.

69. In understanding the treasury aspects of the proposal, Belasco relied upon Pohlschroeder and Heidtke. Tr. 910.

C. COLGATE'S INVESTMENT PARTNERSHIP

70. Yordan made follow-up phone calls to Pohlschroeder regarding the May 15th proposal. Yordan wanted to bring Taylor and Fields by again. Tr. 248, 3086.

71. Yordan thought that either CP had told Merrill that CP was not interested in the transaction or that CP was working on it. Tr. 3086-87.

72. On July 18, 1989, Pohlschroeder had a telephone conversation with Taylor regarding:

"Invest. partnership

73. Pohlschroeder claimed not to remember if he or Taylor suggested that the business purpose of the investment partnership was to "invest in your own debt." Tr. 366-67.

74. In his notes of the July 18, 1989 telephone conversation with Taylor, Pohlschroeder's written statement "every single step to be substantiated" was in reference to the partnership. Ex. 422-ABG; Tr. 366-68.

75. Subsequent to the July 18, 1989 telephone conversation between Taylor and Pohlschroeder, a meeting was held on July 19, 1989 during which Pohlschroeder asked Taylor to prepare a proposal which was provided to CP on July 28, 1989. Tr. 249-50, 370-01, 384; Exs. 57-BE, AAZ (CO845).

76. Taylor had a "fuzzy" recollection of the July meetings with CP. Tr. 701-02.

77. Pohlschroeder scheduled a meeting with Belasco concerning the "Business Purpose" of the proposed deal on July 20, 1989. Tr. 368-69; Ex. AAZ (CO0845).

78. The July 28, 1989 proposal provided to Pohlschroeder and also Belasco was outlined in steps and addressed a business purpose for the steps. Ex. 57-BE; Tr. 249-50, 370-72, 384.

79. Pohlschroeder understood, in July of 1989, that as outlined in the July 28, 1989 proposal, CP would take a portion of the capital gain generated on the sale of the short-term notes for cash and LIBOR notes and that 85 percent of the gain would be allocated to the tax- neutral partner. Tr. 381-82.

80. Pohlschroeder, while understanding the concept, claimed he was not a tax expert and he did not know how the tax benefits of the transaction to CP were derived. Tr. 375-78.

81. On June 27, 1989, Fields obtained tax advice from Mark Kuller of King & Spalding, regarding a contingent installment sale within a partnership. This advice assumed the formation of a partnership, the installment sale, the allocation of gain to the majority partner, the liquidation of a majority partner's interest, the subsequent disposition of the installment notes, and an allocation of the capital loss between the two remaining partners. Ex. 77-CA; Stip. paragraph 52.

82. Merrill provided a copy of this advice and other tax opinions given by King & Spalding to Fields to CP. Stip. paragraph 52; Tr. 702-03; Exs. 77-CA through 80-CD.

1. AUGUST AND SEPTEMBER PROMOTION

83. Throughout the period CP was considering the transaction, Merrill presented the partnership concept that became the ACM Partnership to CP as a series of transactions in sequential steps. Exs. 57-RE, 58-BF, 59-BG, 81-CE.

84. Merrill gave Heidtke a document entitled "XYZ Corporation Revised Partnership Transaction Summary Draft 8/17/89" which called for a total contribution of $200 million. The amount of the contribution was related to tax benefits contemplated by CP. Tr. 252- 53, 259; Ex. 59-BG.

85. The $200 million capital contribution amount was related to generating a capital loss to offset the Kendall capital gain. Knowing the amount of the Kendall gain, CP wanted to have an adequate amount in the partnership in order to buy an amount of LIBOR Notes that could create the necessary amount of capital loss. Tr. 913.

86. Fields testified that he did not recall why $200 million was chosen, why it was allocated 15 percent to CP and 85 percent to the other partner, that the dollar amounts were related to the target debt repurchase, and that he did not think they had anything to do with the size of CP's capital gain. Tr. 870-72.

87. According to Pohlschroeder and Belasco, the $200 million was related to the amount of debt the partnership planned to purchase as well as the tax benefits CP was seeking. Tr. 258-59, 870-71, 93; Ex. 57-BE.

88. Through October 24, 1989, internal cash flows and rate of return analyses assumed an installment sale in quarter zero of the partnership's first year of $200 million of assets for 70 percent cash and 30 percent LIBOR notes. Exs. 60-BH through 66-BN. The written descriptions of the transactions also assumed a ratio of to percent cash to 30 percent LIBOR notes. Exs. 57-BE through 59-BG.

89. The estimated notional on the $60 million LIBOR Notes reflected in the pre-October 27, 1989 cash flows was between $161 and $166 million. Exs. 60-BH through 66-BN.

90. Through October 24, 1989, the cash flows prepared by Merrill showed the partnership purchasing CP debt of $50 million. The remainder of the $140 million cash generated from the installment sale of $200 million was shown as invested in financial assets. Exs. 60-BH through 66-BN.

91. The October 27, 1989 "Pre-Tax Cash Flow Analysis" assumed an installment sale of $170 million of assets for 80 percent cash and 20 percent LIBOR Notes, with the approximately $140 million of the proceeds invested in CP debt. Ex. 67-BO.

92. Merrill advised CP that the transaction produced approximately $20 million present value benefit to CP, after tax but before Merrill's advisory fee. Exs. 57-BE (last page), 58-BF (p. 5 (excluding cover letter) entitled "Federal Income Tax Considerations"), 59-BG (p. 5).

93. Fields worked with Taylor and Pepe in performing the calculation. Tr. 873.

94. The calculation was based on the difference between the cost to CP of the tax gain recognized upon the installment sale, as a minority partner, and the benefit to CP of the tax loss CP would recognize as a majority partner, after the majority partner left the partnership, discounted back to 1989. The calculation assumed the sale of $200 million in short-term notes for $140 million in cash and LIBOR Notes with a value of $60 million. Tr. 871-72; Ex. 58-BF (p. 5 (excluding cover letter) entitled "Federal Income Tax Considerations").

95. Merrill estimated negative $5.10 million after-tax cash flow for the installment sale gain and a positive $36.61 million of after- tax cash flow from the installment sale loss. Ex. 58-BF (last p.).

96. A September 4, 1989 cash flow revised the after-tax cash flows to reflect a distribution of a portion of the LIBOR Notes in the first quarter and a sale of the notes in the third quarter. The net after-tax cash flow of the installment sale, and combined distribution and sale of the LIBOR Notes was $45 million, $31 million of which stemmed from capital losses. Ex. 62-BJ.

97. CP was advised by Merrill that CP would have to contribute assets to the Partnership or the Partnership would have to borrow for CP to have sufficient basis to claim the capital loss. Exs. 58-BF (last p.), 71-BS.

98. Prior to the formation of ACM, CP discussed having a second CP subsidiary coming into the Partnership after it was formed. Ex. 424-ABI.

99. The after-tax cash flows reflecting a $20 million net present value benefit to CP all assumed that the capital loss -would be recognized by CP in the seventh quarter of the Partnership's existence. Exs. 58-BF (last p.), 60-BH, 62-BJ, 64-BL, 65-BM.

100. August and September cash flows reflecting a $20 million net present value benefit to CP were entitled "Perpetual Partnership" and assumed an effective tax rate of 34 percent. Exs. 58-BF (last p.), 60-BH, 62-BJ, 64-BL, 65-BM.

101. While familiar with a September 1, 1989 document containing an estimate of transaction costs, Belasco, Pohlschroeder and Fields all claimed to have no idea why the document was entitled "Perpetual Partnership." Tr. 385, 877, 966; Ex. 69-BQ.

2. THE EXIT STRATEGY

102. Prior to the formation of ACM, Merrill advised CP that if the Partnership were dissolved after one year, CP's net present value of the partnership investment would be NEGATIVE $4.07 million. Ex. 70-BR.

103. Fields and Pepe prepared schematics reflecting a tax planning strategy (the "Exit Strategy") to eliminate the built-in gain, and thus the deferred tax liability to CP as a result of ACM Partnership transactions. Tr. 885-88; Ex. AYR.

104. The tax planning strategy called for a tax free liquidation of the "Investment Partnership" into a newly formed subsidiary, owned 98 percent by CP and 2 percent by Merrill, followed by the redemption of Merrill's interest and then the merger of the new corporation into a CP controlled subsidiary. Tr. 887; Exs. AYR, AYX (AA00022).

105. Fields discussed the exit strategy with Pohlschroeder prior to a meeting with CP's accountants. Tr. 888.

106. Heidtke remembered discussing the exit strategy, but not the specifics as to when or what was discussed. Tr. 192.

107. Belasco discussed an exit strategy for Southampton-Hamilton Company ("SH") and CP from the Partnership after two years. Tr. 969.

108. Pohlschroeder took notes at three separate meetings where an exit strategy was discussed with, among others, CP's accountants. Ex. 423-ABH (C1090, ACM01644-A (bottom of page) and C1092, C1093); Tr. 430-33, 436-39.

109. At trial, Pohlschroeder claimed he did not specifically recall discussions regarding the exit strategy. Tr. 430-33, 436-39.

110. In 1989, Stephen F. Rossi ("Rossi"), a certified public accountant with Arthur Andersen & Co. ("Arthur Andersen"), was the audit engagement manager for CP. Tr. 1889.

111. Most of Rossi's discussions involving ACM were with Pohlschroeder. Tr. 1913.

112. Rossi met with representatives of CP and two or three representatives of Merrill regarding ACM Partnership. Tr. 1891-92.

113. At the meeting, the potential structure and contemplated time frames for the transactions were discussed. Tr. 1894-95.

114. On or around January 9, 1990, Rossi recorded the time frame of the ACM Partnership transactions, in steps, as follows:

Date                Description

116. The exit strategy was an anticipated step in the ACM Partnership transactions. Tr. 1911-12; Ex. AYX (AA00021-22).

117. Respondent's audit of ACM began in January of 1991. Tr. 968.

3. THE SEPTEMBER SCHEMATICS

118. Merrill's "Presentation to Colgate-Palmolive Company Investment Partnership September 20, 1989" only addressed the tax aspects of the transaction and did not address liability management concerns. Tr. 274; Ex. 81-CE.

119. Merrill's September 20, 1989 schematics described the tax consequences of each of the following steps of the transaction:

     Step 1         Formation of the Partnership

121. Fields did not recall preparing the specific document but recalled working on something like it at the request of CP for a presentation to CP's senior management. Tr. 876.

122. Belasco testified he recalled getting the schematics from Merrill but not when or how he got them. Tr. 921.

123. Pohlschroeder's calendar reflects a September 20, 1989 "Merrill Lynch" meeting with Heidtke, Jacobson and Taylor and Fields. Ex. AAZ (CO847).

124. Heidtke first learned of ACM in the late summer or early fall of 1989. Tr. 104.

125. Heidtke's first impression of the Merrill proposal was that it had some very significant tax benefits. Tr. 105.

126. Heidtke understood that the proposal involved a series of steps which, if followed, would result in very significant tax benefits for CP. Tr. 108.

D. THE FORMAL APPROVAL

1. COLGATE SENIOR MANAGEMENT

127. As CP's CFO during the years in issue, Agate was responsible for the global financial activities of the corporation, including internal and external reporting, treasury, tax, and internal audit activities. Tr. 1501; Stip. paragraph 9.

128. As CFO, Agate reported directly to Chief Executive Officer Reuben Mark ("Mark"). Heidtke and Belasco reported directly to Agate. Tr. 1502.

129. During 1989, Agate Met With Heidtke several times each week, and met with Belasco almost as frequently. Tr. 1503.

130. CP's procedure for approval of a financial transaction was approval by Agate and the vice-presidents who reported to him, followed by a formal presentation to CEO Mark and then to the finance committee and Board of Directors. Tr. 1504.

131. Agate attended all CP Board of Directors ("Board") and finance committee meetings. Tr. 1501.

132. Agate first heard of the ACM proposal from either Heidtke or Belasco. Tr. 1507, 1511.

133. Heidtke, Belasco and probably Pohlschroeder described the ACM transaction to Agate. Tr. 120-21.

134. Prior to describing the transaction to Agate, Heidtke attended a lengthy meeting with Taylor, Fields, Simpson, Pohlschroeder, Belasco, a representative of CP's accounting department controller, and perhaps a member of Belasco's staff. At that meeting the transaction was discussed on a lengthy step-by-step basis to understand the advantages and disadvantages involved. Tr. 118, 120.

135. Agate approved the transaction for presentation to CP's CEO and Board. Tr. 1509.

136. Agate met with Merrill early on in his involvement in the transaction, but testified he did not specifically recollect what was discussed. Tr. 1509.

137. Agate did not discuss the ACM transaction with any other persons either inside or outside of CP, but was aware of discussions with Arthur Andersen, CP's auditor. Tr. 1517-18, 1527.

138. Agate testified he had no recollection of a formal presentation regarding ACM. Tr. 1513.

139. Agate recalled being shown charts by Belasco, similar to the sixth page of the September 20, 1989 "Presentation", reflecting the manner in which the capital gain and loss from the transaction were spread out, over different years. Tr. 1511; Ex. 81-CE.

140. Belasco expressed concerns to Agate regarding whether the proposed transaction had appropriate commercial justification for its structure. Belasco informed Agate he thought the transaction did. Tr. 1516, 1535.

141. Agate recalled no other concerns being raised regarding the proposed ACM transaction prior to discussing the transaction with Mark. Tr. 1516.

142. Agate testified he recalled no specific or general steps taken to satisfy the concerns regarding whether there was appropriate economic justification for the transaction. Tr. 1535-36.

143. Agate testified he did not recall whether any specific steps were taken to minimize CP's audit or litigation risk from entering into ACM. Tr. 1535-36.

144. Belasco informed CP management that Kannex Corporation N.V. ("KNX") would have to exit the Partnership before the end of 1991 in order to realize the tax benefits of the transaction -- the carryback of the loss to offset the 1988 Kendall gain. Tr. 968.

2. THE OCTOBER 3, 1989 MEMORANDUM

145. Pohlschroeder wrote a memorandum to Heidtke entitled "ABN Liability Management Partnership" dated October 3, 1989 ("October 3, 1989 memorandum"). Ex. 86-CJ.

146. At the time Pohlschroeder prepared the October 3, 1989 memorandum, the tax benefits of ACM were already firmly planted in everybody's mind. Tr. 115.

147. By mid or late September 1989, Belasco had concluded that ACM would work from a tax viewpoint and he recommended the Company proceed with the transaction. Tr. 922.

148. Taylor believed CP was committed to doing the deal by or about September 20, 1989. Tr. 559.

149. On October 3, 1989, Agate, Heidtke, Belasco and Pohlschroeder discussed the matters in Pohlschroeder's October 3, 1989 memorandum to Heidtke and the offset between the LIBOR Note and CP's existing interest rate swaps under which CP paid a floating interest rate in exchange for a fixed-rate on a $300 million notional amount. Exs. 423-ABH (ACM01644-A), 86-CJ; Tr. 430, 433-37; PF 811.

150. Pohlschroeder's October 3, 1989 memorandum did not mention that CP would benefit from the ACM Partnership by deriving the benefits of future improvements in the credit spread of CP's debt. Ex. 86-CJ.

151. Pohlschroeder justified the partnership's purchase of CP debt on the grounds that at the then current price (par), the debt was tradeable. Ex. 86-CJ (pp. 2, 3).

152. In his October 3, 1989 memorandum, Pohlschroeder stated that Algemene Bank Nederland N.V. ("ABN") could be bought out once CP's objective of shortening the average life of CP's debt maturity had been accomplished. Ex. 86-CJ (p. 9).

153. Pohlschroeder's memorandum opined that one distinct advantage of using a partnership rather than purchasing debt directly was the reduction in transaction costs. Ex. 86-CJ (p. 2).

154. Merrill assisted Pohlschroeder in preparing the portion of Pohlschroeder's October 3, 1989 memorandum to Heidtke that related to SH's ability to adjust the Yield Component. Tr. 276; Ex. 86-CJ (p. 8).

155. Merrill provided CP with a Liability Management Partnership Executive Summary dated October 11, 1989, discussing certain of the same matters as those discussed in the October 3, 1989 memorandum. Ex. 76-BZ; Stip. paragraph 51.

3. PREPARATION FOR THE OCTOBER 12, 1989 BOARD MEETING

156. Agate, Heidtke and Belasco prepared a formal presentation to Mark regarding ACM prior to the October 12, 1989 CP Board meeting. Tr. 1514-15.

157. Heidtke and Belasco, and possibly Pohlschroeder and Jacobson, discussed the tax and treasury aspects of the meeting with Mark. Tr. 928.

158. Mark approved the ACM transaction prior to the presentation to CP's Board. Tr. 1519.

159. After Mark approved the ACM transaction, a large meeting was held with Merrill. Because of CP's expressed commitment to ACM, the meeting did not last long. Tr. 928.

160. Agate and his subordinates prepared and rehearsed a presentation on ACM for the October 12, 1989 CP Board meeting. Tr. 1518.

161. Visuals, entitled "Liability Management Partnership", were presented to the Board. Tr. 123; Ex. 87-CK.

4. THE CP BOARD PRESENTATION

162. CP's Board had oversight responsibilities for the risk management function and regular presentations were made to the Board regarding risk management transactions and accomplishments. Tr. 77.

163. When Belasco explained the structure of the transaction to the Board, he focused on sheltering the Kendall gain. Tr. 177, 929; Ex. 87-CK (2nd, 3rd and 4th unnum. pp.).

164. Belasco explained the simple principle behind the basis recovery rules of an installment sale to the Board. Tr. 962.

165. Belasco believed he told the Board that CP would have to recognize 17 percent of the installment sale gain when the Citicorp Notes were sold but he did not know if he told the Board the amount of the gain. Tr. 961-62.

166. CP wanted to shelter the installment gain and Belasco told the Board that, based on the overall economics of the transaction, it would be sheltered. Tr. 962.

167. Belasco told the Board that the transaction would generate significant tax benefits. Tr. 957.

168. Heidtke then explained the treasury aspects of the transaction to the Board. Tr. 121-23; Ex. 87-CK.

169. The ostensible reasons for CP's participation in the transaction, as reflected in the October 12, 1989 Board minutes, were extensions of Pohlschroeder's October 3, 1989 memorandum. Exs. 88- CL, 86-CJ, AZD (pp. 21, 24, 25); Tr. 163-66.

170. When ACM was presented to the CP Board, the presentation included references to CP's "Average Debt Maturity." Ex. 87-CK (unnum. p. 7); Tr. 124.

171. Heidtke told the Board that ABN was to be a partner, even though he knew that KNX was actually the partner. Tr. 174-75.

172. Heidtke told the Board that ABN would be the partner because the Board would not be familiar with KNX, while ABN was a huge multinational bank known throughout the world. Tr. 175.

173. Based on discussions he had with Pohlschroeder, Heidtke told the Board that ABN would permit CP desired flexibility. Tr. 175; Ex. 88-CL (CO117).

174. Heidtke had not discussed the transaction with ABN at that time, although he later understood that ABN would permit CP desired flexibility. Tr. 175-76.

175. Heidtke thought he assumed ABN would be bought out at the relative values of assets in the Partnership. Tr. 176.

176. The CP Board minutes did not reflect that a reason for entering into ACM was to retire a portion of CP's debt at a relatively cheap price. Ex. 88-CL (CO117); Tr. 167-68.

177. One of the slides used in the ACM presentation to CP's Board addressed tax considerations, legislation, regulations, and litigation. Tr. 1519; Ex. 87-CK.

178. Belasco told the Board that the Service might challenge the transaction because it generated a large capital loss. Tr. 931.

179. Agate testified that he could not recall any discussion of ACM's tax considerations, legislation, regulations, or litigation at the October 12, 1989 Board meeting or the November 8, 1989 finance committee meeting. Tr. 1519-20.

180. Agate testified that he could not recall any discussions with CP Board or finance committee members regarding ACM. Tr. 1519- 23.

181. Agate testified that he did not recall any concerns about ACM raised by members of CP's audit committee. Tr. 1526.

182. It is unusual that documentation regarding CP's decision to participate in ACM did not contain written materials alluding to the opinion of Agate. Ex. AZD (p. 7) (Smith); Entire Record.

183. Howard B. Wentz, Jr. ("Wentz"), educated at Princeton and Harvard, was an outside director on CP's Board and also served on CP's finance and audit committees. Tr. 1599-1600.

184. Wentz has also served corporations other than CP as a management consultant, CEO, and chairman of the board. Tr. 1600.

185. Wentz testified that he was at the October 12, 1989 Board meeting but could not recall any presentation having been made regarding ACM. Tr. 1609-10.

186. Wentz testified that he was familiar with the concept of debt spreads, or measuring the value of a corporate security by comparison of its price with, for example, Government securities or bonds, and that such concepts were discussed from time to time in Board and finance committee meetings. Tr. 1613-14.

187. Wentz testified that he could not recall any of his thinking about the pros and cons of CP's entering into ACM. Tr. 1615.

188. Wentz testified that he never discussed ACM audit risk or litigation risk. Tr. 1616.

189. Wentz testified that he never discussed ACM with other CP Board members, CP employees, professional associates, or outside counsel. Tr. 1617-19.

190. Wentz testified that he did not recall any tax aspects of or benefits to CP from participating in ACM. Tr. 1617.

191. On July 10, 1991, two weeks after the partial purchase of KNX's partnership interest for $100,897,203.60, there was a finance committee meeting. Ex. NP; Stip. paragraphs 213, 214.

192. The minutes of the meeting reflected that Heidtke commented on the ACM Partnership, but did not elaborate any further. Ex. NP (CO125).

193. The presentation materials included bullet points on ACM's "planned 1991 liquidation", "attendant tax advantages", and "Treasury management objective[s]", including investing in CP debt, balancing debt maturities and managing interest rate risk. The presentation materials also referred to "Associated interest rate swaps." Ex. 496- AYO.

194. Agate and Wentz, then chairman of the finance committee, attended the July 10, 1991 meeting. Ex. NP (CO125).

III. ALGEMENE BANK NEDERLAND N.V.

195. During 1989, ABN was the Netherlands' largest bank and one of the Netherlands' largest financial institutions, with more than $85 billion in assets and approximately 950 offices in 43 countries worldwide. ABN had approximately 29,000 employees. Stip. paragraph 35.

196. During the period in issue, ABN offered comprehensive corporate, institutional and individual financial services, including domestic and international lending, trade finance and international payments, international corporate finance and advisory services, global investment management and advisory services, foreign exchange, treasury and risk management services, and trust services. Stip. paragraph 37.

197. During the period in issue, LaSalle National Bank, an indirect subsidiary of ABN, was the trustee of CP's Employee Savings and Investment Plan and the Employee Stock Ownership Trust ("ESOP"). Citibank N.A. ("Citibank") was the custodian for the ESOP. Stip. paragraphs 22, 36.

198. During the period in issue, ABN Trustcompany (Curacao) N.V. ("ABN Trust") was a subsidiary of ABN. Stip. paragraph 38; Tr. 992; Ex. 516.

199. ABN Trust and ABN New York had separate reporting lines to Amsterdam. Tr. 985.

A. DEN BAAS

200. Den Baas, an employee of Rabobank, received an MBA from Erasmus University in Rotterdam. Tr. 1089-90. Beginning in 1984, den Baas was in ABN's ex patriate training program and worked for a number of ABN affiliates, including La Salle National Bank in Chicago as a credit training employee. In 1987, den Baas moved to ABN New York's Treasury department and assisted clients in derivative product transactions. Tr. 1090-91.

201. Between the middle of 1989 to 1990, den Baas formed a group called Financial Engineering at ABN New York, which developed more complicated derivative products and hedging structures for corporate clients. Tr. 1091, 1135. The Financial Engineering Group developed into a five member group headed by den Baas and remained in existence until 1993. Members included Chris Kortlandt ("Kortlandt"), Shaun Clinton ("Clinton"), Susan Casper ("Casper"), and a secretary. Tr. 1091, 1135-36.

202. Prior to October 1989, den Baas was approached by Taylor to provide a tax-neutral foreign investor to be a partner in a partnership with CP that would invest in CP debt. Tr. 514, 708, 710- 11, 1137, 1214.

203. Taylor and den Baas discussed the term of ABN's participation in what became ACM Partnership. Tr. 710.

204. Taylor informed den Baas of the installment sale transaction. Tr. 710.

205. Den Baas knew that Taylor needed a tax-neutral investor that would be managed outside the United States. Tr. 711, 1139.

206. In September 1989, Taylor believed den Baas understood that a tax-neutral partner was required because there would be an acceleration of income which the tax-neutral partner would absorb. Tr. 710-11.

207. In September of 1989, Taylor and den Baas were involved in Nieuw Willemstad Partnership (unrelated to CP), a partnership which entered into a financial advisory services agreement with Merrill on September 15, 1989. Tr. 803-04, 1215-16, 3126, 3180-82; Exs. ACX, ACZ; PF 1058.

208. Den Baas understood that the partnership would invest in non-CP debt initially, but that subsequently the majority of the partnership investments would be long-term CP debt. Tr. 1093.

209. ABN was interested in the transaction because it provided a means to establish a relationship with CP and because the potential yield to ABN as a result of the loan and the swap profits from swap spreads were greater than that provided through a direct lender relationship. Tr. 1122.

210. To ABN, it was much more important to know what type of credit risk it would be exposed to than what type of interest denominations it would end up with. Tr. 1142.

211. As a result of his conversation with Taylor, den Baas contacted Peter de Beer ("de Beer") about identifying a foreign partner. Tr. 711, 1093.

212. As a result of his conversation with Taylor, den Baas also requested the account management area of ABN New York to write up an analysis of CP. Tr. 1093.

B. ABN CREDIT APPROVAL

213. In 1989, Denise Gallagher Rokholt ("Gallagher") was an assistant vice-president at ABN New York. She was a member of the group responsible for marketing ABN's products and services worldwide to corporations that had over $500 million in sales and were based in New York. Tr. 2185.

214. Gallagher reported to Susan Pearson ("Pearson"), the leader of the Manhattan group. Tr. 2185.

215. CP was on ABN New York's prospect list when Gallagher started working for ABN New York in 1988. Tr. 2186.

216. Gallagher's group did not have direct contact with CP because CP was "over-banked", meaning that CP had more banks than it needed and tended only to deal with banks that were part of its revolving credit. Tr. 2187.

217. After ACM was formed, CP became a client of ABN. ABN then had access to CP and Pohlschroeder to determine CP's needs. ABN also became a member of CP's revolving credit agreement. Tr. 1137, 2217, 2219.

1. THE CREDIT PROPOSAL

218. Gallagher prepared a Credit Proposal dated October 3, 1989 ("Credit Proposal") requesting a loan to KNX for a term of one year based on information she received from den Baas. The Credit Proposal was signed by Gallagher and Pearson. Ex. DP; Tr. 2188-91, 2205.

219. The format of the Credit Proposal was the standard ABN credit proposal. Tr. 2188-90.

220. While KNX was named as the borrower, CP was listed as the client by Gallagher in the place on the Credit Proposal normally used for the borrower. Exs. DP, AZH, AZI; Tr. 2788-91.

221. The Credit Proposal includes an analysis of CP's credit, not that of KNX, who was listed as a borrower. Ex. DP.

222. Den Baas and Pearson initially told Gallagher about the Partnership transaction. Tr. 2207.

223. Gallagher's understanding of the transaction was based on her communications with den Baas. Tr. 2208.

224. Den Baas claimed that he did not have any responsibilities securing the loan from ABN to KNX. Tr. 1188.

225. Gallagher wrote most of the Credit Proposal in order to analyze the credit risk of CP for a transaction done in another part of the bank. Tr. 2188-90.

226. KNX was not incorporated on October 3, 1989, at the time Gallagher wrote the Credit Proposal. Stip. paragraph 68; Tr. 218; Ex. DP.

227. ABN New York had an internal ranking system, from 1 to 10, based on credit quality. Within this system, 1 was the highest rating and ABN New York gave CP a 2 rating, an acceptable credit risk. Tr. 2193; Ex. DP.

2. NACC APPROVAL

228. Whenever a branch of ABN had a credit application, that application was first sent to the North American Credit Committee ("NACC"), located at ABN Chicago, for approval. Tr. 1113, 3350-51, 2197.

229. The NACC had to first approve the ABN loan because it was a U.S. dollar loan and ABN was looking at CP. Tr. 1026.

230. NACC would forward a credit application to the Risk Management Division ("RMD") in ABN Amsterdam if the application were for a loan greater than $15 million. Tr. 999, 3350-51, 3353, 2195.

231. NACC would also forward its advice to ABN Amsterdam regarding credit applications. Tr. 3352.

232. ABN Amsterdam had the final approval for loans greater than $15 million. Tr. 1026, 3350-52.

233. Ronald Brouwer ("Brouwer"), a credit analyst heading a group of credit analysts at ABN Chicago, analyzed credit proposals for NACC at ABN Chicago. Brouwer located the Credit Proposal in the NACC's files prior to testifying. Tr. 3349; Ex. DP.

234. The Credit Proposal was forwarded to NACC and RMD by ABN New York for approval. Tr. 3362.

235. NACC sent, via telex, an advice dated October 11, 1989 to RMD, and copied to ABN New York, regarding the Credit Proposal which was approved by Brouwer. Ex. DQ; Tr. 3354, 3363, 3366, 3375.

236. In preparation for his testimony, Brouwer located the October 11, 1989 advice in ABN's files. Tr. 3357; Ex. DQ.

237. Brouwer's approval document references a "Colgate partnership memorandum" dated October 10, 1989 which Brouwer did not locate in his files. Tr. 3355-56; Ex. DQ.

238. The purpose of the October 11, 1989 advice from NACC to RMD was to inform ABN Amsterdam and ABN New York that NACC was recommending the approval of credit to CP on certain conditions. Tr. 3354; Ex. DQ.

239. NACC recommended approval of the loan to KNX "with the following conditions:

1) The timing of the purchases and sales of the various

240. The Correspondent Banking Department ("CBD") of ABN approved the risk and quality of banks issuing notes. The CBD approval condition set forth in NACC's advice to RMD was to ensure that the risks borne by KNX from the Partnership's holding assets of other banks was acceptable and that the banks were of good quality. Tr. 3355; Ex. DQ.

241. The October 11, 1989 advice set forth the conditions because NACC thought it would be the best structure, deal or credit risk for ABN. These conditions were discussed in the credit committee meeting attended by Brouwer. Tr. 3355, 3367, 3375; Ex. DQ.

242. Brouwer would not have signed the advice if he did not attend the NACC meeting where the transaction was discussed. Tr. 3375; Ex. DQ.

243. Brouwer believed that NACC's October 11, 1989 advice and the conditions contained therein were accurate and complete when he signed the advice. Tr. 3375-76.

3. THE RMD APPROVAL

244. RMD sent an advice to NACC, copied to ABN New York, agreeing with the conditions set forth by the NACC and approving the Credit Proposal. Ex. DR; Tr. 3361.

245. RMD's advice to NACC was in the files Brouwer checked prior to testifying. Ex. DR; Tr. 3357.

246. RMD's understanding, set forth as an additional condition to those of the NACC, was that Merrill would again orally agree to buy the medium term notes at par on November 29, 1989. Ex. DR.

247. Den Baas referred to the Citicorp Notes as medium term private placements. Tr. 1148.

248. The RMD in Amsterdam requested that ABN, through den Baas, syndicate its loan to KNX. Tr. 1190; Ex. DR.

249. The RMD, established two lines of credit to "administrate." One line was to its client KNX and the other line was to its client CP. The RMD assigned CP a client number. Ex. DR.

250. In its advice, the RMD indicated that with respect to KNX, it would administrate credit risk of $170 million until November 29, 1989, and $153 million thereafter of which $100 million was to be syndicated out. Ex. DR. Den Baas was aware of this request to the RMD. Tr. 1190.

251. Den Baas recalled that ABN was concerned with a potential conflict of interest in entering into ACM because of ABN's role in CP's ESOP. Tr. 1124-25; Stip. paragraph 36. See PF 239.

252. Den Baas claimed he did not recall the NACC or RMD advices. Tr. 1109-12, 1113-1116; Exs. DQ, DR.

4. PROCEDURES -- CHANGED CONDITIONS

253. The NACC generally would keep documents in its files reflecting whether conditions were changed. Tr. 3358.

254. Under ABN's procedures, the ABN branches were supposed to inform the NACC, preferably in writing, if conditions were changed. Tr. 3358-59.

255. Brouwer's files do not reflect any phone messages or writings indicating that any of the conditions listed in the October 11, 1989 advice of NACC to RMD or the advice of RMD to NACC were changed. Tr. 3359, 3361.

256. Brouwer had personal knowledge of thousands of credit proposals and of this total amount, the conditions in only 5 to 10 percent of the credit proposals may have been changed verbally and not documented. Tr. 3378.

257. Brouwer had no personal knowledge that the conditions of the NACC or RMD advices were changed verbally. Tr. 3379; Exs. DQ, DR.

258. NACC should have been notified if conditions were changed. Tr. 3361; Exs. DQ, DR.

259. ABN generally authorizes deals through advices such as the NACC and RMD advices. Tr. 3360; Exs. DQ, DR.

260. The Credit Proposal was stamped "APPROVED". Ex. DP.

261. When the ABN New York operations assistants received an advice from the credit committees, they would attach it to the original copy of the credit proposal. The operations assistants would also stamp the credit proposal and find someone in the ABN New York account management group who would initial and date the proposal when it was approved. Tr. 2200.

262. On October 11, 1989, Gallagher initialled the Credit Proposal "APPROVED Per RMD. " Tr. 2200. She would not have initialled the Credit Proposal if she thought the Credit Proposal was not approved by RMD. Tr. 2202; Exs. DP, DQ. She did not recall the NACC or RMD advices. Tr. 2212-16.

C. DE BEER

263. De Beer, an attorney, is currently an employee of ABN-AMRO Bank who began working at ABN in 1984. In October 1987, de Beer was transferred to Curacao, where he worked as a trust officer at ABN Trust Curacao. Tr. 982-83.

264. A trust officer within ABN Trust Curacao was a lawyer who worked within the legal department assisting clients in setting up corporate structures. Tr. 983.

265. In 1989, de Beer was promoted to head ABN Trust Curacao's legal department and he was later promoted to deputy managing director of ABN Trust Curacao. De Beer left Curacao in February 1991 to become the managing director of ABN Trust Switzerland. Tr. 983-84.

266. In 1989, as head of the ABN Trust Curacao legal department, de Beer managed a team of four lawyers who assisted mainly corporate clients in creating Netherlands Antilles companies and/or foundations to facilitate financial transactions and in managing those companies for clients. Tr. 984, 1005.

267. During the period de Beer worked in Curacao, ABN Trust set up approximately 15 non-U.S. corporations owned by foundations. Tr. 1008.

268. In early 1989, ABN Trust Curacao had 100 employees. Tr. 985.

1. THE TAX ANGLE

269. In September or October 1989, de Beer recalled being contacted by either den Baas or Taylor regarding CP's interest in setting up a partnership with a non-U.S. partner. Tr. 986.

270. De Beer understood that Merrill and CP were trying to accomplish a tax angle through a partnership. Tr. 987.

271. De Beer understood that the tax angle involved LIBOR notes. Tr. 1010.

272. Taylor and Fields explained the tax angle of the ACM Partnership to de Beer. Tr. 1004.

273. Taylor and Fields told de Beer that there would be a shift in partnership interests, and the gain would go to a Netherlands Antilles company and the loss to the U.S. corporation. Tr. 1005.

274. At the time of the formation of ACM, de Beer understood that the tax angle involved the partnership entering into transactions that would create a capital gain and in a later stage a capital loss, and that KNX, the tax-neutral and majority partner would take the majority of the gain, while in a later stage, the U.S. partner would take the loss. Tr. 995-96, 1005.

275. ABN Trust was asked to participate in the partnership because ABN Trust had experience setting up non-U.S. corporations for the purpose of facilitating financial transactions and ABN Trust had access to the funding required to finance the participation. Tr. 1009.

276. Without the tax angle, ABN and/or ABN Trust Curacao would not have been a necessary participant in the ACM transaction. Tr. 1018.

277. From the perspective of ABN Trust, the deal was structured principally for tax purposes. Tr. 1018.

278. According to de Beer, ABN Trust or ABN became a partner rather than simply loaning money because the tax advantages would not have been available had they not become a partner. Tr. 1018.

279. De Beer agreed that absent the tax purpose, ABN could have lent directly to the Partnership without becoming a partner. However, had there been no tax purpose, de Beer did not think that ABN Trust would have been involved in the transaction. Tr. 1019.

280. Had there been no tax purpose, de Beer believed CP would have gone to its main banks for a loan. Because ABN made the tax angle possible, CP used ABN. Tr. 1019-20.

281. ABN made the loan to KNX and not directly to the Partnership for tax reasons. The tax angle relating to the capital gain and loss from the ACM transaction would not have worked if the loan was made directly to ACM. Tr. 1017.

282. Neither ABN Trust nor ABN ever really wanted to become a partner in ACM. They were simply accommodating the form of the transaction requested of them. Tr. 1020.

283. De Beer anticipated that ABN Trust would benefit from this transaction through fees charged to ACM for managing and administering the Partnership and that ABN would benefit through the spread ABN would earn on its loan to KNX. Tr. 1009.

284. Calculations were performed by den Baas regarding KNX's anticipated return from the ACM transaction. Tr. 1074-75.

2. THE TAX ASPECTS TO ABN

285. Whenever ABN Trust Curacao entered into a transaction with a tax angle, it wanted to know exactly what the tax angle was and if there were adverse consequences for ABN in either the Netherlands Antilles or the United States. Tr. 1012.

286. Under Netherlands Antilles Profit Tax Ordinance, the income derived by KNX was taxed, for the period in issue, at the rate of 2.4 percent to 3 percent. Capital gains realized upon the disposal of investments were not taxable and capital losses were not deductible. Stip. paragraph 247.

287. Under Netherlands Antilles Profit Tax Ordinance, if a company borrows funds to finance its investments, the interest payable from such a loan was deductible for tax purposes provided the loan was from a bank or similar financial institution. If the company borrowed from other than a bank or a similar financial institution or from a related party, then interest on such loans were deductible for tax purposes only if a ruling were first obtained from the Inspector of Taxes. Stip. paragraph 248.

288. De Beer determined whether, as a result of ABN's participation, there were any adverse Netherlands Antilles' tax consequences for ABN and he spoke to den Baas and ABN's counsel regarding potential U.S. tax consequences for ABN. Tr. 1013.

289. Den Baas claimed that at the time of entering into ACM, no one informed ABN that there would be a large gain to KNX and he knew nothing about it until year end, when the K-1 was received. Tr. 1154.

290. Den Baas claimed that, although he asked, Taylor refused to discuss the tax implications of the transaction with him prior to the formation of the partnership and did not do so subsequently. Tr. 1155.

291. Den Baas and Taylor had known each other since 1987 and are friends. Tr. 1137.

IV. THE ACM PARTNERS

A. KANNEX CORPORATION N.V.

292. KNX was incorporated in Curacao, Netherlands Antilles on October 25, 1989. During the period in issue, ABN Trust, whose address was Pietermaai 15, Curacao, Netherlands Antilles, was the sole managing director of KNX and maintained the books and records of KNX. Stip. paragraph 68.

293. KNX was incorporated in the Netherlands Antilles for U.S. tax reasons. Tr. 990.

294. KNX was formed solely to be a partner in ACM. Tr. 1033.

1. OWNERSHIP BY FOUNDATIONS

295. KNX was owned by two Netherlands Antilles foundations or stichtingen, Glamis and Coign, which each held 3,000 shares of the authorized capital of KNX. The total issued share capital of KNX was 6,000 shares of common stock. Each share had a par value of $1. Tr. 989; Stip. paragraph 70; Ex. 104-DB.

296. A stichting or foundation was a legal entity in its own right. The legal concept of the stichting developed from capital being set aside for a special non-profit or charitable purpose and was originally used by religious and welfare groups. Stip. paragraph 241.

297. The principal difference between a stichting and a corporation was that a stichting had neither members nor shareholders. The board of a stichting, which managed its affairs, was not subject to the overall control of any shareholders or members. The initial members of the board were appointed in the Articles of the stichting, but thereafter any vacancies were filled by the remaining board members or by some other person or body nominated for the purpose. Stip. paragraph 242.

298. De Beer was Chairman of Coign and Glamis and, in effect, controlled them. During the period in issue, Verhoef or other employees of ABN Trust, were members of the Boards of Directors of Coign and Glamis. Tr. 1007; Stip. paragraph 72.

299. Each stichting borrowed $3,000 from ABN Trust or KNX and then contributed that amount to KNX to make up KNX's requisite minimum capital under foreign law. Tr. 1007; Stip. paragraph 240; Exs. 124-EF through 126-EH (AB500183).

300. The foundations were specially created to participate in the transaction, had no purpose other than to hold the shares of KNX, and conducted no commercial activities. Tr. 989, 1007-08, 1010.

301. The foundations were set up as the shareholders of KNX in order to keep the assets of KNX off ABN's balance sheet. Tr. 1006-07, 1010.

302. The management agreement between ABN Trust and KNX, signed by de Beer on behalf of the foundations, was a standardized agreement entered into to satisfy the back office people and had no substantive value. Ex. 363-RI; Tr. 1056-57.

303. By management agreement "made from" October 25, 1989, executed by den Baas, ABN (New York Branch) agreed to provide to KNX (1) advice on hedging strategies to reduce KNX's interest rate exposure; (2) evaluations of KNX's credit risk and interest rate risks; and (3) special services at KNX's request. Ex. 362-RH (p. 1); Tr. 1145-46.

304. The management agreement provided that KNX shall reimburse ABN for out-of-pocket expenses on a cost plus basis. The management agreement does not include any other statement concerning compensation for services provided by ABN. Ex. 362-RH; Tr. 1054, 1055, 1146.

2. THE LOAN TO KANNEX

305. By Revolving Credit Agreement dated November 2, 1989, ABN Cayman Islands agreed to make loans available to KNX in the aggregate maximum principal amount of $180 million for one year. Ex. 115-DM; Tr. 2192.

306. KNX required the loan because its capital was insufficient to make its capital contribution to ACM. Tr. 1016.

307. The Revolving Credit Agreement generally set insert at a rate of LIBOR plus 30 basis points. Exs. 115-DM, DP.

308. The interest rate set in the Revolving Credit Agreement was based on what ABN New York would charge CP if CP used a credit line with ABN New York. Tr. 2192.

309. The revolving loan from ABN to KNX was secured by the stock held by the foundations and thus, by KNX's interest in ACM. The loan funded the "capital contribution" made by KNX to ACM. Tr. 1016, 1024- 25; Ex. 115-DM.

310. The Revolving Credit Agreement was signed, on behalf of ABN Cayman Islands, by Pearson who worked at ABN New York. Ex. 115-DM; Tr. 2185.

311. Den Baas claimed he did not know why his name was on the notice list of the revolving credit agreement. Tr. 1189-90.

312. Den Baas informed Pohlschroeder and other CP representatives that ABN was funding KNX. Tr. 1029.

313. Pohlschroeder considered KNX to be an entity of ABN Trust, but claimed that he did not know where KNX got the funds it contributed to ACM. Tr. 419-20.

B. SOUTHAMPTON-HAMILTON COMPANY

314. SH, a special purpose subsidiary, formed to participate in ACM on behalf of CP, was incorporated in Delaware on October 24, 1989. Stip. paragraphs 63, 64; Tr. 915.

315. During the period in issue, the officers of SH were as follows:

Belasco * * * Chairman of the Board and President

317. CP's Federal income tax returns were calendar year returns. Tr. 963; Stip. paragraphs 4 through 6.

318. SH's employee for 1989, 1990 and 1991 was David Dupert and his salary for 1989, 1990 and 199. was $200, $1,200 and $1,200, respectively. Stip. paragraph 649.

C. MERRILL LYNCH MLCS, INC.

319. Merrill Lynch MLCS, Inc. ("MLCS") was incorporated in Delaware on October 27, 1989. Stip. paragraph 66.

320. During the period in issue, MLCS was a wholly owned subsidiary of Merrill Lynch Capital Services, Inc., Merrill's swap subsidiary. Taylor was the President of MLCS, and Pepe was Vice- President. Stip. paragraph 67; Tr. 661-62; PF 3.

321. CP requested that Merrill become a partner in ACM. CP wanted Merrill to have financial exposure to what was going on in the Partnership so that they would, in effect, deliver the results. Tr. 445.

322. CP requested that Merrill become a partner in ACM to substantiate the Partnership for tax purposes. Ex. 424-ABI.

323. CP also wanted to ensure, for tax reasons, that there was a non-CP partner in the Partnership once KNX left. Ex. 424-ABI.

V. THE FORMATION OF ACM

324. To de Beer, ACM was an investment partnership. Tr. 1028.

325. ACM was formed as of October 27, 1989 as a general partnership under the New York general partnership law. Stip. paragraph 91; Ex. 137-ET.

A. THE ACM PARTNERSHIP AGREEMENT

326. The Partnership Agreement generally provided that all income, gain, expense, and loss, as reported by the Partnership for federal income tax purposes, would be allocated among the partners in proportion to their capital accounts. Ex. 137-ET.

327. On February 28, 1990, the Partnership Agreement was amended to provide that all income, gain, expense and loss, as reported by the Partnership on its books, would be allocated among the partners in proportion to their capital accounts. Ex. 138-EU.

328. The Partnership Agreement provided that each partner's capital account would be adjusted on February 28, 1990, and upon the occurrence of specified Revaluation Events based on the fair market value of the Partnership assets as of the date of the revaluation event. Specified Revaluation Events included a change in a partner's proportionate interest, a disposition by the Partnership of any CP debt; a Yield Component adjustment; the distribution of assets; the last business day of the Partnership's fiscal year; and after November 30, 1989, upon request of a partner. Such adjustments to capital accounts would reflect the manner in which the unrealized income, gain, loss, or expense inherent in the Partnership assets (that had not been reflected in the capital accounts previously) would be allocated among the partners if there were an actual disposition of such assets for their fair market value on the Revaluation Date. Ex. 137-ET (section 4.03(b)). Revaluations occurred at the end of the November 30th year, upon distribution of assets, upon changes in KNX's interest, and quarterly at SH's request. Exs. 141-EY(2) through 156-FO.

329. The Partnership Agreement provided that each partner's capital account would be decreased by the fair market value of property distributed to it by the Partnership. Ex. 137-ET (paragraph 4.03(a)).

330. Revaluation Worksheets, prepared by Merrill, were used to record the capital accounts. Tr. 1278; Exs. 142-FA through 156-FO.

B. TERMS OF THE ACM PARTNERSHIP AGREEMENT RELATED TO COLGATE

332. Pohlschroeder claimed that Merrill came forward with the concept at his behest, as he wanted CP to benefit from future improvements in the price of CP debt. Tr. 251-52; Ex. 57-BE.

333. Pursuant to Section 4.04(c), (d), and (e) of the Partnership Agreement, two components of gain or loss on CP debt instruments held by ACM, an interest rate risk component ("Yield Component") and a credit risk component ("Quality Component") for each revaluation period, were allocated among MLCS, KNX, and SH in accordance with special rules. Stip. paragraph 101.

334. The interest rate risk component or Yield Component reflected changes in the value of CP debt brought about by changes in interest rate levels or the shape of the yield curve. Ex. AZH (p. 15); Tr. 1782, 1282, 2525.

335. The value of the fixed-rate CP debt moves inversely with the movements in interest rates because when interest rates fall investors will demand a lower price to bring their yield up to a market level. Tr. 114, 139-40, 527-28, 530.

336. The Partnership Agreement provided that the gain or loss attributable to the Yield Component was initially allocated 83 percent to KNX, 16.7 percent to SH, and 0.3 percent to MLCS, roughly the same as all other income, gain, and loss. SH, however, was given the right to adjust the allocation of the Yield Component to KNX, provided that KNX received not less than 50 percent or more than 89.7 percent of that gain or loss. Stip. paragraph 102.

337. The credit risk component or Quality Component reflected the risk that CP would default on its debt obligations and the possible recovery upon default. Stip. paragraph 101; Tr. 1783.

338. The credit risk component or Quality Component effectively provided that SH and not KNX would be allocated any increases in the value of CP debt attributable to an increase in CP's creditworthiness. Ex. 517 (pp. 29-30); Tr. 301.

339. The allocation of the Quality Component for a particular CP debt depended on whether there was an improvement or deterioration in CP's credit. Such improvement or deterioration in credit was measured by the change in implied spread of the debt over the yield of an index. If CP's credit improved, the spread would narrow; if CP's credit deteriorated, the spread would widen. The Quality Component was the change in the value of the CP debt attributable to this narrowing or widening of the spread. The Quality Component for a revaluation period for a particular CP debt was allocated as follows: (i) the portion attributable to changes in the implied spread within a 50 basis point range over the higher of the Original Spread or the Target Spread was allocated 0.3 percent to MLCS, 15 percent to KNX and 84.7 percent to SH; and (ii) the remaining portion of the Quality Component was allocated 0.3 percent to MLCS and 99.7 percent to SH. Stip. paragraph 103.

340. Pursuant to Section 4.04(b) of the Partnership Agreement, from the date of the initial transfer of the $205 million by SH, MLCS, and KNX to ACM until February 28, 1992, the first $1,241,000 of ACM's income and gain for each fiscal year (pro rated daily on a basis of a 365-day year), otherwise allocable to SH, was allocated to KNX ("Preferred Allocation" or "Special Income Allocation"). Stip. paragraph 100.

C. PRE-BERMUDA MEETING

341. At a meeting between CP and Merrill, held the day before the first Bermuda meeting and attended by Pohlschroeder and CP's Washington tax attorneys Lee, Toomey and Kent, CP's attorneys advised CP that ABN should take some spread risk. Exs. 424-ABI (p. ACM01649), 526-AZJ; Stip. paragraph 703; Tr. 444, 446-47.

342. Pohlschroeder claimed he did not recall this conversation. Tr. 446-48.

D. BERMUDA MEETING

343. On or about October 18 through 20, 1989, a meeting was held in Bermuda and attended by Heidtke, Pohlschroeder, Belasco, Jacobson, Cassidy, Simpson and Peters from CP; Taylor and Fields from Merrill; and den Baas, de Beer and attorney Joanna Peters from ABN (the "first Bermuda meeting"). Tr. 129-30, 299, 415-17, 516, 936-37, 986-87, 1011-12. Willie Wilson from Shearman & Sterling and Robert Feldgarden from Lee, Toomey & Kent also attended representing CP. Tr. 417; Ex. AAZ (CO848).

344. Most of the details were agreed upon before the first Bermuda meeting, and although there was some fine tuning in Bermuda, a lot of the time was spent figuring out how to record the transactions and document them from a legal viewpoint. Tr. 937.

345. The first Bermuda meeting was conducted to fine tune the economic terms that had to be agreed on, such as what sort of a return ABN would be receiving before entering into the ACM arrangement, and also how much risk ABN would take with regard to the various risks that would be inherent in ACM holding CP's obligations. Tr. 130-31.

346. The first Bermuda meeting, as well as subsequent Partnership meetings, were held off shore because, due to the tax aspects of the deal, the Partnership wanted to keep the transaction out of the U.S. as much as possible. Tr. 1014-15.

347. There were a disproportionate number of tax lawyers present at the first Bermuda meeting. Tr. 1143.

348. The tax aspects of the transaction were discussed in the presence of all participants at the first Bermuda meeting. Tr. 1013.

349. When the first Bermuda meeting ended, ACM was not yet documented and signed, but the conceptual framework had been laid for putting into formal effect the transactions CP envisioned. Tr. 133- 34.

350. Neither Heidtke nor Pohlschroeder had met any representatives from ABN or KNX prior to the first Bermuda meeting. Tr. 128, 413-14, 1101.

351. Heidtke led the negotiations for CP at the first Bermuda meeting. Tr. 128, 158.

352. Den Baas led the technical financial discussions on behalf of KNX. Tr. 158, 419, 1150.

353. On October 19, 1989, Pohlschroeder participated in a discussion with den Baas. CP requested that ABN share in the credit risk exposure to the CP debt. Ex. 425-ABJ; Tr. 449-51.

354. KNX demanded the Preferred Income Allocation in exchange for sharing in the credit risk (reflected in the Quality Component) of the CP debt. Tr. 1156-57, 1159.

355. The $1,241,000 Preferred Income Allocation amount was predominantly attributable to KNX's agreement to share in the credit risk of CP debt. Tr. 1158-59.

356. By agreeing to share in the credit risk of CP debt, KNX provided SH with a credit option. Tr. 1157-59.

357. Credit options were and are difficult to price. Tr. 1158- 59.

358. The $1,241,000 Preferred Income Allocation was based on calculations den Baas made which assumed the worst-case scenario, such as ACM's whole portfolio being invested in 27-year CP debt, to more likely scenarios. Tr. 1158-59.

359. The $1,241,000 was considered by den Baas to be an option fee paid by SH to KNX in exchange for KNX agreeing to take the specified share of the credit risk of CP debt. Tr. 1173, 1158-59.

360. According to Heidtke, one of the reasons KNX received the Preferred Income Allocation was to "provide a number of legal protections in the way of covenants and -- and ratio tests and other things which would in some way provide credit protection for the lender." Tr. 133.

361. KNX's return reflects a nominal sensitivity to credit risk because the $1,241,000 Preferred Income Allocation or "me first" payment to KNX more than covered the adverse wealth effects from a 15 percent of a 50 basis point decline (or 7 1/2 basis points) in the credit quality of CP's debts. Tr. 2250, 2757-59, 2869.

1. THE YIELD COMPONENT

362. The Yield Component provision in the Partnership Agreement giving SH an option to adjust KNX's share of the interest rate risk from the CP debt was not problematic for KNX because den Baas knew KNX would hedge that interest rate risk. Tr. 1167-68.

2. OTHER TERMS OF THE PARTNERSHIP AGREEMENT

363. The Partnership Agreement appointed one representative of each of the three general partners to the Partnership Committee, which was given the responsibility of making Partnership decisions and conducting business affairs. Ex. 137-ET.

364. SH appointed Pohlschroeder as Representative, and Belasco and Jacobson as Alternate Representatives. Stip. paragraph 64.

365. MLCS appointed Taylor as Representative, and Pepe and Simpson as Alternate Representatives. Stip. paragraph 67.

366. KNX appointed de Beer as Representative, and Verhoef and Geraldine X. C. Martines, also an employee of ABN Trust, as Alternate Representatives. On June 4, 1991, KNX appointed Jaap van Burg ("van Burg") as Representative and Koen van Baren ("van Baren") as Alternate Representative, both employees of ABN Trust. Stip. paragraph 73.

367. A few decisions required the consent of all three members of the committee: No new partners could be admitted, no additional capital contributions could be required, and no partner could sell, lease, distribute, transfer, assign, or otherwise dispose of any part of its Partnership interest unless all three committee members agreed. All other matters required the consent of partners having an aggregate capital account balance equal to, or greater than, 99 percent of all partners' capital. Ex. 137-ET (section 5.03).

368. Under the Partnership Agreement, SH was required to maintain a minimum percentage (two percent) of the Partnership capital. Ex. 137-ET (section 4.02(b)).

369. This provision was characterized as a "make well" agreement by CP and Merrill. Ex. 424-ABI; Stip paragraph 381.

370. Under section 4.02(b) of the Partnership Agreement, if adverse interest movements or the preference income given to KNX caused SH's equity position to decrease, SH would have to add capital to the Partnership effectively providing ABN with additional security on the loan it made to KNX. Exs. 424-ABI, AZH (pp. 18, 61); Tr. 2799- 2801.

371. The terms of the Partnership Agreement limited the partners' ability to withdraw from the Partnership: KNX was given the right to redeem its interest in the Partnership any time after February 28, 1992. MLCS and SH, on the other hand, could not withdraw until February 28, 1993, and March 31, 1993, respectively. Ex. 137-ET (section 8.01).

3. AGREEMENT OUTSIDE THE PARTNERSHIP AGREEMENT

372. In October 1989, CP, Merrill and de Beer had an understanding outside of the written Partnership Agreement as to the date KNX would leave the partnership. Tr. 1047.

373. In October 1989, CP, Merrill and KNX intended and agreed, with some room for maneuvering, that KNX would be taken out of the partnership or would decrease its partnership interest from a majority to a minority partner in a reasonably short time, and prior to February 28, 1992. Tr. 1046-48.

374. CP, Merrill and de Beer discussed and agreed that KNX would leave ACM prior to the February 28, 1992 redemption date set forth in section 8.01(a) of the Partnership Agreement and did not negotiate the February 28, 1992 redemption date. Tr. 1046; Ex. 137-ET.

375. Heidtke understood that there was a "defined duration" to ABN's participation in ACM of two years. Tr. 177.

376. The defined duration related to the realization by CP of the "tax dynamics" of the transaction. Tr. 176-77.

377. Jacobson expected the Partnership to last for two years. Tr. 1462-63.

378. Pohlschroeder claimed he had no expectations regarding whether KNX would leave the Partnership in two years and did not know whether KNX would exercise its option to leave the Partnership on February 28, 1992. Tr. 412-13.

379. To limit ABN's exposure, it was important that KNX become a minority partner within a reasonably short term. Tr. 1047-48.

4. SIDE LETTERS

380. By a letter agreement dated October 27, 1989, CP agreed that as long as KNX was a party to the Partnership, CP would not dispose of its interest in SH without ABN Trust's consent. Ex. 140- EW.

381. By a letter agreement dated November 20, 1989, ABN Trust, as managing director of KNX, agreed not to pledge, hypothecate, mortgage or otherwise grant a lien or security interest in its partnership interest, or enter any lending arrangement, requiring it to pay (except for payments to the extent of funds available by distribution from the Partnership) or perform until after February 28, 1992. Ex. 141-EY(1).

E. TRANSACTION COSTS

382. Heidtke did not recall discussing transaction costs, other than the Preferred Income Allocation to KNX, at the first Bermuda meeting. Tr. 159-60.

1. SERVICE FEES PAID BY SH

383. By letter dated October 27, 1989, CP engaged Merrill as a financial advisor to assist CP in finding participants for a joint venture, negotiating the terms and conditions of the joint venture; reviewing the suitability of possible investments for the joint venture; and to advise CP regarding appropriate terms and conditions of the transactions undertaken by the joint venture. The agreement provided for consideration in the amount of $200,000 upon execution of the agreement and $1,545,000 upon the funding of the joint venture to at least $100 million. Merrill's engagement was generally exclusive until December 31, 1991, specifically with respect to transactions substantially similar to the transactions discussed with Merrill prior to the date of the letter. CP agreed to indemnify and hold harmless Merrill and its affiliates (other than MLCS) for liabilities relating to ACM transactions, including any liability resulting from (i) the status of MLCS as a partner in ACM and (ii) the failure of a court to respect the corporate existence or independence of MLCS. Ex. 90-CN.

384. Once the Partnership was funded, SH paid Merrill the $1.745 million arrangement fee. Stip. paragraph 366; Tr. 738, 918.

385. A portion of the $1.745 million arrangement fee was paid to Merrill for locating the Citicorp Notes. Tr. 738-39.

386. SH paid $443,946.82 of legal and accounting fees attributable to services performed through December 31, 1989, relating to the formation of and initial transactions of ACM, itemized below:

     Arthur Andersen               $ 54,000.00

387. SH's legal fees to Shearman & Sterling in the amount of $307,605.56 were for services rendered in connection with the formation of a special-purpose subsidiary, negotiation and preparation of a Partnership Agreement, advice concerning the activities of the Partnership, and the negotiation and preparation of documents representing various partnership investments. Ex. 411-AAE.

388. SH and CP paid legal fees totalling $151,392.78 to Shearman & Sterling for services performed between December 31, 1989 and January 10, 1992 relating to ACM transactions. Stip. paragraph 366; Exa. 411-AEE through 416-AAJ.

389. In connection with Citibank's loan to ACM to fund the redemption of KNX, ACM paid a facility fee and transaction costs of Citibank totalling $142,229.87. These costs were paid by ACM subsequent to the redemption. Stip. paragraphs 368, 369; Ex. 308-OC (10079).

390. On March 31, 1992, ACM paid legal fees to Shearman & Sterling of $54,522.59. Stip. paragraph 370.

2. FEES PAID BY ACM

391. By letter agreement dated November 22, 1989, ACM agreed to pay ABN Trust an annual fee of $25,000 for administrative and investment management services. Ex. 179-GO. During the period in issue, ACM paid ABN Trust $75,000 in fees. Exs. 180-GP (AB500006, 36, 55), 338-QF, 335-QW.

392. In addition to the annual fee, ACM reimbursed certain expenses of ABN Trust and N.V. Fides. Exs. 180-GP (AB 500036, AB 500032, AB 500054, C0017, AB 500023, C0040, C0038, AB 500055, AB 500014, C0025, AB 500006), 338-QF, 355-QW, 358-QZ. N.V. Fides was an affiliate or sister-company of ABN Trust, sharing the same staff. Tr. 1060.

393. At the first Partnership meeting, on October 27, 1989, ACM engaged Merrill as a financial advisor and Qualified Appraiser for fees of $10,000 and $5,000, respectively, per Partnership year. Exs. 177-GM, 178-GN. During the period at issue, ACM paid Merrill $30,000 for advisory and appraisal services. Stip. paragraph 109; Exs. 178- GN, 355-QW (8th unnum. p.).

394. Subsequently, an engagement letter dated October 27, 1989 was executed between Merrill and ACM providing that Merrill would be retained as the sole and exclusive advisor to ACM until December 31, 1991, and specifically with respect to transactions substantially similar to the transactions discussed with Merrill prior to the date of the letter. Ex. 176-GL.

3. ORIGINATION AND REMARKETING COSTS

395. On or about September 1, 1989, Merrill prepared the "Perpetual Partnership Cost Component Analysis", itemizing the cost components underlying the after-tax, net present value of the partnership investment estimate as follows:

     Origination of Short-Term Notes     $1.32 million

396. The $1.32 million cost component for "Origination of Short- Term Notes" was the cost of selling the private placements and obtaining LIBOR Notes. Tr. 917, 737; Ex. 69-BQ.

397. The "Remarketing of LIBOR Note" refers to the cost to sell the LIBOR notes. Tr. 738; Ex. 69-BQ.

398. In September 1989, Belasco understood that the $1.29 million cost component for "Remarketing of LIBOR Notes" was an estimate of the friction cost on the sale of the LIBOR notes. Tr. 917; Ex. 69-BQ.

399. Belasco expected that if the transactions contemplated by the partnership concept that became ACM were done as CP hoped, then CP would bear most, if not all, of the transaction costs. Tr. 920; Ex. 69-BQ.

400. CP agreed to pay all the transaction costs because it was the beneficiary of the partnership transactions and the entity that would receive the tax benefits. Tr. 920, 327.

401. Based on discussions Belasco had with Pohlschroeder and Heidtke, Belasco believed the transaction costs were reasonable. Tr. 919; Ex. 69-BQ.

402. Pohlschroeder testified he did not discuss the ACM origination or remarketing costs with anyone at Merrill. Pohlschroeder accepted Merrill's estimate of those costs. Tr. 271-72, 398; Ex. 69-BQ.

403. Heidtke recalled seeing a schedule of costs that attended the construction and implementation of ACM Partnership and some of the envisioned transactions going forward which totalled $6 or $7 million. Heidtke believed that the schedule of costs was developed by Pohlschroeder and Belasco jointly. Tr. 156-57.

404. In September 1989, Pohlschroeder assumed that SH would bear all of the origination and remarketing costs. Tr. 398.

405. Pohlschroeder also claimed that he did not know who was going to bear the origination costs. Tr. 491-92.

406. At the second Bermuda meeting, on and around October 27, 1989, Fields acted as a scrivener, recording estimates of anticipated transaction costs discussed among Taylor, Belasco, Pohlschroeder, and perhaps some lawyers. Tr. 690, 877-78; Ex. 406-ZZ.

407. Taylor testified he did not recall whether he had any conversations about estimated transaction costs on October 27, 1989 in Bermuda, but that he provided estimates of costs of anticipated transactions of the Partnership to CP and would not be surprised if such conversations occurred. Tr. 690.

408. Based on discussions among Taylor, Belasco, and Pohlschroeder, Fields recorded estimated transaction costs of $6.95 million including $1.3 million attributable to the origination on the short-term notes and LIBOR Notes and $1.1 million for remarketing the LIBOR Notes. Tr. 877-78; Ex. 406-ZZ.

409. On October 28, 1989, Belasco prepared an itemization of transaction costs based on his discussions with Fields and Taylor. His itemization reflected gross transaction costs of $7.91 million, including $2.0 million for the "origination/sale" of short-term notes and $1.1 million to remarket the LIBOR Notes. Tr. 957-58; Ex. 407- AAA.

410. Belasco also itemized net transaction costs. He calculated the net transaction costs by discounting the gross transaction costs by 34 percent. Ex. 407-AAA.

411. Belasco compared the October 28, 1989 itemized transaction costs to the September 1, 1989 estimate. Exs. 69-BQ, 407-AAA.

412. On its 1989 income tax return, CP claimed tax benefits to cover up to $5 million of transaction costs relating to the arrangement fee to Merrill and the origination and sale of the BFCE LIBOR Notes. Tr. 1905; Ex. AYX (p. 6); Stip. paragraph 188.

F. ACM PARTNERSHIP MEETINGS

413. During the period KNX participated in ACM, Partnership meetings were held at offshore locations on the following dates:

     Meeting                  Date

414. The Partnership meetings were regularly attended by Taylor, Pepe, den Baas, Pohlschroeder, Jacobson, and de Beer, until he left ABN Trust Curacao. Exs. 163-FV through 175-GH; Tr. 489, 662, 983-84, 1049-51, 1138-39, 1461.

415. Minutes of the Partnership meetings stating rationales for the actions taken were drafted and circulated prior to the meetings. Exs. XB, YD through YK.

416. At the Second Partnership Meeting on November 17, 1989, ACM adopted Investment Guidelines, the primary objective of which was to preserve principal, which permitted the following investments:

(a) U.S. Treasury Securities;

417. The November 17, 1989 Investment Policy Guidelines limited the purchase of securities of non-U.S. governmental agencies to five percent of the portfolio. Ex. 164-FW (Ex. A, p. 1).

418. ABN Trust, with the assistance of Merrill, was responsible for investing the Partnership's cash balances in accordance with the Partnership's Investment Policy Guidelines. Ex. 164-FW; Tr. 1057.

419. Generally, ABN Trust invested the Partnership's cash balances in only ABN time deposits. Exs. 144-FC through 155-FN (Reconciliation of Income on Assets), 318-PL through 320-PN (Notes to Financial Statements, "Time Deposits"), 403-ZP (ACM-W-000969), 327- PU, 329-PW, 331-PY, 333-QA, 337-QE, 339-QG, 342-QJ, 344-QL, 350-QR, 352-QT.

420. ABN New York Financial Engineering was the broker for certain time deposits purchased by the Partnership during 1990 and 1991. Tr. 3538.

421. ABN Trust was responsible for maintaining custody and safekeeping of the Partnership's investments. Ex. 179-GO.

422. ABN New York had physical custody of the Partnership's investments, including the CP debt. Exs. 403-ZP (ACM-W-000970), 404- ZQ.

423. Beginning on October 31, 1989, and through the remainder of the period in issue, ACM maintained a bank account at ABN New York. Stip. paragraph 106.

424. On November 2, 1989, SH, MLCS and KNX transferred $205 million to ACM pursuant to Section 4.01 of the Partnership Agreement, as follows:

                    Amount         Percent

425. On November 2, 1989, KNX borrowed $169,400,000 from ABN and transferred that amount to ACM. Ex. DZ (AB 100035).

VI. THE CITICORP NOTES

A. THE PURCHASE OF THE CITICORP NOTES

426. On November 3, 1989, Merrill arranged for ACM to purchase from Citicorp $205 million of certain five-year floating rate-notes ("Citicorp Notes") at par due October 19, 1994. The Citicorp Notes bore interest at the commercial paper rate plus fifteen basis points, payable monthly. The holder of the Citicorp Notes had the option of tendering the notes for repayment on October 16, 1991, at 100 percent of the principal amount. Stip. paragraphs 111, 112; Tr. 712-13.

427. The Citicorp Notes were not registered under the Securities Act of 1933. The Citicorp Notes also were not traded on an established securities market, defined as (i) a national securities exchange registered under Section 6 of the Securities Exchange Act of 1934, (ii) an exchange exempted from registration under Section 5 of the Securities Exchange Act of 1934 because of its limited volume of transaction, or (iii) any over-the-counter market in which quotes for the Citicorp Notes were regularly disseminated by identified brokers or dealers through an interdealer quotation system. Stip. paragraph 113.

428. When ACM purchased the Citicorp Notes, the partners were aware that ACM would sell the Citicorp Notes for cash and LIBOR Notes. Tr. 138, 315, 1149.

429. Taylor contemplated that the Citicorp Notes would be sold at the end of November, 1989. Tr. 537-38.

430. ACM needed to sell the Citicorp Notes within weeks to accomplish the tax aspects of the transaction. Tr. 314-15.

B. THE PURPOSE FOR THE CITICORP NOTES

431. The decision to purchase private placements was tax- motivated. Private placements were intended to qualify the sale of the notes for installment sale treatment. Tr. 138, 523, 940.

432. KNX would not object to ACM holding Citicorp Notes if the time frame were acceptable. Tr. 1149.

433. As den Baas understood, KNX would not object to ACM holding Citicorp Notes if a sale of those notes were at a profit or at par. Tr. 1149.

434. As den Baas understood from the beginning, prior to the formation of ACM, it was decided that ACM would purchase floating- rate private placement securities. Tr. 712, 1148; Exs. 57-BE, 58-BF, 59-BG.

435. The Citicorp Notes were drafted, based on models provided by Merrill, prior to the formation of ACM. Exs. XI, XD; Tr. 3581-82.

436. Floating-rate notes were purchased by ACM because they would trade close to par, assuming the credit of the issuer held up. Tr. 1148-49.

437. Credit risk and basis differences between LIBOR and commercial paper rates aside, floating-rate notes generally trade at par. Tr. 714-15 (Taylor).

438. As set forth in the Citicorp Note Purchase Agreement, Moody's Investors Service, Inc. specifically reviewed and analyzed Citicorp's credit in connection with the issuance of the Citicorp Notes. Moody's assigned the Citicorp Notes an A1 rating. Exs. 194-HK, 195-HL, 181-GQ (Section 1.3).

439. If the credit rating of an issuer of a floating-rate note remained the same, then the value of the floating-rate note was typically very close to par on the days on which the floating-rate was reset to the then current market rate. Floating-rate notes did not trade too far from par value and, as such, their interest rate risk was essentially zero. Ex. 517 (p. 33) (Grundfest).

440. The put option on the Citicorp Notes "provided the Partnership with meaningful protection against declines in Citicorp's credit. . . . The put provision . . . allowed the Partnership to reduce the time period of its exposure to only two years, and at that point to recover 100 percent of the note's principal value without regard to the credit risk or market value of other Citicorp Debt." Ex. 521 (pp. 104-06 and n. 148) (Grundfest). In addition, the put option "could be exercised to protect against the market risk that CP (commercial paper] rates would lag other short-term investment rates." Ex. 521 (p. 108 n. 155).

441. KNX was not subject to a loss due to Citicorp credit deterioration because of the put option. Tr. 2480 (Tucker), 2761 (Plotkin); Ex. 521 (pp. 104-06 and n. 148) (Grundfest).

442. ACM wanted a shorter put on the Citicorp Notes. Tr. 713.

443. KNX could suffer a loss if Citicorp defaulted, but because it was very difficult to envision Citicorp defaulting, that risk was nominal and insignificant. Tr. 2480, 2489 (Tucker); Tr. 2760, 2761 (Plotkin).

444. Based on the recognized "too large to fail" doctrine of financial economics, investors expect that the government would not let Citicorp go bankrupt because of the systemic shock such a default would have on the economy. Tr. 2480, 2760.

445. A lender accepts default risk. Tr. 2488.

446. Economically, it would be the height of folly for the Partnership to take all the money it had and put it solely in the hands of Citicorp if the Partnership felt there was any risk associated with the Citicorp Notes. Tr. 2662, 2609.

447. Under ACM's Summary of Financial Accounting Policies ("ACM's Accounting Policies"), absent an extraordinary change in any of the factors affecting the market value of the Citicorp Notes, the fair market value of the Citicorp Notes was deemed to be the cost or accreted value to the Partnership. Ex. 162-FU.

448. The Citicorp Notes were considered a cash equivalent and valued by the Partnership at cost, the par value. Tr. 663; Ex. 162- FU; Stip. paragraphs 111, 112.

449. Taylor testified that ACM purchased the Citicorp Notes to invest the cash in the Partnership while identifying the CP debt to buy. Tr. 523.

450. The Minutes of the First Partnership meeting on October 27, 1989 reported that the Citicorp Notes were purchased to maximize the investment return on the partnership assets pending the acquisition of CP debt. Ex. 163-FV (p. 2).

451. Given the expectations regarding the sale of the Citicorp Notes, any increased return would be de minimis. Ex. AZH (pp. 23-24) (Plotkin).

452. Pohlschroeder did not compare the transaction costs to be incurred on the sale of the Citicorp Notes with transaction costs on the sale of other instruments. Tr. 492.

453. In determining whether the Partnership would earn a reasonable return on the Citicorp Notes, Pohlschroeder did not take the transaction costs on the sale of the notes into consideration. Tr. 493.

454. Given the transaction costs incurred, if Citicorp's credit did not increase during the period from November 3, 1989 through November 28, 1989, there was no potential for profit on the sale of the Citicorp Notes. Ex. 519 (Tables, pp. 12-13 specifically Tables IV-E, IV-F, Column 2).

C. THE ISSUER OF THE CITICORP NOTES

455. Prior to the formation of ACM, Taylor asked Merrill's debt desk to be on the lookout for clients that would be interested in floating-rate private placements with a put option. Tr. 712-13.

456. On or about October 15, 1989, Merrill presented Citicorp with the opportunity to issue the floating-rate notes. Merrill stated that the issue needed to be a private placement and unregistered. Tr. 1546.

457. Steven F. Greene ("Greene"), educated at Amherst and Yale, was an assistant vice president of Citicorp in 1989, responsible for long-term funding for Citicorp. Tr. 1544-45.

458. Greene testified that issuing the floating-rate notes to ACM enabled Citicorp to save about five basis points versus the long- term funding rate to Citicorp in the market. Tr. 1546.

459. In pricing the Citicorp Notes, Greene assumed that the put option would be exercised. Tr. 1560, 1566.

460. Because Greene assumed that the put would be exercised, he compared the price of the Citicorp Notes to two year issuances. Tr. 1567; Ex. HH.

461. Beder testified that the put option was worth approximately 5 basis points to ACM. Ex. 519 (p. 22 and Tables, p. 8, IV-A).

462. Valuing the embedded put option of the Citicorp Notes is very difficult and there are numerous methodologies that could be used. Tr. 2583.

463. Citicorp was willing to issue the floating-rate notes because they were favorably priced. Tr. 1546-47, 1551, 1567; Ex. HH.

464. Tucker opined that Citicorp was compensated by issuing the floating-rate notes with a below market coupon which enabled them to finance below their usual funding rate. Assuming a value of five basis points for the put option, Citicorp saved, in addition, between three to eight basis points. Tr. 2287-89, 2292; Ex. AZF (p. 46).

VII. THE AVAILABILITY OF COLGATE DEBT

465. In a letter dated October 3, 1989, Yordan informed Heidtke that the following debt was available: 9-5/8 percent debentures due 2017, 8.4 percent notes due 1998 (Met Note), and 9-1/2 percent Eurodollar debenture due 1996. He assured CP that CP's relationship with Met Life would be a key element in CP's achieving an attractive price. Ex. 82-CF; Tr. 116-17.

466. Heidtke had no recollection of specific discussions with Yordan regarding the availability of the CP debt. Tr. 198-99.

467. Other than his October 3, 1989 letter and attending the first Bermuda meeting, Yordan had minimal involvement in the development of ACM. Ex. 82-CF; Tr. 3090, 3091-92.

468. Yordan first heard that CP was contemplating the formation of a liability management partnership from Taylor or Pohlschroeder, but probably Taylor. Tr. 3086-89.

469. Den Baas did not independently determine whether CP debt was available in the market prior to the formation of ACM. Tr. 1149.

470. Pohlschroeder informed Heidtke on October 3, 1989 that pursuant to an inquiry to Met Life, "we feel confident that the partnership can purchase sufficient CP debt in the open market to establish a hedged capital structure with approximately $140 MM of CP debt and $60 MM of LIBOR note hedge." Ex. 86-CJ (p. 5).

471. In November 1988, Met Life approached Heidtke and Pohlschroeder with respect to renegotiating the terms of the Met Note, specifically to add an event risk clause which would protect Met Life in the event of a takeover of CP. Stip. paragraph 164; Exs. 218-JN, 219-JO; Tr. 154.

472. In the Fall of 1988, Met Life approached a number of companies in addition to CP, attempting to add event risk language to the terms of the debt obligations Met Life held. Tr. 1763-64.

473. As a result of the November 1988 meeting with Met Life, Pohlschroeder thought he could buy the Met Note. Tr. 262, 851.

474. In late Summer or early Fall 1989, Pohlschroeder inquired of Met Life whether Met Life would be interested in discussing a possible sale of the Met Note. Stip. paragraph 164.

475. On October 23, 1989, Pohlschroeder educated himself by discussing the pricing on the Met Note with Yordan. Ex. 426-ABK; Tr. 453-54. Pohlschroeder indicated on the notes "wk of the 13th Friday 17th", the date the Note Purchase Agreement between Met Life and ACM was executed in Bermuda. Exs. 229-JY, 164-FW; Tr. 455.

476. Prior to traveling to Bermuda on November 16, 1989, Charles Symington ("Symington") had a clear idea of an acceptable price to Met Life for the Met Note. Tr. 1760.

477. By internal Met Life memorandum dated November 14, 1989, a Met Life employee requested the delivery of the Met Note in connection with the sale of the Note to an affiliate of CP on Friday, November 17, 1989. Ex. 222-JR.

478. On November 13, 1989, Symington telephoned Pohlschroeder in New York, leaving a message that the "pricing is + 85." Tr. 457-58; Ex. 400-ZG; Stip. paragraph 349.

479. Pohlschroeder claimed that he and Symington discussed the price for the Met Note generally on November 16, 1989 but that Symington did not give him a price until November 17, 1989, when, after Symington discussed the price with his boss, he told Pohlschroeder Met Life would be willing to sell at 85 basis points over the applicable Treasury. Tr. 320-21.

480. According to the Partnership's Revaluations, ACM acquired the Met Note at a spread of 84.8 basis points to Treasuries. Exs. 149-FH through 155-FN (p. 1).

A. ACM'S PURCHASE OF THE MET NOTE

481. By Note Purchase Agreement dated as of November 17, 1989, ACM agreed to purchase $100 million principal amount of the Met Note from Met Life for the aggregate purchase price of $101,461,000 (principal of $99,291,000 plus accrued interest of $2,170,000). Stip. paragraph 167. The Met Note matured on March 1, 1998 and paid interest on the unpaid portion of its principal amount semiannually on March 1 and September 1 of each year at the rate of 8.4% per annum. The Note required $12,500,000 principal prepayments each March 1 through 1996, and $6,500,000 on March 1, 1997 and its average maturity was 4.3. years. Exs. 23-W, AZE.

482. The spread above Treasury debt of similar maturity to a corporate bond represents the premium a borrower pays because its credit is not as good as that of the United States. A small spread represents a higher quality credit. Ex. AZH (p. 20 n. 38).

483. The minimum target spread set for acquisition of the Met Note was 100 basis points over Treasuries. Exs. 163-FV (p. 1), 149-FH through 155-FN (p. 1).

484. The target spread was set with ABN's investment targets in mind. Ex. AYX (p. 5, (3)).

485. The difference between the target spread and the original acquisition spread (84.8 basis points) made the Met Note approximately $400,000 more expensive to purchase. Tr. 322; Exs. AZH (p. 5, (3)) (Plotkin), 149-FH through 155-FN (pp. 1) (reflecting acquisition spread).

486. SH bore the approximate $400,000 cost to purchase the Met Note at a spread below the target spread through the Quality Component allocation. Tr. 322; Exs. 142-FA, AYX (p. 5, (3)), YN (P. 1).

487. As a result of the difference between the target spread and the original acquisition spread, KNX would not share in changes in the value of the Met Debt resulting from changes in the credit quality (the Quality Component) of the Met Note unless the spread widened from the acquisition spread of 84.8 basis points to a spread of between 100 and 150 over Treasuries. Ex. AZH (p. 20 n. 38 and p. 34).

488. The Met Note never moved within the sharing range, thus KNX never shared in changes in the value of the Met Debt as a result of changes in its credit quality. Exs. 142-FA through 155-FN (Quality Component within "Sharing range" = 0).

489. When Pepe valued the Met Note for purposes of the November 27, 1989 Partnership Revaluation, he came up with a value different from the purchase' price of the Met Note. The difference, $8,654, was credited to the capital account of SH and impacted the allocations of the Quality and Yield Components. Tr. 1366-67, 1371; Exs. 142-FA (p. 3, line 2 "Prior Adjustments Effective: S -- H Co. Purchase Adjustment"), YP (draft revaluation without adjustment, compare "Adjusted Cost Basis" of draft with "Adjusted Cost Basis" of final).

B. THE LONG BONDS AND EURO NOTES

490. In October, 1989, Yordan went to Bermuda to discuss the availability and prices of the Long Bonds and Euro Notes. Tr. 466, 3089, 3091.

491. At that time, Yordan knew who held some of the long bonds. Tr. 3091.

492. In Bermuda on October 27, 1989, Pohlschroeder wrote two sets of standing orders to be given to Merrill to purchase the Euro Notes and Long Bonds, stating "Peter de Beer, Curacao will give instructions from C to M.L after Citi's purchase." Ex. 427-BL; Tr. 464-65.

493. Instructions or standing orders were given to Merrill for purchases of CP Long Bonds and Euro Notes at two different times. Ex. 427-ABL; Tr. 464-65.

494. On December 4, 1989, ACM purchased $31 million principal amount of CP's Long Bonds from Merrill, which was accounted for at a purchase price of $31,493,396 plus accrued interest of $1,160,347. Stip. paragraph 178. The Long Bonds matured on July 15, 2017 and paid interest semiannually an January 15 and July 15 of each year at the rate of 9.625% per annum. Ex. 28-AB.

495. Merrill agreed to sell the Long Bonds to ACM by November 28, 1989. The settlement date for the Long Bonds was December 4, 1989. Exs. 237-KH, 238-KI.

496. By December 1, 1989, ACM agreed to purchased CP Euro Notes of $1 million principal amount for $1,025,500 plus accrued interest of $66,763.89 and $4 million principal amount for $4,102,000 plus accrued interest of $271,277.77. The settlement dates were December 4, 1989 ($1 million) and December 8, 1989 ($4 million). Exs. 237-KH, 238-KI; Stip. paragraph 173.

497. The Euro Notes matured on March 21, 1996 and bore interest from March 21, 1986 at the rate of 9.5% per annum, payable annually on March 21 of each year commencing March 21, 1987. Exs. 25-Y (p. 4), 26-Z (Ex. A, p. A-1).

VIII. ACM'S SALE OF THE CITICORP NOTES FOR CASH AND LIBOR NOTES

498. On November 27, 1989, ACM sold $175 million principal amount of the Citicorp Notes to the Bank of Tokyo ("BOT") ($125 million) and Banque Francaise du Commerce Exterieur ("BFCE") ($50 million). The aggregate consideration consisted of cash in the amount of $140 million and eight notes, maturing December 1, 1994, and requiring quarterly payments of floating LIBOR for twenty quarters on a stated notional amount of $97.76 million ("LIBOR Notes"). A separate LIBOR Note was executed for each of the Citicorp Notes sold. Stip. paragraph 126.

499. The LIBOR Notes were not registered under the Securities Act of 1933; nor were the LIBOR Notes readily tradable on an established securities market, defined as (i) a national securities exchange registered under section 6 of the Securities Exchange Act of 1934, (ii) an exchange exempted from registration under section 5 of the Securities Exchange Act of 1934 because of its limited volume of transaction, or (iii) any over-the-counter market in which quotes for the LIBOR Notes were regularly disseminated by identified brokers or dealers through an interdealer quotation system. Stip. paragraph 127.

500. The LIBOR Notes were intended to qualify the transaction for installment sale reporting, thus permitting the tax aspects of the transaction to be accomplished. Tr. 329, 527, 914, 943.

501. The installment sale had no economic effect on the value of the CP debt and was unrelated to the allocation of the Yield and Quality Component. Tr. 888-90.

A. THE REPORTED TAX CONSEQUENCES OF THE SALE

502. ACM reported the sale of the Citicorp Notes on the installment method for contingent payments contained in Temp. Treas. Reg. section 15A. 453-1(c)(3), providing for the ratable allocation of basis over the term of a contingent obligation. ACM recovered $29,250,760 million (1/6) of its $175,504,563.50 million tax basis in the Citicorp Notes in 1989, thereby recognizing $110,749,239 ($140 million cash less $29,250,760 basis) of short-term capital gain for tax purposes on the sale. Stip. paragraph 132.

503. At the time of the sale of the Citicorp Notes, CP was aware of the relief provisions of Temp. Treas. Reg. section 15A.453- 1(c)(7). Stip. paragraph 324; Tr. 964, 971, 1498.

504. It was not in CP's interest to request permission to use a more appropriate method for recovering its tax basis in the Citicorp Notes pursuant to Temp. Treas. Reg. section 15A.453-1(c)(7)(ii) because the tax benefits relating to the ACM transaction were more favorable than an alternative method. Tr. 971, 1498.

505. For the tax year ending November 30, 1989, the $110,749,239.42 of the installment sale gain was allocated: $91,516,688.57 to KNX; $18,908,406.73 to SH; and $324,144.12 to MLCS. Stip. paragraph 132.

506. As CP believed likely, KNX paid no U.S. taxes on its 82.63 percent share of the installment sale gain. Ex. 127-EJ; Stip. paragraph 312.

507. KNX paid no foreign taxes on its 82.63 percent share of the installment sale gain. Stip. paragraphs 247, 249; Exs. RK, RL, RM, RN, RO.

508. The $110.7 million short-term capital gain was not reflected in ACM's capital accounts, its audited financial statements or the Revaluation Worksheets. Exs. 142-FA through 156-FO; 318-PL through 322-PP, 518 (p. 21).

509. On Schedule M (Reconciliation of Partners' Capital Accounts) of ACM's November 30, 1989 return, the partners' capital accounts were increased by the $110.7 million gain and then decreased by that same amount, with the notation "tax but not book" gain. Ex. 1-A.

510. On July 26, 1990, the Partnership adopted "United States Tax Accounting Balance Sheet and Net Income Statement" which reflected the $110.7 million gain in the partners' capital accounts; as assets (based on tax basis); and as income. Ex. 167-FZ.

511. During 1989 through 1991, KNX paid no U.S. income tax. Exs. 127-EJ through 136-ES.

512. During 1989 through 1992, KNX paid Netherlands Antilles profit tax in the approximate amount of $114,000. Exs. RK through RO; Stip. paragraph 239.

B. THE CITICORP NOTE PURCHASERS

513. In connection with the sale of the Citicorp Notes, ACM conveyed to Merrill the criteria that the purchasers be able to issue cash plus LIBOR notes. The issuers of the LIBOR notes were required to be creditworthy in accordance with standards established by ACM. The issuer had to be rated A or better. Stip. paragraph 321.

514. Merrill suggested the following potential purchasers of the Citicorp Notes to ACM: BOT, BFCE, and Mitsubishi Bank. Stip. paragraph 322.

515. None of the three banks approached by Merrill rejected the possible purchase of the Citicorp Notes from ACM. Stip. 323.

516. Heidtke considered BOT and BFCE highly rated from a credit standpoint. Tr. 140-41.

517. BOT had an AA rating at the time the BOT LIBOR Notes were issued. Tr. 1428.

518. BFCE, as a quasi-governmental bank, did not have a technical long-term credit rating, however, their obligations were traded in the market like the obligations of a AAA entity. Tr. 1428.

519. At the origin of ACM, taking into account the credit risk of Citicorp and market conditions generally, Taylor estimated the price at which the Citicorp Notes could be sold by ACM which, for the one-month period the Notes were held, was reasonably accurate. Tr. 533-34, 537.

IX. THE BOT AND BFCE SWAPS

520. Aditya Reddy ("Reddy"), a vice president in the securitization department of BOT, has an MBA. Tr. 1623. In 1989, Reddy was an assistant vice president at BOT and worked for Yukiharu Kiho in the BOT Capital Markets Group. Tr. 1624; Stip. paragraph 135. He evaluated structured transactions and assisted in routine derivative transactions that the swap desk executed for customers. Tr. 1624.

521. During the period in issue, Louis de Bellegarde ("de Bellegarde") was the First Vice President of BFCE. Stip. paragraph 152.

522. Prior to ACM purchasing CP debt, Taylor informed Merrill sales personnel that he was interested in finding issuers of LIBOR notes and provided schematics, prepared by his group, and similar to those provided to BOT by Merrill sales personnel. Tr. 720-21; Stip. paragraph 144; Exs. 211-IQ, JE. Taylor understood that the Sales Group would make inquiries of whether foreign banks would be interested in the transactions on a generic basis. Tr. 721.

523. Merrill approached BOT and BFCE with schematics outlining a structured transaction which involved the sale of private placements for cash and LIBOR notes and hedge and asset swaps. Tr. 1626-28, 1636-37, 1640-41; Stip. paragraphs 144, 157; Exs. 211-IQ (pp. 1-5), JE.

524. A fixed income salesman from Merrill approached BOT towards the end of October with respect to the transaction. BOT subsequently had several meetings with Pepe regarding the transaction. Tr. 1638- 39, 1626, 1651 (referencing November 9th memorandum, Ex. IG).

525. On November 9, 1989, BOT New York requested that BOT Japan authorize BOT New York to purchase the Citicorp Notes and enter a basis (or asset) and hedge swap with Merrill. Ex. IG.

526. Specific details on the ACM transaction were given to BOT three or four days prior to November 9, 1989. Ex. IG; Tr. 1651.

527. Merrill required that BOT commit to the deal within a few days of November 9, 1989. Tr. 1651-52; Ex. IG (p. 1).

528. The transaction was not routine to BOT. Tr. 1639.

529. Originally, there were discussions that the private placements would be purchased for 75 percent cash and 25 percent LIBOR Notes. While the percentage of cash and notes changed to 80 percent and 20 percent, respectively, there was no flexibility to BOT in the percentage of cash to LIBOR Notes in the transaction. Tr. 1641-42. BOT asked whether it could purchase the Citicorp Notes for all cash and was told no. Tr. 1646-47.

530. BOT issued six LIBOR Notes to ACM because, in the event the transactions were unwound, separate notes would be easier to sell. BOT did not care how many LIBOR Notes were issued; BOT regarded the notes as one transaction. Tr. 1642.

531. BOT was informed that ABN was a partner. BOT demanded the name of the other partner prior to the execution of the transaction and was informed that it was CP. BOT was not informed that MLCS was a partner. Tr. 1643.

532. BOT would not have purchased the Citicorp Notes for cash and LIBOR Notes if it could not have entered into the hedge and asset swaps. Tr. 1646.

533. BOT had minimal input into the drafting of the LIBOR Notes. Tr. 1649.

534. Reddy did not value the LIBOR Notes BOT issued. While BOT checked Merrill's valuation of the LIBOR Notes, BOT was relying on Merrill to make the payments on the LIBOR Notes through the hedge swap. Tr. 1650.

535. Reddy asked his supervisor why he valued the LIBOR Notes. Tr. 1650.

536. On November 27, 1989, Merril ³ entered into a "hedge" swap and an "asset" (or "basis") swap with each of the purchaser banks (BOT and BFCE), which gave BOT and BFCE an asset and liability that were attractively priced versus other alternatives in the market. Tr. 1418, 1629; Exs. 206-IC, 207-ID, 213-IZ, 214-JA.

537. Merrill Lynch & Co., Inc. guaranteed the cash flows on the swaps between BOT and Merrill's swap subsidiary. Tr. 1631, 661-62.

538. Pursuant to the hedge swaps, the banks agreed to pay Merrill LIBOR less 25 basis points (BFCE) or LIBOR less 18.75 basis points (BOT) on a notional amount which amortized ratably over five years. Exs. 213-IZ, 207-ID, AZF (pp. 18, 19, 21, 22).

539. In exchange, Merrill agreed to pay the banks floating LIBOR for twenty quarters on a stated notional amount. This stream of payments was equal to the payments the banks were required to make under the LIBOR Notes. Exs. 213-IZ, 207-ID, AZF (pp. 18, 19, 21, 22); Tr. 1634.

540. The hedge swaps effectively converted the transactions, from the banks' perspective, to synthetic funding below the banks' funding rate. Exs. IG (p. 4), AZF (pp. 18-22, 49), JM (p. 3); Tr. 611-13, 623-24, 550-51 (Taylor describing Ex. 211-IQ, schematics reflecting a generic transaction from the perspective of the purchasing banks), 1630.

541. Because the payments made by BFCE and BOT pursuant to the hedge swaps were based on an amortizing principal amount, the payments were much less volatile than the payments required to be made under the LIBOR Notes. Tr. 612; Ex. AZF (p. 18).

542. Because the notional amount of the LIBOR Notes never changed, LIBOR note payments increased or decreased based solely on changes in LIBOR. Thus, a change in interest rates significantly affected the LIBOR Note payments and thus the value of the Note. For example, if LIBOR doubled, the value of the LIBOR Note would almost double. Tr. 527-28.

543. The payment impact of a change in interest rates is roughly five times greater in the case of the LIBOR Notes than on a simple loan, whose payment stream is amortized with level payments under varying interest rates. Because the discount rate would follow a change in interest rates, the actual change in value of the LIBOR Notes is less dramatic than the change in total payments, but still very significant. Ex. AZH (p. 16 n. 29) (Plotkin).

544. A LIBOR Note is highly interest rate sensitive and thus, a very volatile instrument. Tr. 653; Exs. 517 (p. 33) (Singleton), 521 (p. 118-19) (Grundfest), AZH (p. 16) (Plotkin).

545. The LIBOR Note had an unusual cash flow. Tr. 1629-30, 1664- 65 (Reddy).

546. BOT funded in the LIBOR market and preferred LIBOR based assets. Tr. 1629.

547. Under the asset swaps, the purchaser banks were obligated to pay Merrill the income stream (monthly commercial paper plus 15 basis points) on the Citicorp Notes. Exs. 206-IC, 214-JA, AZF (pp. 14-17, 21-22); Tr. 745-46.

548. Under the asset swaps with BOT and BFCE, Merrill was obligated to pay the banks monthly LIBOR plus 25 basis points on a notional amount equal to the principal amount of the Citicorp Notes purchased. After the initial three coupon periods (as of the third Wednesday of February), LIBOR plus 25 was stepped-up to LIBOR plus 40. On the BOT asset swap, the step-up was LIBOR plus 50 for all subsequent coupon periods. Exs. 206-IC, 214-JA, AZF (pp. 14-17, 21- 22); Stip paragraph 126.

549. BOT and Merrill negotiated the plus and the step-up on the asset swap. Tr. 1633, 1643-44.

550. The step-up gave Merrill an incentive to sell the Citicorp Notes. Tr. 1633-34.

551. Under the asset swap agreements, Merrill had the right to terminate the swaps in return for arranging a sale of the Citicorp Notes at par. Exs. 206-IC (p. 3, other provisions, para. 3), 214-JA (p. 3, other provisions, para. 3), AZF (p. 18). BOT expected and wanted Merrill to exercise their right to call the Citicorp Notes. Tr. 1645-46.

552. It was BOT's understanding that Merrill planned to unwind the asset swap as soon as possible in early 1990. Ex. IG (p. 3).

553. BOT negotiated an up-front payment of $35,000 from Merrill in return for the work the transaction caused BOT. Tr. 1644; Ex. 206- IC (p. 3).

554. Prior to purchasing the Citicorp Notes, BOT analyzed the risk of holding the Citicorp Notes and its risk that Merrill would default under the asset and hedge swaps. Tr. 1636.

555. BOT believed that the hedge and asset swap eliminated BOT's economic interest rate risk from the transaction. Ex. IG (p. 3).

556. BOT considered the return under its asset swap with Merrill of 25 basis points over LIBOR on the Citicorp Notes attractive at the time. In addition, BOT made 16 to 17 basis points on the hedge swap as the 18.75 basis points below LIBOR it paid was approximately 15 to 16 basis points less than its funding rate. BOT's return was above what it could get if it had just purchased the Citicorp Notes in the market, but given the work and complexity involved, the return was satisfactory. Tr. 1665; Exs. IG (p. 4), AZF (p. 49).

557. Through the swaps, BOT and BFCE were compensated by financing a fraction of their purchases at below LIBOR, their usual funding rate. Ex. AZF (p. 49).

558. Merrill discussed the expected term of the asset swap with BFCE prior to BFCE issuing the LIBOR Notes and engaging in the asset and hedge swap with Merrill. Tr. 1303.

559. Pepe told BFCE that it should obtain credit approval to hold the asset until the Citicorp put date. Tr. 1303.

560. Merrill provided BFCE with a computation of the amount BFCE would make if the Citicorp notes were sold at par on December 20, 1989. Tr. 1307; Ex. 215-JI.

561. It was BFCE's understanding that Merrill had committed itself to buy the Citicorp Notes at par by December 20, 1989 (or at the latest on December 23, 1989). Exs. JL, JM (p. 2), JG (p. 1).

X. THE SALE OF THE CITICORP NOTES BY BFCE AND BOT

562. Merrill exercised its call provision under the BFCE asset swap and arranged for BFCE to sell the $50 million Citicorp Notes to Nissho Iwai American Corporation ("Nissho Iwai") at par on December 22, 1989. Simultaneously, the asset swap between BFCE and Merrill was terminated before Merrill became obligated to pay the step-up under the swap. Stip. paragraph 192; Tr. 659, 1308; Exs. 508, MC, 214-JA, 282-LZ.

563. Simultaneously with the purchase of the Citicorp Notes by Nissho Iwai, effective December 22, 1989, Merrill entered into an asset swap with Nissho Iwai. Nissho Iwai paid Merrill the income stream (monthly commercial paper plus 15 basis points) on the Citicorp Notes in exchange for monthly LIBOR plus 25 basis points on a notional amount equal to the principal amount of the Citicorp Notes purchased. After the initial three coupon periods (as of the third Wednesday of March), LIBOR plus 25 was stepped-up to LIBOR plus 50 basis points. Ex. WP. Under the asset swap agreement, Merrill had the right to terminate the swaps in return for arranging a sale of the Citicorp Notes at par. Ex. WP (p. 3, other provisions, para. 3).

564. On January 9, 1990, Pepe informed Nissho Iwai that at some point in the coming months there would be a sale of a portion or all of the Citicorp Notes. Ex. AWT.

565. On January 15 and 18, and February 20, 1989, Merrill arranged for Nissho Iwai to sell the Citicorp Notes and the asset swap was simultaneously partially and then fully terminated, prior to the effective date of the step-up. Exs. AWX, AWY, AWV, AWW, WP (unnum. pp. 4-10).

566. On January 17, 1990, Merrill exercised its call under the BOT asset swap and arranged for BOT to sell the $125 million Citicorp Notes to Banker's Trust ($100 million), Tower Management Short-Term Non-profit Trust ($5 million), and County of Long Beach ($20 million). Simultaneously, the November 27, 1989 asset swap between BOT and Merrill was terminated. Stip. paragraphs 197, 202; Tr. 659; Exs. ML, 508.

XI. THE DISCOUNT ON THE SALE OF THE CITICORP NOTES

567. ACM sold the Citicorp Notes at a price of 99.375 or at a loss or discount of $1,093,750 (5/8 of one percent or 62.5 basis points x $175 million). The loss or discount was reflected in the difference between $35,504,563.50 (the book value of the LIBOR Notes) and $34,410,813.50 (Merrill's net present value of the LIBOR Notes). Tr. 326-27, 725-26, 740, 1256; Exs. 380-XJ, 381-XK, 382-XL (ACM 01275), AWC (seventh unnum. p.), AZA, AZF (pp. 10, 12), 217-JK, 144- FC (p. 4 "Original Book Value of LIBOR Notes"), 318-PL.

568. The $1,093,750 discount, also referred to as the origination on the LIBOR Notes or friction on the sale of the Citicorp Notes, was passed to Merrill through the BOT and BFCE swaps. Tr. 744-52, 326-27, 1256, 1317; Exs. AZF (pp. 17, 49), 407-AAA ("Origination/Sale ST Notes"), 406-ZZ ("Orig of Short term Notes = LIBOR Note"), 206-IC, 207-ID, 214-JA, 213-IZ.

A. THE CALCULATION OF THE DISCOUNT

569. Merrill established the amount of the discount on the sale of the Citicorp Notes. Tr. 728.

570. Merrill's net present value of the LIBOR Notes was set based on the difference between $174,410,813.50 (comprised of the discounted par value of the Citicorp Notes ($175 million x 99.375 = 173,906,250) plus the accrued interest on the Citicorp Notes ($504,563.50)), and the cash received upon the sale of the Citicorp Notes ($140 million). Merrill's net present value of the LIBOR Notes was thus $34,410,813.50. Tr. 725-26, 728-29; Exs. 382-XL (ACM01275), 380-XJ (ACM01374-75), 381-XK.

571. Merrill sold (sic solved] for the notional amount of the LIBOR Notes based on swap pricing methodologies, which took into account the creation of sub-LIBOR funding (through the hedge swaps) for the issuing banks. There was a $1,301 difference between the set present value of the LIBOR Notes (based on the discounted par value of the Citicorp Notes - see PF 570) and the present value derived from the notional amount based on Merrill's swap pricing methodology. Tr. 727, 729, 3176; Ex. 382-XL.

572. On November 27, 1989, Merrill calculated the net present value of the BOT LIBOR Notes to be $24,579,152.50 and the net present value of the BFCE LIBOR Notes to be $9,831,661. Exs. 380-XJ (ACM01374-75), 381-XK (ACM01025).

573. Taylor provided Pohlschroeder with an explanation of the economic consequences of ACM's sale of the Citicorp Notes and the pricing of the LIBOR Notes. Tr. 725-26, 476, 484; Exs. 380-XJ, 382- XL.

574. Pohlschroeder did not independently verify the calculations made by Merrill regarding the value of the LIBOR Notes. Tr. 479-80, 484.

575. It was Pohlschroeder's understanding that the origination represented a cost to sell the Citicorp Notes and not a change in market value because the Citicorp Notes were floating-rate notes that, by definition, could not fluctuate in value since changes in interest on the Notes follow changes in market interest rates. The market value of the Citicorp Notes did not change as a result of a change in the perceived quality of Citicorp during the period ACM held the notes in November of 1989. Ex. AZA (AA00188).

1. ACCOUNTING FOR THE DISCOUNT -- THE REASONS BEHIND THE

577. Rossi discussed issues with Groeneveld regarding ACM's financial statements, including the issue of whether to reflect the selling costs of the Citicorp Notes on ACM's financial statements. Tr. 1915, 1932.

578. Rossi facilitated the resolution of issues regarding ACM's financial statements by talking primarily to Pohlschroeder. Tr. 1926- 27, 1932.

579. In 1990, on the written request by Arthur Andersen (Curacao) for an explanation, Rossi noted "[d]iscussed with Erik on 1/28, with Hans P., Jeff L, questions answered S/R". "Hans P." was Pohlschroeder. "Jeff L" was Jeff Lindenbaum, an experienced assistant on the CP audit staff of Arthur Andersen. Tr. 1916, 1890; Ex. AYY. Rossi's note was consistent with his practice of making notes, accurate to the best of his ability, of discussions he had with clients. Tr. 1920.

580. Rossi and Groeneveld spoke about Groeneveld's desire for an explanation as to the reasoning for ACM's not recognizing a result on the sale of the Citicorp notes on ACM's financial statements for the fiscal year ended November 30, 1989. Exs. RB (AB000217, paragraph (3)), AYY (p. 2, paragraph (3)). Pohlschroeder was going to have his people investigate the issue. Ex. RB (AB000217, paragraph (3).

581. CP requested that Arthur Andersen (Curacao), in cooperation with Rossi and CP, consider how to keep the $1,093,750 discount on the sale of the Citicorp Notes off ACM's balance sheet. Ex. AZA (AA00118).

582. CP did not want the $1,093,750 discount on the Citicorp Note sale reflected in ACM's financial statements for the fiscal year ended November 30, 1989. The reasons were mainly tax driven, as CP thought that the inclusion of this discount in ACM's financial statements might set the IRS on top of the reasons why the Partnership was constructed in the first place and the planned tax losses might be denied. Ex. AZA (AA00118).

583. The November 30, 1990 general ledger of ACM makes an adjusting entry reversing the $1,093,750 loss attributed to the BFCE and BOT LIBOR Notes. Ex. 324-PR (7th unnum. p.).

584. All considered alternatives to keep the $1,093,750 discount off ACM's balance sheet to avoid Service scrutiny were based on the premise that CP alone would bear that cost. Ex. AZA (AA00118-19).

585. One proposed alternative was to reflect the LIBOR Notes on the balance sheet at a cost value that included the $1,093,750 discount. Ex. AZA (AA00119).

586. In the opinion of Arthur Andersen, the alternative of reflecting the LIBOR Notes at a value that included the $1,093,750, required a side letter to the Partnership Agreement stating that the LIBOR Notes were the one exception to the valuation rules which otherwise required a valuation at market and providing that the LIBOR Notes should be valued at market increased by the $1,093,750. Ex. AZA (AA00119).

587. Rossi testified he recalled no contact with Merrill regarding ACM's accounting policies. Tr. 1934.

588. Pohlschroeder testified he was not involved in determining ACM's Accounting Policies and that they were prepared by Merrill. Tr. 495-96; Ex. YM.

2. ACM'S ACCOUNTING POLICIES

589. According to ACM's Accounting Policies adopted at the Fourth Meeting of the ACM Partnership Committee on February 28, 1990, for purposes of the Partnership's Revaluation Statements, the LIBOR Notes were carried based on adjustments to cost. The Notes were amortized on a straight-line basis and, upon certain revaluation events, valued based on interest rate changes. In effect, when the Notes were valued based on interest rate changes, the Notes were valued and then the origination attributable to the LIBOR Notes held by ACM was added to that value. Tr. 663, 1268, 1325, 756-57; Exs. 166-FY (p. 2), 162-FU (paragraph VII. A) (the LIBOR Notes "will be carried on the books of ACM at cost, and adjusted . . . (i) for amortization of principal on a straight-line basis; and (ii) for movements in interest rates upon the following events: (a) distribution of any LIBOR notes; (b) redemption of any partner; and (c) liquidation of the Partnership").

590. To arrive at a LIBOR Note value based on interest rate changes, Merrill compared the then current book value of the LIBOR Notes to the sum of Merrill's LIBOR Note valuation plus the attributable origination. The prior book value of the LIBOR Notes was adjusted by the difference, with the effect that the LIBOR Notes value included the origination costs. Tr. 763-766, 1284, 1286-87, 1290-91, 1325; Exs. 144-FC (p. 4), 153-FL (p. 5), 155-FN (p. 5), 428- ABM (CO967), AWC (8th through 11th p.), AWE (13th p.), AWF (last p.); PF 589.

591. ACM's financial statements also carried the LIBOR Notes based on adjustments to cost and further provided that, in the event that the LIBOR Notes were distributed to a partner before maturity, they were to be distributed at book value. Exs. 318-PL through 320-PN (Balance Sheets and Notes to Financial Statements, Significant Accounting Principles (b)).

592. The original cost or book value of the BFCE LIBOR Notes was $10,144,161. This amount was computed by subtracting the $40 million of cash paid by BFCE to ACM for the Citicorp Notes from the $50 million par value plus accrued interest of $144,161 on the Citicorp Notes. Tr. 759; Exs. 428-ABM, 217-JK.

593. The origination attributable to the BFCE LIBOR Notes was $312,500 (5/8 of a percent times 50 million). That amount was equal to the difference between the $10,144,161 book value of the BFCE LIBOR Notes and Merrill's $9,831,661 net present value of those Notes on November 27, 1989. Tr. 757, 759, 475, 1331; Exs. 217-JK, AZF (p. 17), AWC (last p.), 428-ABM, 430-ABO, 318-PL, 380-XJ (ACM01374).

594. The origination attributable to the BOT LIBOR Notes was $781,250, computed by multiplying 5/8 of a percent times the $125 million face value of the Citicorp Notes sold to BOT. Tr. 1325-26; Exs. AZF (p. 17), AWC (seventh unnum. p., last p.); PF 498.

3. THE LIBOR NOTES WERE NOT CARRIED AT FAIR MARKET VALUE

595. The LIBOR Notes could not be sold for the amount which, under the Accounting Policies of ACM, they were carried on the revaluations and financial statements. Tr. 1328, 1333-34; Ex. AWF (last p.).

596. The Partnership's valuation methodology concerning the LIBOR notes was flawed economically because it violated fundamental principles of cost and accrual accounting. Tr. 2634-37; Ex. AZH (p. 14, n. 26).

597. Essentially, upon valuation of the LIBOR Notes, the origination cost that was being amortized on a straight-line basis, was unamortized. Tr. 2636; Ex. AZH (p. 14, n. 26).

598. The $1,093,750 discount on the sale of the Citicorp Notes represented a prepaid expense that, under fundamental accrual accounting principles, should be properly assigned to income from the LIBOR Notes for each accounting period. Tr. 2635.

599. The costs of selling the private placements were to be borne by CP or its affiliates. Tr. 1328, 1404-05.

600. If the LIBOR Notes were sold by ACM, the formal Accounting Policies of the Partnership provided for the pro rata sharing of the origination cost. Ex. 162-FU.

601. The LIBOR Notes were not to be sold by ACM while KNX was the majority partner. Tr. 1404-05, 1426; Exs. AZA (AA00118), 57-BE, 58-BF, 59-BG, 81-CE; PF 81, 96; Entire Record.

B. THE DISCOUNT ON THE CITICORP NOTES WAS PASSED TO MERRILL THROUGH THE SWAPS

602. Of the total discount on the sale of the Citicorp Notes (the "origination costs"), $504,563.50 was received by Merrill on December 20, 1989, because the effective date of the asset swap payments owed to Merrill by the banks was November 15, not the November 27 swap transaction date. Because the asset swaps transferred the income stream from the Citicorp Notes to Merrill, the $504,563.50 is equal to the accrued interest on the Citicorp Notes from the last payment date of the Citicorp Notes (November 15, 1989) to the date of sale (November 27, 1989). Tr. 725, 744-50; Exs. 206- IC, 214-JA, 217-JK, 382-XL (last p. "accrued interest"), AZF (p. 17).

602.a. The remaining discount was passed to Merrill through an up-front payment of $168,339 made by BFCE (Ex. 214-JA, p. 3, other provisions, para. 2) and over time, through the BOT hedge swap. Under the BOT hedge swap, the notional amount upon which BOT made payments to Merrill ($25 million) had a greater value at the inception of the swap than the net present value of Merrill's swap payments ($24,579,218), which were equal in value to the net present value of the BOT LIBOR Notes. Tr. 751-52; Exs. 207-ID, 382-XL (last p.), AZF (p. 17).

603. If the asset swap could not be unwound, i.e., the Citicorp Notes could not be sold, the discount on the Citicorp Notes passed to Merrill through the swaps would be used by Merrill to pay the step-up required under the asset swaps. Tr. 749-50.

604. As a result of passing the origination to Merrill through the swaps, Merrill had a financial incentive to terminate the asset swaps between BOT and Merrill and BFCE and Merrill. Tr. 1359-60, 750; PF 603.

605. The cash flows upon the termination of the BFCE-Merrill and BOT-Merrill asset swaps resulted in Merrill netting $603,919.04:

      BFCE ASSET SWAP

XII. ASSIGNMENT OF BFCE LIBOR NOTES TO SOUTHAMPTON

606. By Assignment Agreements dated as of December 12, 1989, ACM agreed to assign its rights and obligations under the BFCE LIBOR Notes to SH on December 13, 1989, as a return of capital of SH in ACM. Stip. paragraph 184.

607. The value of the BFCE LIBOR Notes according to the December 13th Partnership Revaluation Worksheets was $10,133,540, equal to the original cost value, $10,144,161, less the difference between the value on November 27th and the value on December 13th, 1989. Tr. 760, 762, 765; Ex. 144-FC.

608. As of December 13, 1989, SH's capital account was reduced by $10,133,540. Stip. paragraph 184; Ex. 144-FC (p. 4). Included in the $10,133,540 was $312,500, the market spread or origination. Tr. 765, 737 (market discount refers to origination), 1333-35; Ex. AWF (last p.).

609. As a result of valuing the LIBOR Notes based on adjustments to cost, the reduction to SH's capital account included the entire portion of the origination cost attributable to the BFCE LIBOR Notes ($312,500). PF 590, 608.

610. On December 13, 1989, Merrill valued the LIBOR Notes at $34,401,762. Exs. 279-LW (922), YP (ACM01188). Based on Merrill's valuation, the value of the BFCE LIBOR Notes on December 12, 1989 was $9,821,534, the $34,401,762 value of all the LIBOR Notes multiplied by the proportional notional amount, the notional amount of the BFCE LIBOR Notes over the notional amount of all the LIBOR Notes ($34,401,762 x 27,910,000/97,760,000). Exs. 279-LW, 382-XL, 198-HU through 205-IB (last page of LIBOR Notes), 429-ABN; Tr. 766.

611. SH's capital account was not decreased by the fair market value of the BFCE LIBOR Notes distributed to it by ACM on December 13, 1989. PF 595, 608-10.

A. THE REASON FOR DISTRIBUTING THE BFCE LIBOR NOTES

612. The tax benefits associated with adjusting the LIBOR Note holding were part of the proposal that Merrill made. Tr. 267.

613. On December 13, 1989, ACM exchanged $4.7 million principal amount of Long Bonds for $5 million principal amount of CP 8.72 percent notes due June 13, 1993. The Note paid interest semiannually on March 31 and September 30 of each year. Stip. 181; Ex. 265-LH.

614. Pohlschroeder testified that ACM distributed the BFCE LIBOR Notes because the Partnership portfolio required less of a hedge upon the December 13, 1989 CP debt exchange, which decreased the volatility of the Partnership's portfolio. Tr. 352-53; Stip. paragraph 181.

615. On March 1, 1991, ACM exchanged $4.85 million principal amount of the Long Bonds for $5 million principal amount of CP 8.06% notes due March 1, 1994. The Note paid interest semiannually on March 1 and September 1 of each year. Stip. paragraph 182.

616. The volatility of the CP debt held by ACM decreased as a result of the exchange. Tr. 354.

617. ACM did not distribute the LIBOR Notes on or around March 1, 1991. Tr. 354; Entire Record.

618. Pohlschroeder testified that ACM did not consider distributing the LIBOR Notes at that time, but that it was a point of discussion. Tr. 354-55.

619. At the Third Partnership Committee meeting, Taylor stated that:

the debt exchange . . . would reduce the Partnership's exposure

621. At trial, Taylor did not recall how the adjustment of the sharing of the Yield Component related to the effect of the LIBOR Note distribution upon KNX. Tr. 794-95.

622. At the time he made the statements, Taylor understood that ABN was hedging its risks with respect to KNX's interest in the LIBOR Notes held by ACM through swaps with Merrill and that gains or losses on the swaps between Merrill and ABN offset gains or losses of KNX in the LIBOR Notes held by ACM. Tr. 628-29, 636, 782, 784, 3180.

623. On November 13, 1989, Merrill provided an analysis of the hedging effect of the LIBOR Notes if ABN's share of interest rate volatility was reduced (through an adjustment to the Yield Component) or five-year CP debt was exchanged for some or all of the Long Bonds held by the Partnership. Ex. 399-ZF.

624. Pohlschroeder testified that the adjustment to KNX's share of the Yield Component had nothing to do with ACM's decision to distribute the BFCE LIBOR Notes. Tr. 353.

625. Heidtke could not recall whether any analysis of the effectiveness of the LIBOR Note as a hedge was made subsequent to the distribution of the BFCE LIBOR Notes from ACM. Tr. 192.

B. THE DISTRIBUTION OF THE BFCE LIBOR NOTE LIMITED SOUTHAMPTON'S

627. Singleton's analysis was based on Merrill's analyses of the effect of the LIBOR Notes as a hedge of CP fixed-rate debt. Tr. 1794- 95; Exs. 517 (p. 33, n. 58), 468-AXR, 469-AXS, 470-AXT.

628. Based on the Merrill assumptions Singleton used, on December 13, 1989, the LIBOR Notes reduced SH's potential minimum exposure to interest rate risk by 43 percent. Singleton's conclusion, in his report, that the purchase of the LIBOR Notes reduced SH's potential minimum exposure to interest rate risk by 57 percent was incorrect, thus overstating the effectiveness of the LIBOR Note as a hedge. Tr. 1797-1800 (In Exhibit 8 to Singleton's report, the "Min" band, or differential of 6.23, expressed in terms of reduction from the Min Fixed level of 14.54, is 43 percent) , 2255; Exs. 517 (p. 32), 468-AXR.

629. In Exhibit 8 to Singleton's report, the value of Max Fixed as of 12/13/89 is 72.27; the value of Max Total as of 12/13/89 is 66. Tr. 1800-01; Exs. 517, 468-AXR.

630. In Exhibit 8 to Singleton's report, the "Max" differential of 6.27, expressed in terms of a reduction from the Max Fixed level of 72.27, is 8 5/8 percent. Tr. 1801; Ex. 517.

631. Following the methodology expressed in Singleton's report, as of 12/13/89, the LIBOR Notes reduced SH's potential maximum exposure to interest rate risk by 8 5/8 percent. Tr. 1799-1801; Ex. 517 (pp. 32-35).

632. Singleton's expression of the alleged LIBOR Note hedge benefit in terms of the Min Fixed-Min Total band distorted the effectiveness of the hedge, because the percentage change calculated at such minimum levels (43 percent), as distinguished from the percentage change calculated at such maximum levels (8 5/8 percent), reflected a much greater numerical percentage change. Tr. 1799-1803.

633. Following the methodology of Exhibit 8 to Singleton's report, just prior to the distribution of the BFCE LIBOR Note from ACM to SH, the value of Min Fixed was 10 percent of 153.23, or 15.32. Tr. 1802; Exs. 469-AXS, 51.7 (pp. 32-35).

634. Following the methodology of Exhibit 8 to Singleton's report, just prior to distribution of the BFCE LIBOR Notes from ACM to SH, the value of Min Total was approximately 6.54 million. Tr. 1802; Exs. 469-AXS, 517 (pp. 32-35).

635. The resulting 8.78 "Min" band, or the differential between the 15.32 and the 6.54 before distribution of the BFCE LIBOR Note to SH was wider than the Min Fixed-Min Total band after distribution of such note. Tr. 1802-03; Ex. 517 (pp. 32-35).

636. The methodology employed in Exhibit 8 to Singleton's report shows the LIBOR Notes provided a greater percentage of hedge against interest rate risk to SH before distribution of the BFCE LIBOR Note, than the percentage of such hedge provided by the LIBOR Notes after the distribution. Tr. 1799-1803; Ex. 517 (pp. 32-35).

637. The distribution of the BFCE LIBOR Note to SH increased SH's exposure to the Yield Component risk within ACM by shifting the range of exposures that SH could potentially face with respect to the P debt away from zero, thereby limiting SH's flexibility to achieve zero exposure to interest rate risk (a pure exposure to the credit Quality Component). Ex. 517 (pp. 32-35); PF 633-636.

638. Heidtke understood that upon the distribution of the BFCE LIBOR Notes in December 1989, the range of hedging opportunities for CP decreased. Tr. 192.

C. LOAN PARTICIPATIONS -- KANNEX

639. Generale Bank purchased a $25 million participation in the loan made under the Revolving Credit Agreement between ABN Cayman Islands and KNX, which was repaid by KNX on March 16, 1990. Stip. paragraphs 391, 395.

640. In offering the participation to Generale Bank, ABN provided Generale Bank with a Term Sheet dated December 5, 1989 providing information about KNX. The Appendix to the Term Sheet, setting forth the value of KNX's direct interest in investment portfolio as per November 30, 1989, did not include the BFCE LIBOR Note. Ex. ABQ.

641. Banco Espirito Santo, New York, acquired a $25 million participation in a loan made to KNX which was repaid by KNX on January 18, 1990. Stip. IS 400, 402.

642. On December 5, 1989, ABN provided Banco Espirito Santo with a Term Sheet dated November 30, 1989 providing information about KNX. The Appendix to the Term Sheet, setting forth the value of KNX's direct interest in investment portfolio as per November 30, 1989, did not include the BFCE LIBOR Note. Ex. ACA.

643. Banco di Roma acquired a $25 million and a $50 million participation in the loan made under the Revolving Credit Agreement between ABN Bank Cayman Islands and KNX. Stip. paragraphs 403, 406, 409; Exs. ACL, ACJ. The $75 million participation of Banco di Roma was repaid by KNX on July 24, 1991. Stip. 5 411.

644. On December 6, 1989, ABN provided Banco di Roma with a Term Sheet dated December 5, 1989 providing information about KNX. The Appendix to the Term Sheet, setting forth the value of KNX's direct interest in investment portfolio as per November 30, 1989, did not include the BFCE LIBOR Note. Den Baas was involved in syndicating the loan to Banco di Roma. On December 13, 1989, den Baas sent a November 30, 1989 term sheet and investment portfolio to Banco di Roma. Exs. ACG, ACH; Tr. 1190-97.

XIII. THE SALE OF THE BFCE LIBOR NOTE TO UNIBANK

645. By Assignment Agreements dated as of December 22, 1989, SH agreed to assign its rights and obligations under the BFCE LIBOR Notes to Sparekassen SDS ("Unibank" ) ⁴ for aggregate consideration of $9,406,180. Stip. paragraph 187; Exs. 275-LR, 276-LS.

646. On its 1989 federal income tax return, CP reported a loss attributed to SH's sale of the BFCE LIBOR Notes to Sparekassen SDS in the amount of $32,429,839, computed as follows:

Cash proceeds from sale                          $ 9,406,180

647. SH recognized a tax loss of about $32 million. This loss more than offset SH's distributive share of the installment sale gain reported upon the sale of the Citicorp Notes by ACM. The net loss of SH in the amount of $13.5 million was reported by CP on its 1989 consolidated income tax return. Ex. 6-F (Statements 198, 227, 228); Stip. paragraphs 4, 132, 188.

A. POHLSCHROEDER'S ROLE IN THE SALE OF THE BFCE LIBOR NOTE

648. Pohlschroeder was a member of the Board of Directors of SH, and participated in a Board meeting regarding the sale of the BFCE LIBOR Note by SH. Tr. 465, 468; Exs. 272-LO, 273-LP.

649. On December 15, 1989, Pohlschroeder wrote to Pepe asking that Pepe value the BFCE LIBOR Note that SH was considering selling. Tr. 466; Ex. 274-LQ.

650. On February 8, 1993, in response to Respondent asking, were you consulted as to what to do with the LIBOR based notes distributed to SH in December of 1989, meaning should they be kept or sold, Pohlschroeder responded "I was consulted? No. " Respondent then asked "Who would have been making that decision?" to which Pohlschroeder responded "Southampton-Hamilton, I guess, the advisors and the people that were on the board and represented Southampton-Hamilton, but I was not part of that transaction." Ex. AYQ (p. 95).

651. In response to being asked by Respondent, were you ever consulted regarding whether or not SH should keep such an asset (referring to the BFCE LIBOR Note distributed to SH in December of 1989) or not, Pohlschroeder answered no. Ex. AYQ (p. 97).

B. SCHICKNER'S SWAP REPO

652. Neil Schickner, a vice president of Unibank, graduated from Harvard College and Stanford Law School. Since 1984, he has worked for Unibank, which was known as Sparekassen until it merged with two other Danish banks in 1990. Tr. 1569-70.

653. In 1989, Unibank opened a branch in New York. Schickner, who had been working in Denmark syndicating loans and issuing bonds, came to New York in May of 1989 to start up Unibank's Capital Markets Desk. He was the sole person on Unibank's Capital Markets Desk. Tr. 1571-72, 1578.

654. Schickner visited investment banking houses in New York, including Merrill, to advise them that Unibank would be interested in capital market transactions. Tr. 1578-79, 1667.

655. Simultaneously with the sale of the BFCE LIBOR Notes to Unibank, on December 22, 1989, Merrill entered into a hedge swap with Unibank. Exs. UW, VE, ⁵ 275-LR, 276-LS.

656. From Unibank's perspective, the swap effectively converted the purchase of the BFCE LIBOR Notes to a synthetic amortizing asset at a rate above Unibank's LIBID to LIBOR financing rate. Tr. 1575-76, 653.

657. Unibank viewed the purchase of the BFCE LIBOR Notes and hedge swap with Merrill as a packaged transaction and would not have purchased the BFCE LIBOR Notes without entering into the hedge swap with Merrill. Tr. 1687-88.

658. Schickner did not view the BFCE LIBOR Notes as "LIBOR Notes" but rather as an obligation to make a series of payments on a notional amount. Tr. 1686.

659. Pepe arranged the Bale of the BFCE LIBOR Notes to Unibank and the simultaneous hedge swap with Schickner. Tr. 1343, 1580.

660. Unibank was approached by Merrill to purchase the BFCE LIBOR Notes prior to December 5, 1989. Tr. 1668-69; Ex. VA.

661. Under the hedge swap, Unibank was obligated to make twenty quarterly payments of LIBOR on a notional amount of $27,910,000; this stream of payments mirrored the payments to be made under the BFCE LIBOR Notes Unibank purchased. Tr. 655, 773, 1573; Exs. UW, VE, 202- HY, 203-HG, 275-LR, 276-LS, AZF (pp. 26-27).

662. Under the hedge swap, Merrill was obligated to pay Unibank LIBOR plus 35 basis points on an amortizing notional amount of $9,406,180 (the BFCE Note purchase price) plus ratable principal amortization. Exs. UW, VE, AZF (pp. 26-27); Tr. 1573-74; Stip. paragraph 187.

663. The lower the notional amount upon which Merrill was obligated to make payments under the Unibank hedge swap, the better off Merrill would be financially. Tr. 1347.

664. As an incentive for Merrill to call the asset (the BFCE LIBOR Notes), the swap agreement provided for a step-up in the basis points over LIBOR payable to Unibank after a specified time. Tr. 657, 1576-77.

665. A call provision in the swap permitted Merrill to unwind the swap by causing the BFCE LIBOR Notes held by Unibank to be sold. Exs. UW, VE; Tr. 657, 1576-77.

666. Merrill expected it would want to unwind the Unibank- Merrill hedge swap and BFCE LIBOR Notes so Merrill and Unibank agreed to a step-up in the margin which provided assurance to Unibank that Merrill would unwind the transaction within a short time. Tr. 1576; Exs. UW, VE.

667. On December 5, 1989, Unibank requested credit approval for the BFCE LIBOR Note transaction. Credit approval was granted until March 1, 1990. Exs. VA (UB000822), VW; Tr. 1583-84.

668. Pepe testified that, upon arranging for the purchase of the BFCE LIBOR Notes by Unibank, he was informed by Unibank that Unibank had credit approval to hold the BFCE LIBOR Notes for only so long, and thus Merrill had to sell the Notes for Unibank or terminate the transactions prior to the December 1, 1994 termination date of the swaps. Tr. 1354-55; Exs. UW, VE.

669. There is nothing in the swap confirmations between BFCE and Unibank reflecting that Unibank had credit approval for only so long or that provided that Merrill had to sell the Notes or terminate the transactions prior to the December 1, 1994 termination date of the swaps. Exs. UW, VE.

670. Pepe testified that if Unibank wanted to sell the BFCE LIBOR Notes and Merrill could not arrange for a buyer, then Unibank would have to sell the notes for whatever the market value of those Notes were. Tr. 1410-11.

671. Under the Unibank-Merrill hedge swap, Unibank agreed that it would not assign, re-offer or resell any of its rights under the LIBOR Notes except in a transaction arranged and consented to by Merrill. Exs. UW, VE (p. 3, "other provisions", paragraph 2).

672. Merrill and Unibank had a business understanding that Merrill would exercise its call option and unwind the entire transaction within a period of time less than the period of time set forth in the documents -- on March 1, 1990. Tr. 1584, 1576-77; Exs. VR (p. 1, C, last para.), UW, VE.

673. Schickner called the purchase of the BFCE LIBOR Note and hedge swap with Merrill the BFCE Swap Repo. Exs. VG (p. 2), AJE (UB000068), AFF (p. 1); Tr. 1591-92, 1688, 1694-95.

674. On February 28, 1990, Schickner requested that the credit line for the BFCE LIBOR Notes be extended until June 1, 1990. Ex. VW; Tr. 1593-94.

675. Merrill requested that Unibank extend the understood time period of the transaction. Under the initial swap document, Unibank was entitled to a step-up of 85 basis points on LIBOR based payments being made by Merrill. Unibank agreed to decrease the step-up to 45 basis points because it wanted future business from Merrill. Exs. VE, UW, UX, VY; Tr. 1589-91.

676. In Merrill's discussions, on behalf of SH, regarding Unibank's purchase of the BFCE LIBOR Notes from SH, Merrill negotiated the spread or margin Unibank would earn over LIBOR, the initial plus on Unibank's spread (the Party A spread Merrill was obligated to make). Exs. UW (p. 2), VE (p. 2); Tr. 1347-49, 1586.

677. Merrill then backed into the notional amount, equal to the price to be paid for the BFCE LIBOR Note, so that the payments on that notional amount would be equal to the amount that Merrill received under the hedge swap with BFCE, assuming the provisions providing for a stepped-up amount of 85 basis points, were not implemented. Merrill thus ensured that it could not lose money on the swap, regardless of how LIBOR changed, if the step-up provision was not implemented. Tr. 1348, 2355-58, 2361; Ex. AZF (pp. 50-51).

678. Given the manner in which the notional amount upon which Unibank paid was determined, the probability of the difference between the sales price of the BFCE LIBOR Note and Merrill's original value of the LIBOR Note (without including the origination) being attributable to a bid-ask spread is about E to the minus hundredth power. The claim that the pricing of the LIBOR Notes upon their sale is determined by a bid-ask spread, as set forth in Beder's report, is impossible. Tr. 2356-58; Ex. 519 (p. 26 and Tables, p. 18, VI-B, VI-C).

679. Merrill had a financial incentive to terminate the hedge swap between Unibank and Merrill. Tr. 657, 1359-60.

680. Merrill provided CP with a $1 million estimate, based on swap pricing methodologies, of the remarketing or friction costs which would be incurred upon the sale of the LIBOR Notes prior to the transaction taking place. Merrill's estimate became guidelines Merrill used in discussing the sale of the LIBOR Notes with Unibank. Tr. 1341-42, 1349-50, 3176; Ex. 380-XJ (ACM01376-77).

681. Merrill had a financial incentive to negotiate against SH's interest because it was in Merrill's financial interest for the notional amount, the price of the BFCE LIBOR Note upon which it paid under the swap, to be low. Tr. 1349-50; PF 662-663.

682. The price at which Unibank purchased the BFCE LIBOR Notes from SH ($9,406,180) included an accrued interest factor which, as a result of the provision in the swap between Unibank and Merrill providing that Unibank's payments to Merrill would commence on December 1, 1989, twenty-two days prior to the date upon which Merrill's payments to Unibank commenced, was passed to Merrill. Exs. UW, VE; Tr. 1345-46.

683. The difference between the reduction to SH's capital account upon distribution of the LIBOR Notes and the amount received for the Notes from Unibank was $727,360, consisting almost entirely of transaction costs: the $312,500 paid to originate the BFCE LIBOR Notes and an additional $390,000 friction associated with the LIBOR Notes' sale. The remaining difference of $27,312 was attributed to interest rate changes between December 13, 1989 and December 20, 1989. Tr. 1333-35; Exs. AWF (last p.), AZF (p. 26); PF 593.

684. The remarketing fee was the difference between Merrill's net present value of the BFCE LIBOR Notes on the date SH sold the Notes and the sale price of the Notes. Tr. 397, 475, 738, 1332, 1334- 35; Exs. AZF (p. 26) (Tucker), 430-ABO, AWC (last p.); AWF (last p.).

685. Because the payments of the BFCE LIBOR Notes that Unibank bought were, at the inception of the swap, worth more than the payments Unibank received from Merrill; and because the initial hedge swap payment to Merrill ran from December 2, 1989, as opposed to the December 22, 1989 date upon which Merrill's obligations commenced, the remarketing fee was passed through the swap to Merrill. Exs. UW, UX, UY, UZ, VE, AZF (pp. 49-53) (Tucker); Tr. 1349-50.

C. TERMINATION OF THE BFCE INSTALLMENT NOTES

686. It was BFCE's understanding at the inception of the hedge swap that the hedge swap would be unwound by March 1990. BFCE understood that the LIBOR Note issued by BFCE would be cancelled and the corresponding hedge swap terminated. Exs. JM (p. 3), JH (p. 1).

687. Both BOT and BFCE contemplated buying all of the $175 million of the Citicorp Notes from ACM. It was BOT's and BFCE's understanding that the hedge swap, related to $10 million of the $35 million LIBOR Notes, would be terminated as early as March 1990. Exs. IG (p. 3), JG (p. 1, last paragraph), JH.

688. In February 1990, BFCE's understanding was that Merrill had extended their commitment to cancel the BFCE LIBOR Notes and related hedge swaps for three months and, in return for what BFCE characterized as a premium, BFCE agreed. Ex. MO.

689. Merrill initiated and arranged for the termination of the BFCE LIBOR Notes and the hedge swap between BFCE and Merrill. Tr. 1353-54, 660-61.

690. By Termination Agreement dated June 1, 1990, between BFCE and Unibank, the obligations of BFCE to make payments under the BFCE LIBOR Notes were terminated for consideration in the amount of $9,234,392. Stip. paragraph 203.

691. The hedge swaps between Merrill and BFCE (entered upon issuance of the BFCE LIBOR Note) and Merrill and Unibank (entered upon sale of the BFCE LIBOR Note) were simultaneously terminated. Exs. MS, MT, 213-IZ, 284-MN, UW through UY, VE, VY, WD, WE.

692. Merrill paid BFCE $36,973, termed a liability discount, to entice BFCE to terminate the hedge swap and the BFCE LIBOR Notes. Through the liability discount, BFCE effectively captured a portion of its 25 basis points under LIBOR funding that it was given through the swaps when it issued the LIBOR Notes. Tr. 1357; Exs. MS (p. 2), MT.

693. The hedge swap between Merrill and BFCE was terminated based on the valuation methodology used when the LIBOR Notes were created. Tr. 1358.

694. Merrill acted as valuation agent upon the termination of the BFCE LIBOR Notes between BFCE and Unibank, and marked to market the Unibank-Merrill swaps. Tr. 1681-85; Exs. WG, WD, WH.

695. There was no need to discuss the valuation of the BFCE LIBOR Notes with Unibank upon the termination of the BFCE LIBOR Notes between Unibank and BFCE and the simultaneous termination of the hedge swap between Unibank and Merrill because the amount owed to Unibank by BFCE upon termination of the BFCE LIBOR Notes was equal in amount to what Unibank owed to Merrill under the Unibank hedge swap. Tr. 1358-59. The amount Merrill owed to Unibank upon the termination of the Unibank hedge swap was set under the agreement, to be the then amortized notional, thus negotiations were unnecessary. Tr. 1358, 1681-82; Exs. WG, WD, MS, MT.

696. The cash flows on the BFCE-Merrill and Unibank-Merrill hedge swaps resulted in Merrill realizing $416,655.13:

12-1-89 to 3-1-90        Unibank pays Merrill          $593,087.50

XIV. THE LIBOR NOTES

697. Merrill suggested that the business purpose of the LIBOR Notes would be to hedge the interest rate sensitivity of the CP debt to be purchased by ACM. Tr. 370-71, 1257; Ex. 57-BE. Merrill's suggestion was set forth in a July 28, 1989 memorandum addressed to Pohlschroeder discussing the proposed steps of the ACM transactions. Ex. 57-BE.

698. On February 8, 1993, in response to being asked the question, whose idea was it to hedge the Partnership's assets with LIBOR Notes, Pohlschroeder informed the Service that at the first or second partnership meeting, ABN (Diviero [sic] and his advisors) brought up the concern that ABN wanted to be hedged. Pohlschroeder further stated to the IRS that he suggested a hedging range of 50 percent, based on CP's typical exposures, to which ABN agreed. Tr. 462; Ex. AYQ (p. 56).

699. In Pohlschroeder's October 3, 1989 memorandum to Heidtke, he stated that a hedge ratio was going to be negotiated with ABN. Tr. 461. Pohlschroeder further stated that a $60 million LIBOR note hedge was an accommodation to ABN. Ex. 86-CJ (p. 5).

700. At trial, Pohlschroeder testified that the idea of negotiating a hedging ratio with ABN was dropped. Tr. 461.

701. KNX never used or even considered using the LIBOR Notes to hedge the CP debt to be held by ACM. Den Baas never performed any calculations of the hedging effect of the LIBOR Notes against the CP debt. Tr. 1159.

A. THE EFFECTIVENESS OF THE LIBOR NOTES AS A HEDGE

702. Den Baas considered the LIBOR Notes a rough hedge against the CP debt due to the difference in the maturities of the instruments. Tr. 1160; PF 701.

703. ABN's action in hedging KNX's interest in the CP debt held by ACM was a financial indication that ABN believed the LIBOR Notes held by ACM were a poor hedge of the CP debt. Tr. 2085; Ex. AZF (p. 32).

704. Changes in the value of the LIBOR Notes were driven by short-term interest rates because the payments were based on the notional amount multiplied by the three month LIBOR rate. Tr. 2251; Exs. AZF (pp. 31-32), 198-HU through 205-IB (p. 7).

705. The LIBOR Notes would not act as an effective hedge because there is very little correlation between the short-term LIBOR rate and the longer-term U.S. interest rates (the average maturity of the CP debt held by ACM was about eight years) of the CP debt. Ex. AZF (p. 31) (Tucker); Tr. 2251-52.

706. The yield curve is a set of yields or interest rates for debt instruments of various maturities that prevails at a fixed point in time. Ex. AZF, p. 6.

707. The shorter-term rate of interest that causes value changes in the LIBOR notes and the longer-term rate of interest that causes value changes in CP debt can and often do exhibit different, independent behavior. The yield curve shifts, rotates and twists. Exs. AZF (p. 32) (Tucker), 521 (pp. 116-118) (Grundfest); Tr. 2245-48 (Tucker), 1833 (Singleton), 2045 (Beder), 2622 (Plotkin).

708. Tucker opined that for the five years preceding ACM's formation, the correlation among the 3 month LIBOR rate, the rate used to set the payments on the LIBOR Notes, and yields on 10 and 20 year U.S. Treasury bonds, rates affecting the value of the CP debt, were .68 and .59, respectively. The low correlations show that the LIBOR Notes were not an effective hedge. Exs. AZF (p. 32), 198-HU through 205-IB, 521 (p. 110); Tr. 2568-69, 2015 (yields on corporate bonds follow Treasuries).

709. Beder opined that there was an error in Tucker's correlation analysis but did not provide to the Court an exhibit analyzing that error. Tr. 3279, 3332-33.

710. Beder opined that Tucker should have used 5 year swap rates, as opposed to the 3 month LIBOR rate in analyzing the effectiveness of the LIBOR Notes as a hedge. She opined that when she correlated the 5 year swap rate to the 10 year Treasury, the correlation was .90, but she did not provide her correlation analysis to the Court. Beder's correlation analysis was based on rates in the three year period preceding ACM's formation. Tr. 3279-80, 3331-32.

711. Of the eight possible combinations of movements between short and long-term rates, the LIBOR Notes would move in the right direction to hedge the CP debt in only two of the combinations. In the six remaining combinations, the LIBOR Notes would not act as a hedge and in two combinations, there would be a negative hedge. Tr. 2987.

712. The Partnership could have more cheaply and accurately hedged the interest rate risk of holding CP debt by engaging in "plain vanilla" interest rate swaps in which it paid a fixed-rate of interest to the swap dealer in return for a floating-rate tied to LIBOR. Tr. 2468-71; Ex. AZF (p. 33) (Tucker).

713. It was possible in the market to create a more accurate hedge than the LIBOR Note against the CP debt. Tr. 1160 (den Baas).

714. The LIBOR Notes held by ACM were a very poor and inefficient hedge. Tr. 2622; Ex. AZF (pp. 31-32).

715. Economically, a LIBOR note is analogous to a notional principal contract or half of a leg of an interest rate swap. Tr. 2256, 771, 331, 3164.

716. The LIBOR Notes were not a natural hedge to the CP debt. It is not natural to hedge long-term debt with short-term derivatives. Tr. 2256.

717. CP paid more than 17% in transaction costs just to originate the notes ($1,093,750 divided $35 million multiplied by .1703). Given the costs borne by CP and SH to originate and sell the LIBOR Notes, the LIBOR Notes were a very expensive hedge. Tr. 2622-23; PF 567, 593, 594, 683, 832, 888.

718. Based on KNX's hedging outside of ACM and ACM's lack of obligations requiring a certain cash income stream, the Partnership did not need a hedge at all. Tr. 2623-25, 2721, 2729-31, 2733 (Plotkin).

B. MERRILL'S HEDGING ANALYSES

719. Taylor, Heidtke, Pohlschroeder and Belasco testified that the business purpose for the LIBOR Notes held by ACM was to act as a hedge of the CP debt. Tr. 527, 140, 329, 943.

720. Taylor and Pepe analyzed the effect of the LIBOR Notes as a hedge of the CP debt prior to CP entering into ACM. Tr. 692, 1248-49, 1276; Exs. 72-BV, 74-BX.

721. Merrill's analyses of the effectiveness of the LIBOR Notes as a hedge assume a flat term structure, that is that yields on all instruments are identical or there is only one interest rate in the economy. It also assumes that the yield curve makes only parallel shifts, implying perfect correlation among all rates of interest, whatever the term. Exs. AZY (p. 32) (Tucker), 72-BV ("Note"), 74-BX ("Note (c)"); Tr. 2453.

722. There is not only one interest rate in the economy and the yield curve shifts in non-parallel fashion. Ex. AZY (p. 32) (Tucker); Tr. 2045 (Beder), 2245-48, 2453-54 (Tucker); PF 721.

723. In analyzing the effectiveness of the LIBOR Note as a hedge, Beder also assumed parallel shifts in the yield curve by her method of measuring duration. Tr. 2246, Ex. 519 (Tables, p. 20).

724. There are many more duration measures that are richer or more appropriate than that which Beder used. Tr. 2586-90.

725. There are a number of term structure models that accommodate different yield curve properties or shapes and that could have been used by Merrill or Beder to analyze the effectiveness of the LIBOR Notes as a hedge. Tr. 2586-89.

726. In her analysis of the effectiveness of the LIBOR Note Ex. 519 (Tables, p. 20); Tr. 2454; Entire Record.

727. Pohlschroeder used Merrill's analyses in discussing the LIBOR Note as a hedge in his October 3rd memorandum to Heidtke. Tr. 458-60; 1276; Exs. 86-CJ (pp. 4, 6-8), 72-BV, 74-BX (0000910-11).

728. Heidtke did not independently verify the hedging analysis in Pohlschroeder's October 3, 1989 memorandum. Tr. 164-65.

729. Merrill provided CP with analyses, prepared by Pepe, of the effectiveness of the hedge of the LIBOR Notes subsequent to entering into the Partnership. Tr. 1252; Exs. 468-AXR through 486-AYJ.

730. Merrill included the impact of the LIBOR Notes as a hedge to KNX in its post November analyses, even though Taylor and Pepe knew that ABN was hedging the LIBOR Note. Tr. 1408, 1427-28; Exs. 468-AXR through 486-AYJ.

731. Pepe did not know when the swaps (the Big and Small Swaps) between ABN and Merrill relating to the LIBOR Notes held by ACM were proposed. Tr. 1408.

732. Prior to the formation of ACM, Taylor told Yordan that ABN agreed to take the Yield Component allocation of CP because ABN intended to enter into hedge transactions to neutralize the interest rate risk of the CP debt. Tr. 3090.

733. It was Taylor's experience that, in complicated transactions, investors hedge their risks. Tr. 3164-67.

734. Taylor considered den Baas a sophisticated investor, knowledgeable of swaps. Tr. 3167-68.

735. When Taylor arranged the ACM Partnership, Taylor believed ABN would hedge its risks outside the Partnership. Tr. 3175, 3179.

736. Prior to the formation of ACM, Taylor arranged a swap for ABN as an issuer of a LIBOR note, hedging for ABN the payment streams on the LIBOR note it issued by converting ABN's obligation to a synthetic liability. Tr. 1142, 3183.

XV. KANNEX SWAPS

A. IN GENERAL

737. With the assistance of den Baas and his ABN New York Financial Engineering Group, KNX entered into "plain vanilla" interest rate swaps with ABN Cayman Islands based on the terms of the CP debt acquired by ACM. Through these swaps, KNX hedged its interest rate risk, as closely as could be achieved, with respect to its percentage interest in the CP debt held by ACM. Exs. 362-RH, SG, AZF (pp. 37-41, App. E (first page of which is entitled "MET NOTE SWAPS -- TERMINATION DATE 9/30/93), Exs. SQ through SV (Met Note), TB through TI (Long Bonds), TP through TX (Euro Notes), TZ through UD (CP 8.72% Note), UJ through UL (CP 8.06% Note); Stip. paragraphs 257, 259, 262, 264, 266; Tr. 1096-97, 1144-45, 1146-47, 1160, 1166, 1169.

738. Through the KNX interest rate swaps relating to the CP debt, KNX engaged in off-balance-sheet swaps to convert the CP fixed- rate debt into a LIBOR-tied series of floating cash inflows. KNX virtually eliminated its exposure to rising long-term interest rates or, equivalently, declining CP debt values. Reciprocally, KNX virtually eliminated its exposure to the possibility of declining long-term interest rates or, equivalently, rising CP debt values. Ex. AZF (pp. 38-39).

739. Den Baas advised de Beer to hedge the CP debt and executed many of the ABN-KNX swaps, particularly the initial positions. Ex. 362-RH; Tr. 1124, 1144-45, 1169.

740. Den Baas received a request list from Amsterdam, regarding how Amsterdam wanted the ACM transaction handled, which requested that KNX hedge out the implicit interest rate risk from the ACM Partnership. Tr. 1164-65.

741. Den Baas always understood that KNX's interest rate risk from ACM had to be hedged. Tr. 1165.

742. With one inapplicable exception, ABN would not enter into transactions subjecting itself to interest rate risk. Tr. 1165-66.

743. With respect to each piece of CP debt acquired by ACM, KNX entered into a swap with ABN wherein it received LIBOR on a notional amount equal to its percentage interest in the Yield Component of CP debt, in exchange for making a fixed payment on the same notional amount. The termination dates of the CP debt swaps generally corresponded to the maturities of the specific CP debt being hedged and KNX's payments under the swaps generally corresponded to the coupon payment dates on the CP debt. Tr. 1171; Exs. SG, AFZ (pp. 37- 41, App. E), SQ through SV (Met Note swaps terminating 9/30/93, fixed payment dates of 3/1 and 9/1 until 7-9-91), PF 481 (Met Note 4.3 yr. avg. maturity, coupon dates of 3/1 and 9/1); Exs. TB through TI (Long Bond swaps terminating 7/15/2017, fixed payment dates of 1/15 and 7/15), PF 494 (Long Bonds matured 7/15/2017, coupon dates of 1/15 and 7/15); Exs. TP through TX (Euro Note swaps terminating 12/8/91, fixed payment dates of 6/8 and 12/8), PF 497 (Euro Notes matured 3/21/96, coupon date of 3-21); Exs. TZ through UD (CP 8.72% Note swaps terminating 6/13/93, fixed payment dates of 6/13 and 12/13) PF 613 (CP 8.72% Note maturing 6/13/93, coupon dates of 3/31 and 9/31); Exs. UJ through UL (CP 8.06% Note swaps terminating 3/1/94, fixed payment dates of 3/1, 9/1) PF 615 (CP 8.06 Note maturing 3/1/94, coupon dates of 3/1, 9/1). Stip. paragraphs 257, 259, 262, 264, 266. A summary of KNX's swaps with respect to the CP debt held by ACM follows:

             MET NOTE SWAPS -- TERMINATION DATE 9/30/93

/**/ Swaps terminated 12/2/91.

/***/ 48.885 (Partner 3) X 89.7% (Partners 3, 4, 5).

                     Notional

/**/ 48.885 (Partner 3) x 89.7% (Partners 3, 4, 5).

/**/ 48.885 (Partner 3) x 89.7% (Partners 3, 4, 5).

/**/ 1 Million acquired 12/4/89. 4 Million acquired 12/6/89.

/***/ 48.885 (Partner 3) x 89.7% (Partners 3, 4, 5).

                      Notional

/**/ ACM exchanged 4.85 million of Long Bonds for $5 million 8.06% Note due 3/1/94.

/***/ 48.885 (Partner 3) x 89.7% (Partners 3, 4, 5).

/****/ Final two swaps terminated 12/2/91.

/*****/ Amended 2/15/91 to change floating rate payment dates.

745. KNX similarly adjusted its swap positions when the Partnership altered its CP debt holdings (such as when the Long Bonds were exchanged for other CP debt) or when KNX's interest in ACM changed (such as when a portion of KNX's position was purchased by CP and SH or redeemed). Tr. 1171; PF 743.

B. KANNEX'S RETURN

746. The swaps in which KNX engaged brought KNX to a LIBOR level. Tr. 1175.

747. The LIBOR based cash flows KNX received under the swaps were correlated with KNX's LIBOR based loan from ABN. Tr. 2571-72.

748. The basis of KNX's return from the ACM Partnership was interbank swap rates. Tr. 1174.

749. With respect to KNX's interest in the change in value of the CP debt attributable to interest rate changes (the Yield Component allocation under the ACM Partnership Agreement), den Baas testified that KNX would earn the difference between KNX's percentage interest in the yield on the CP debt held by ACM and the fixed interbank swap rate it paid under KNX's CP debt swaps (in exchange for the LIBOR rate it received on the same notional amount). Tr. 1174-77.

750. In the swap market, traders are indifferent to receiving a floating or fixed-rate, thus permitting the exchange of a fixed-rate for an equivalent floating-rate on the same notional amount. Tr. 1176, 2526.

751. The fixed interbank swap rate on KNX's CP debt swaps was comprised of a Treasury yield, equivalent to the floating LIBOR based rate it received, plus a swap spread representing the spread charged by financial institutions for doing a swap. Tr. 1175-76.

752. To determine the fixed interbank swap rate on a particular KNX swap, den Baas chose a Treasury corresponding as closely as possible to the maturity of the swap and added the offer side of the swap spread. Tr. 1175-76.

753. To value and revalue the CP debt of ACM, for purposes of the Revaluation Worksheets, a Treasury index was selected by attempting to match the average life of the Treasury bond to the average life of the CP note. Tr. 1294.

754. The amount of allocable Yield Component under the ACM Partnership Agreement was attributable purely to changes in Treasury spreads. Tr. 1282, 2525.

755. Where ABN had immediate economic consequences from an ACM revaluation, such as at the purchase or redemption of KNX's interest, Pepe would discuss the index with den Baas or with someone who worked for den Baas. Pepe also discussed the index with ABN at the time ABN put on certain swaps. Tr. 1294-95; Ex. 443-AWJ (p. 2) ("Since KNX must actually trade Treasuries based upon the Base Treasury yields, KNX would determine yields on Base Treasuries for each Note. These yields, along with previously determined spreads, are used by ML to set prices of each Note."); compare Exs. AWB (2d unnum. p., bottom), 151-FJ (p. 1 of 4, line 1 (Original Yield of Treasury Index or Most Recent Mark), TG (p. 2, Party A Fixed Rate).

756. Den Baas denied ever discussing the selection of Treasuries with Merrill. Tr. 1178.

757. The KNX swaps were entered into with ABN because ABN, unlike an unrelated counterparty, was willing to accept the credit risk of KNX. Since ABN had entered into a Revolving Credit Agreement with KNX based on LIBOR, insulating KNX from the interest rate risk embedded in ACM Partnership was in ABN's interest. Tr. 1098-99; Ex. 115-DM.

758. From New York, ABN then hedged the positions it entered into with KNX with respect to the CP debt with third parties. Tr. 1096-97, 1166-67.

XVI. MERRILL-ABN-KANNEX LIBOR NOTE SWAPS

A. BIG SWAP

759. By swap confirmations effective October 27, 1989, ABN New York entered into a hedge swap with Merrill and a mirror swap with KNX, with respect to KNX's percentage interest in the LIBOR Notes held by the Partnership (generally "LIBOR Note Swaps" or "Big Swaps"). In exchange for making payments based on KNX's percentage interest in payments owed to ACM on the LIBOR Notes, ABN received fixed payments based on an amortizing notional amount plus LIBOR -- 25 basis points on the ratably amortizing notional amount. The Big Swaps converted the volatile LIBOR Note to a synthetic, amortizing asset. Tr. 635-36, 1098-1100, 1200, 1328 ("Big Swap"); Exs. SA through SE, SH through SK.

760. Through the Big Swaps, den Baas attempted to insulate KNX as much as possible from the interest rate risk of the ACM LIBOR Notes. Tr. 1096-97.

761. The Big Swaps between KNX and ABN and ABN and Merrill were based on Merrill's $34,410,813 LIBOR Note valuation of November 27, 1989. The original notional amount upon which ABN and KNX were receiving payments under the swaps ($28,433,655.20) was KNX's original percentage interest in the partnership (82.63 percent) multiplied by $34,410,813.50. Exs. 382-XL (ACM 01275), SA, SH, 142-FA (p. 3); Stip. paragraph 93; Tr. 635-36. The notional amount upon which KNX and ABN were making payments under the swaps was KNX's original percentage interest in ACM (82.63 percent) multiplied by the total notional amount of the LIBOR Notes ($97,760,000). Exs. 198-HU through 205-IB, 382-XL, 144-FC (p. 4); Stip. paragraph 93.

762. Each time KNX's interest in the LIBOR Notes held by ACM changed, e.g., on December 13, 1989 when the LIBOR Notes were distributed to SH and on June 27, 1991, when KNX was partially bought out, both sides of the Big Swaps would be reduced proportionately based on the reduction in KNX's percentage interest in the ACM LIBOR Notes. Tr. 784-85; Exs. SA through AE, SH through SK. Thus, on June 27, 1991, when KNX held a 43.03 percent interest in ACM, it was obligated to pay to ABN and ABN was obligated to pay to Merrill a stream of payments on a notional amount of $30,056,000, mirroring 43.03 percent of the payments made on the LIBOR Notes held by ACM, which had a total notional of $69,850,000 (43.03 x $69,850,00 = $30,056,455). Exs. 153-FL (pp. 4-5), SD, SJ.

763. The revised notional under the December 13, 1989 revision to the KNX-ABN-Merrill Big Swaps matches a draft revaluation of ACM Partnership, prepared in early December of 1989, reflecting that on December 13, 1989, KNX held a 87.06 percent interest in the LIBOR Notes held by ACM (60,811,000/69,850,000 (notional on BOT LIBOR Notes) = .87059). Exs. YP (ACM01178), SC, SI; Tr. 485-86; see also Ex. AZH (Ex. D-2); Tr. 2863.

764. For settlement November 29, 1991, simultaneously with the redemption of KNX from ACM, the Big Swaps between Merrill and ABN and ABN and KNX were terminated. There was a $500,000 difference between the termination fee Merrill paid ABN and the termination fee ABN paid KNX. Exs. SE, SK, AZF (pp. 43, 47); Stip. paragraph 231.

765. Upon termination of the Big Swap between ABN and Merrill, the respective sides of the swap were marked to market and a termination payment was determined based on the difference between the marked to market values of the two positions. The methodology used in valuing the respective sides of the swap was consistent with the valuation used in creating the LIBOR Notes and valuing them for purposes of the Partnership Revaluations, without regard to the 5/8 of one percent origination, which was reflected in the Small Swap. Tr. 1329-30, 3162-63.

766. The value of the LIBOR Notes within ACM upon termination of the Big Swap between Merrill and ABN should be reasonably close to the marked to market value used to determine termination payments on the Merrill-ABN Big Swap. Tr. 3162-63.

B. SMALL SWAP

767. Effective October 27, 1989, Merrill entered into a "Small Swap" with ABN and ABN entered into a mirror swap with KNX by which Merrill paid to ABN and ABN to KNX LIBOR less 25 basis points on KNX's percentage interest in the origination cost. KNX made no payments to ABN and ABN made no payments to Merrill on these Small Swaps. The original Small Swap payments were made on a notional amount of $903,765, equal to KNX's initial interest in the partnership (82.63 percent) multiplied by the origination costs ($1,093,750). Tr. 1329-30, 1328 ("Small Swap"); Exs. RY, SL; PF 567; Stip. paragraph 93.

768. Taylor testified that the Small Swap resulted because he made a mistake, at the expense of Merrill, in the original swap confirmation proposed to ABN in connection with the ABN-Merrill swaps related to the ACM LIBOR Notes and that the term of the ABN-Merrill Small Swap was one year. Tr. 633-36, 3162; Exs. RY, RZ.

769. Taylor claimed that his recollection of the reason for the Small Swap had been refreshed since his pre-trial deposition based on reviewing the swap documents and discussing the matter with Pepe. Tr. 788-91.

770. Pepe did not recall the negotiations for the ABN-Merrill Small Swap. Tr. 1427.

771. Pepe did not discuss the Small Swap with Taylor within the three to four months period prior to the ACM trial. Tr. 1427-28.

772. Den Baas testified that he recalled no discussions with Merrill regarding the reason for the Small Swap. Tr. 1133-34, 1218 (ln. 21-25), 1221, 1106-07. He testified that any testimony he gave of his understanding of the matter (see Tr. 1106-07 ("its become my understanding") came from Mark Kuller. Tr. 1220-21.

773. Mark Kuller is counsel for Merrill and assisted Petitioner in preparing witnesses in this case. Tr. 1220-21, 868, 3061.

774. Merrill requested that the swaps between ABN and Merrill related to the ACM LIBOR Notes be split into two documents, which resulted in the Small and Big Swaps. Tr. 1104.

775. In den Baas' view, the likelihood was very large that the Big and Small Swaps between ABN and Merrill mirrored the Big and Small Swaps between KNX and ABN. Tr. 1204-05, 1209-1210; Exs. SL through SP.

776. In response to the question, do you know for a fact whether the Small Swap (between Merrill and ABN) was extended, Pepe stated that he found no evidence in Merrill's files that the Small Swap was extended. Tr. 1426; Ex. RY.

777. Merrill did not search their payment records to determine whether payments were made under the ABN-Merrill Small Swap subsequent to December 1, 1990. Tr. 1426-27; Ex. RY.

778. The Small Swaps were revised on December 13, 1989 to reflect KNX's changed percentage interest in the LIBOR Notes held by ACM. The amendment reduced the notional amount of the swaps to $680,156, which amount was equal to KNX's 87.06 percent interest in ACM reflected on the draft revaluation for December 13, 1989, multiplied by the $781,250 origination cost associated with the BOT LIBOR notes. Exs. SC, SM; Tr. 1098, 1377, 784-85; PF 594.

779. The Small Swap between ABN and KNX was revised on June 27, 1991 to reflect KNX's changed percentage interest in the LIBOR Notes held by ACM. The amendment reduced the notional amount of the swap to $336,172, which amount was equal to KNX's 43.03 percent interest in ACM reflected on the Revaluation Worksheets, multiplied by the $781,250 origination cost associated with the BOT LIBOR Notes. Exs. SO, 153-FL; PF 594.

780. The economic effect of the Small Swap, was that ABN or KNX carefully earned a return on the origination costs incurred upon the sale of the Citicorp Notes. Tr. 635-36, 1107, 2986; Ex. AZH (pp. 58- 59 and App. D).

781. If there were no Small Swap, then ABN's return from the Big Swap would be understated by the amount of the discount on the sale of the Citicorp Notes. Tr. 635-36.

782. No counterparty, other than Merrill, would have been willing to enter into swaps with ABN (the Big and Small Swaps) with respect to the ACM LIBOR Notes for the price Merrill did. Tr. 1120, 1210.

XVII. THE CIRCLE OF PAYMENTS

783. Merrill used the ABN-Merrill Big Swap to hedge a portion of the hedge swaps it entered into with BFCE and BOT. Tr. 626-27.

784. The economic effect of the hedge swaps between Merrill and BOT and BFCE (the banks issuing the LIBOR Notes) and the Big Swaps between KNX, ABN, and Merrill was, with respect to KNX's economic interest in the ACM LIBOR Note payments, a circle of payments from Merrill to the issuing banks to ACM to KNX to ABN and back to Merrill. Ex. AZH (p. 31 and App. D); Tr. 2817.

785. Upon the distribution of the BFCE LIBOR Note to Unibank, economically, the payments on the LIBOR Notes went from Merrill to BFCE, under the BFCE hedge swap, to Unibank, under the LIBOR Notes, and then back to Merrill under the swap between Merrill and Unibank. Ex. AZH (App. D-3).

786. Although the swap payments Merrill made and received were net payments, the effect of netting did not change the economic analysis or effect of the hedge swaps. Tr. 2578-79, 2814-15, 2973-74.

787. Merrill hedged its remaining interest rate exposure on the hedge swaps with BFCE and BOT with futures and Treasuries. Merrill's swap book was run as a balanced book; speculation on interest rates was prohibited. Tr. 639.

XVIII. STRUCTURED TRANSACTIONS

788. A structured transaction is a unique financial product that combines two or more financial instruments or derivatives. Ex. AZF (p. 2) (Tucker).

789. A structured transaction is often engineered by embedding a swap or option feature into a standard security, often a fixed-rate or floating-rate bond. Ex. AZF (p. 2) (Tucker).

790. The Citicorp Notes were a structured transaction. Ex. AZF (p. 9) (Tucker).

791. Structured transactions also include two or more separate financial instruments and/or derivatives, providing multiple cash flows to the participant. Ex. AZF (p. 9) (Tucker).

792. Structured transactions are based on expected cash flows. Ex. 519 (p. 14) (Beder).

793. In the instant case, ACM, KNX, SH, CP, ABN, BFCE, BOT, Citicorp and Unibank were all participants in structured transactions designed by Merrill. Ex. 519 (pp. 14-15) (Beder); Entire Record.

794. Whereas once there was a time when the products and vehicles available dictated the strategies in which an entity could engage, by 1989 the strategies dictated the design of the products and vehicles. Ex. AZF (p. 5); Tr. 2241-42; Entire Record.

A. PETITIONER'S EXPERTS FAILED TO CONSIDER THE KANNEX SWAPS

795. Analyzing the swaps KNX put on provides insight into KNX's expectations and perceptions in entering into the Partnership. Tr. 2571 (Tucker).

796. Beder looked at KNX as though it were playing a role in a structured transaction. She considered the ACM Partnership a structured transaction. Tr. 1996.

797. In analyzing a structured transaction, Beder would analyze all of the cash flows that a participant received and made. Tr. 1996.

798. Beder did not evaluate KNX's swaps and became aware of their existence from Tucker's report. Tr. 1995.

799. Beder's conclusion that KNX's return is sensitive to both CP's credit spreads and interest rates is erroneous when the swaps that KNX engaged in are taken into account. Tr. 2248-29; Ex. 519 (p. 21).

800. At the time Beder testified, her firm was providing consulting services to Merrill. Tr. 1984.

801. Beder included charts reflecting ABN-Merrill swaps that she did not prepare or analyze in her report. Tr. 1999-2001; Ex. 519 (Ex. A, p. 7).

802. Singleton did not evaluate the KNX swaps for the Court. Ex. 517.

803. Singleton's opinion that the exposures of the partners to interest rate and credit risk associated with the holding of CP debt and the internal hedging characteristics of the LIBOR Note were unaffected by the other swaps is, in Tucker's opinion, wrong because the KNX swaps affect KNX's return. Tr. 2248-50, 2257-58; Ex. 517 (pp. 49-51).

B. KANNEX'S RISKS

804. KNX entered into ACM and then, through swaps, reverse engineered itself out of ACM, thereby virtually eliminating all of its risks, except default risk. Tr. 2481-82.

805. KNX bore some credit risk with respect to the BFCE and BOT LIBOR Notes, however, because BFCE and BOT had tremendous credit quality, the probability of their default was nominal or insignificant and KNX's risk was not unlike the risk a creditor bears. Tr. 2489-90, 2517, 2868.

806. KNX bore the risk that CP would default, which is a risk of credit quality, a risk a lender making a loan would bear. Tr. 2511, 2514, 2859.

807. In Tucker's opinion, the risks KNX faced were equivalent to the risks a lender faces. Tr. 2482, 2489.

808. In Plotkin's opinion, the risks and rewards borne by KNX were consistent with the risks and rewards of being a lender. Exs. AZH, AZI; Tr. 2762, 2906.

809. KNX experienced some basis risk as a result of its swaps with ABN relating to the CP debt. The basis risk results because the spread (the "TED spread") between Treasury rates, used in determining the fixed-rate on one side of the swap, and LIBOR based rates on the other leg of the swap, varied over time. In addition, the swap spreads charged to KNX upon the initiation of a swap varied over time. Tr. 2468, 2523-27, 3299-3301; PF 751, 752.

810. Beder's estimate that KNX experienced $3 million of basis risk during its period in ACM was based on how swap spreads changed between 1989 and 1991 with respect to a 10 year Treasury and was made without analyzing the KNX swaps. Tr. 3300, 3314-15.

XIX. THE HEDGE TO COLGATE OUTSIDE ACM

811. The LIBOR Notes held by ACM indirectly offset a portion of CP's $300 million notional amount of interest rate swaps, put on in July of 1989 to meet CP's liability management goals. Under the swaps, CP paid a floating-rate in exchange for a fixed-rate, thereby effectively converting 30 percent of CP's long-term debt from fixed- rate to floating-rate interest. Tr. 440, 442-44; Exs. 55-BC, 404, AZD (p. 18).

812. SH's percentage interest in the floating-rate payments on the LIBOR Notes were indirectly offset by floating-rate payments made by CP on interest rate swaps outside the Partnership. Tr. 430, 437, 2580; Stip. paragraph 31; Exs. 404, 55-BC, 56-BD, 423-ABH (ACM01644-A ("Hedge for existing swap where we paying LIBOR on 300MM swap This LIBOR Note offsets 160MM", the then estimated notional on the LIBOR Notes (Ex. 65-BM)).

813. At trial, Pohlschroeder did not recall whether he discussed the offset with Taylor. Tr. 437.

814. In analyzing what the effect of ACM on CP's liability management goals would be, particularly its ratio of fixed to floating-rate debt, it would be prudent to consider the offset. In analyzing the effect, the offset should have been taken into account. Tr. 2580-81, 2602.

XX. ACM DEBT TRANSACTIONS

A. THE MET NOTE

815. By agreement between CP and ACM dated as of January 3, 1990, CP agreed to issue a new note dated as of September 1, 1989, (the "1989 Note") in exchange for the Met Note, with substantially the same terms as the original Met Note. Stip. paragraph 170; Exs. 23-W, 233-KD.

816. By agreement dated July 26, 1990, the Partnership permitted CP to defer for one year $25 million in principal payments on the Met Note that otherwise would have been due on March 1, 1991 and March 1, 1993. CP paid ACM nothing for this accommodation. Stip. paragraph 171; Exs. 167-FG, 233-KE through 235-KF, AZH (pp. 34-35) (Plotkin), 509 (Chart K), 319-PM (Notes to Financial Statements, "Notes Receivable").

B. EURO NOTES

817. On June 1, 1990, ACM purchased $5 million principal amount of CP's Euro Notes for $5,062,500 plus accrued interest of $92,361.10. Stip. paragraph 174.

818. On September 11, 1990, ACM purchased $1.75 million principal amount of Euro Notes for $1,859,131.94 (including accrued interest). Stip. paragraph 175.

819. On October 23, 1990, ACM purchased $2 million principal amount of Euro Notes for $2,047,500 plus accrued interest of $111,888.89. Stip. paragraph 176.

C. LONG BONDS

820. On September 6, 1990, ACM purchased $4 million principal amount of Long Bonds from Merrill Lynch, Pierce, Fenner & Smith for $3,810,080 plus accrued interest of $54,541.67. Stip. paragraph 179.

821. On September 12, 1990, ACM purchased $6 million principal amount of Long Bonds from Merrill Lynch, Pierce, Fenner & Smith for $5,760,852.54 plus accrued interest of $91,437.50. Stip. paragraph 180.

822. There were no transactions whereby CP exchanged fixed-rate obligations for floating-rate obligations through the use of ACM. Stip. paragraph 347.

823. ACM's holdings of CP debt as of March 1991 is summarized as follows:

               ______________________________________

XXI. SALE OF KANNEX'S PARTNERSHIP INTEREST

824. By Partnership Interest Purchase Agreement between KNX and CP dated as of June 25, 1991, CP agreed to purchase from KNX a 38.31 percent partnership interest in ACM for $85,897,203.60, the amount shown on the Revaluation Worksheet for June 27, 1991. Stip. paragraph 213; Ex. 153-FL.

825. CP funded its purchase of an interest in ACM with funds received from the issuance of commercial paper and the commercial paper was repaid with funds from the equity offering of CP stock on November 26, 1991. Stip. paragraph 650.

826. CP realized $445.5 million from the sale of 11.5 million common shares of stock in 1991. Ex. 14-N (p. 20); Tr. 149.

827. By Partnership Interest Purchase Agreement between SH and KNX dated as of June 25, 1991, SH agreed to purchase from KNX a 6.69 percent partnership interest in ACM for $15 million, the amount shown on the Revaluation Worksheet for June 27, 1991. Stip. paragraph 214; Ex. 153-FL.

828. SH funded its purchase with $10,205,416.67 of funds received from CP as a repayment of a loan SH made to CP on January 27, 1991 which was repaid with accrued interest on June 27, 1991 and $4,794,583.33 as a capital contribution from CP. Stip. paragraphs 211, 650.

829. Upon the sale of KNX's interests to SH and CP, the BOT LIBOR Notes were valued based on the then current interest rate environment. Tr. 1323-1325, 1328, 1290-91; Ex. AWC (unnum. pp. 9-11).

830. Upon the sale of a portion of KNX's interest to SH and CP, Pepe valued the BOT LIBOR Notes based on the then current interest rate environment, added to that value the $781,250 origination attributable to the BOT LIBOR Notes and then compared the result to the then book value of the BOT LIBOR Notes. The difference, $590,497, was added to the value of the LIBOR Notes for purposes of the June 27, 1991 Revaluation Worksheet. Tr. 1290-91, 1323-25; Ex. 153-FL (p. 5 of 5), AWC (unnum. pp. 9-11); PF 594.

831. The valuation of the BOT LIBOR Notes based on changes in interest rates upon the sale of KNX's interest violated the Partnership's Accounting Policies which provided for valuations upon changes in interest rates only upon distribution of the LIBOR Notes, redemption of a partner or liquidation of the Partnership. Ex. 162-FU (paragraph VII. A).

832. As a result of valuing the BOT LIBOR Notes based on changes in interest rates upon the sale of KNX's interests, the value of KNX's percentage interest in ACM and thus the price CP and SH paid for KNX's interest was increased by KNX's percentage interest in the $781,250 origination attributable to the BOT LIBOR Notes. PF 824, 827, 830.

833. At the time of the June 1991 sale of a portion of KNX's partnership interest to CP and SH, the redemption of KNX was contemplated. Tr. 1046-48; Stip. paragraphs 314, 315.

834. CP's and SH's purchases of a portion of KNX's interest caused the Partnership interests of SH and CP to be consolidated by CP for financial purposes. Tr. 148.

835. Subsequent to the purchase of a portion of KNX's interest in ACM by CP and SH in June, 1991, KNX was not within the Quality Component sharing band for any of the CP debt held by ACM. Exs. 153- FL through 156-FO.

836. On June 19, 1991, Pohlschroeder wrote a memorandum to Heidtke, recommending that CP purchase a sufficient share of KNX's interest to give CP a majority interest in the Partnership. The reasons stated by Pohlschroeder were that ACM had successfully altered the maturity structure of CP's debt and obtained effective control of CP debt when credit spreads over treasuries were widest due to event risk and general disfavor of corporate bonds. By June of 1991, credit spreads on CP debt had narrowed to historically low rates. Pohlschroeder does not mention any tax reasons for the purchase. Ex. 494.

837. Discussion with KNX regarding the purchase of a portion of its ACM interests had been held at a previous Partnership Meeting, in February of 1991. Exs. 494, 169-GB; Tr. 401.

838. CP's purchase of KNX's interest was tax-motivated. Tr. 148- 49 (Heidtke).

839. Subsequent to November 30, 1989 and until February of 1991, SH's cumulative profit and loss from ACM, without taking into account Merrill's arrangement fees and attorney and accountants fees, was negative. Ex. 517 (Exs. 16, 17).

XXII. REDEMPTION OF KANNEX'S PARTNERSHIP INTEREST

A. PUT OF THE CITICORP NOTES

840. On August 29, 1991, ACM exercised the options to elect repayment of the remaining Citicorp Notes (Numbered C9, C10 and C11) held by ACM. Stip. paragraph 222.

841. By agreement dated November 18, 1991, Citibank agreed to loan ACM up to $45 million, secured by the CP debt of ACM and nonrecourse to ACM and its partners. Stip. paragraph 228.

B. PARTNERSHIP INTEREST REDEMPTION AGREEMENT

842. By Partnership Interest Redemption Agreement between ACM and KNX dated as of November 27, 1991, ACM agreed to redeem KNX's remaining 43.13 percent partnership interest in ACM for $100,775,915, the amount shown on the Revaluation Worksheet for November 29, 1991. Stip. paragraph 231; Ex. 155-FN.

C. THE RESULTS OF THE PARTNERSHIP

1. THE YIELD COMPONENT

843. CP opted to adjust the Yield Component five times during the life of the Partnership:

           Notice Date         Adjusted To

844. CP elected to adjust the Yield Component upon the agreement to purchase the Met Note in November, 1989; upon the distribution of the BFCE LIBOR Note in December 1989; immediately after the start of the war in the Middle East in August of 1990; in February of 1991; and upon the partial purchase of KNX's interest in June of 1991. Stip. paragraph 102; Exs. 461-AXK, 488-AYL; Tr. 142.

845. Heidtke considered five adjustments to the Yield Component relatively often for CP to take positions on interest rates. Tr. 142.

846. SH's option to adjust the Yield Component resulted in the allocation of $4,102,454 of the total $5,744,233 Yield Component changes to KNX. Ex. AZH modified by Ex. 151-FJ (p. 4); Tr. 2840-41.

847. SH's decisions to adjust the Yield Component were, in hindsight, economically disadvantageous. Ex. 517 (pp. 46-47); PF 846.

2. THE QUALITY COMPONENT

848. During KNX's participation in ACM, Quality Component changes totalled $1,541,712, of which a negative $281 went to KNX. Exs. 142-FA through 156-FO, AZI (p. 48).

849. During KNX's participation in ACM, there were ten revaluations in which Quality Component allocations were made. KNX was allocated a portion of the Quality Component in three of those revaluations. The amount of KNX's allocation in those three revaluations was as follows: (1) ($15,739) on November 30, 1990 (total allocation was ($621,921)); (2) $15,253.00 on May 31, 1991 (total allocation was $512,025); (3) $205 on August 30, 1991 (total allocation was $176,727). Exs. 149-FH, 152-FK, 154-FM; PF 848.

850. Because KNX barely shared in the Quality Component, the yearly Special Income Allocation to KNX (in total $2,304,424) was, according to den Baas "a windfall." Tr. 1173; Exs. 142-FA through 155-FN; PF 848.

851. During KNX's time in the Partnership, the Revaluation Worksheets reflect that the value of the LIBOR Notes fell $2,197,397. Within the Partnership, KNX was allocated $701,713 of that loss. Ex. AZH (p. 49).

3. COLGATE'S RETURN FROM THE PARTNERSHIP

852. As of November 29, 1989, CP's pre-tax return from ACM was 2.5 percent. Tr. 2606-07; Ex. AZH (p. 47) as modified by Ex. AZI.

853. From October of 1989 to November of 1991 short term interest rates decreased. The yield on a three month Treasury bill moved from 8.17 percent to 4.5 percent. The yield on a ten year Treasury Bond fell from 8.3 percent to 7.69 percent. Most of the decrease in rates occurred in 1991. Ex. AZF ("Analytical Record of Yields and Yield Spreads", Table I, p. 14).

XXIII. THE REVOLVING CREDIT AGREEMENT

854. Shortly after KNX was redeemed on November 29, 1991, the remaining outstanding balance of the ABN loan to KNX was repaid. Exs. 124-EF, 125-EH, DZ (AB200004).

855. The credit facility provided by ABN allowed KNX to borrow or capitalize the interest it owed on the short-term loan(s) made by ABN to KNX. As a result, the principal amount owed by KNX to ABN could be increased at the end of each short-term loan by the amount of interest owed on that loan. Exs. 115-DM (p. 3, section 2.1), DZ (AB100015, AB100121 and AB100124, AB100166 and AB100118, AB100008 and AB100010 and AB100119), 122-ED (500174-75).

856. KNX continuously readjusted its outstanding loan balances. Ex. DZ.

857. On September 14, 1990, ABN informed KNX that the credit facility had been increased by $20,000,000 to a total of $200,000,000. Ex. DZ (AB100155).

858. KNX's balance sheet for the period ended May 31, 1991, indicated that KNX owned a "participation" in ACM valued at $196,988,302 and that KNX had outstanding loans of $190,294,602.72. Ex. 124-EF.

859. KNX's balance sheet for the period ended November 30, 1991, indicates that KNX no longer owned a "participation" in ACM and that KNX had repaid its outstanding loans. Ex. 125-EG.

XXIV. KANNEX'S LIQUIDATION

860. In mid July and early August of 1991, KNX consolidated its swap positions with respect to each type of CP debt held by ACM. For each type of CP debt, all of the outstanding swaps relating to that debt were netted and consolidated into one swap. Under the resulting swaps, KNX was paying a fixed-rate that was higher than the LIBOR rate they received on the notional amount equal to KNX's percentage interest in Yield Component of the CP debt. Ex. AZF (App. E); Exs. SW, SG, SQ through SW (Met Note); TJ, SG, TB through TJ, TN (Long Bonds); TX, SG, TP through TX (Euro Notes); UD, UF, SG, TZ through UD, UF (8.72% Note); UL, SG, UJ through UL (8.06% Note); Tr. 1168, 1171.

861. After KNX was redeemed on November 29, 1991, all of KNX's CP debt swaps with ABN were terminated. Exs. AZF (App. E), SX, SZ, TK, TM, TX, UE, UH, UM, UO; Stip. paragraphs 257, 259, 262, 264, 266.

862. Other than the Euro Note swap, which was scheduled to terminate on December 8, 1991, the swaps were terminated by ABN and KNX entering into swaps which offset the outstanding swaps for each type of CP debt, but for the fixed-rate payment, and then terminating both swaps. For example, with respect to the Long Bonds, KNX was paying ABN a fixed-rate of 9.7689 percent in exchange for LIBOR on a notional amount of $13,500,000 (KNX's percentage interest of 48.8850595 percent in the Yield Component allocation of 89.7 percent (Ex. 295-NJ (pp. 2-3)) multiplied by $31.45 million of Long Bonds held by ACM (Exs. 153-FL through 155-FN (p. 1) = $13,790,000). On November 27, 1991, KNX and ABN entered into an interest rate swap whereby KNX paid LIBOR in exchange for a fixed-rate of 9.188 percent on a notional amount of $13,500,000. On December 2, 1991, both swaps were terminated with the result that the LIBOR based payments effectively cancelled each other (based on the fact that they would be the same at the next payment date) and KNX owed ABN the present value of the difference between the fixed-rate coupons (9.7689-9.188) on the $13,500,000 notional over the term of the swap. Exs. AZF (App. E), SX, SZ, TK, TM, TX, UE, UH, UM, UO; Stip. paragraphs 257, 259, 262, 264, 266.

863. Three month LIBOR rates declined more than four percent during the period from November 1989 to December 1991. Exs. 519 (pp. 3,5 (Ex. I-A)), 144-FC through 156-FO (V. (b) "Footnotes to Revaluation Spreadsheet").

864. Because interest rates had fallen, KNX owed money on its CP debt swaps with ABN because the fixed-rate KNX owed on the notional was higher than the floating-rate (LIBOR-based) it was being paid. Exs. SX, SZ, TK, TM, TX, UE, UH, UM, UO; Stip. paragraphs 257, 259, 262, 264, 266; PF 863.

865. KNX's total stockholder equity was $4,104,228.51 for the period ended November 30, 1991. Ex. 125-EG (AB 100238).

866. KNX's total stockholder equity was $17,277.99 for the period ended January 27, 1992, of which $6,000 represents the contributions of Coign and Glamis. Ex. 126-EH (AB 500181, AB 500183).

867. Between November 30, 1991, and January 27, 1992, KNX paid ABN $4,835,452 in termination fees on its swaps with ABN as follows:

     Swap          Termination Fees

868. Between November 30, 1991, and January 27, 1992, KNX's balance sheet reflects ($550,606.98) "profit" due to "swap portfolio revaluation." Ex. 126-EH (AB 500181).

869. For the period ending November 30, 1991, KNX had accrued but unpaid interest in the amount of $1,294,455.99 on its swaps. Ex. 125-EG (AB 100238).

870. The decline in stockholder's equity is attributable to termination fees and "swap portfolio revaluation", as can be seen in the following reconciliation of the stockholder's equity shown on KNX's balance sheet for the period ending November 30, 1991, with the stockholder's equity shown on KNX's balance sheet for the period ending January 27, 1992.

     Stockholder's equity               11/30/91     $ 4,104,228.51

871. Termination fees to KNX on KNX'S swaps relating to CP's 8.72% Note (due June 13, 1993) and CP's 8.72% Note (due 2-94) were artificially increased by $1.655 million. Exs. AZF (p. 43), UE, UM.

872. To terminate its interest rate swaps relating to CP's 8.72% Note and CP's 8.06% Note, KNX should have paid ABN $68,686.17 and $111,766.59, respectively. Thus, the total termination fees paid by KNX should have been $180,452.76. Exs. AZF (p. 43), UE, UM, US (AB500934-35).

873. KNX paid ABN termination fees in the amount of $1,835,452.76 on its interest rate swaps relating to CP's 8.72% Note and CP's 8.06% Note. Exs. UE, UM.

874. According to Clinton, a member of den Baas' Financial Engineering Group, ABN was to allocate $180,452.76 of the termination fees from KNX's swaps relating to CP's 8.72% Note and CP's 8.06% Note to its Swap Desk and $1.655 million to Financial Engineering. Exs. UR, US.

875. By artificial termination fees on two CP debt swaps with ABN and the Big LIBOR Note Swap between ABN and KNX, KWX repatriated $2.155 million to ABN. Ex. AZF (p. 47); PF 764, 871-873.

876. Den Baas testified that he did not know what happened to KNX's profit. Tr. 1178.

877. On or about February 28, 1992, KNX filed a Plan of Distribution in Liquidation with the Curacao Office of the Commercial Register. Curab N.V. ("Curab"), whose address was 15 Pietermaai, Curacao, Netherlands Antilles, was appointed liquidator. Stip. paragraph 75.

XXV. ACM'S SALE OF BOT LIBOR NOTES

878. On December 15, 1991, ACM sold the remaining BOT LIBOR Notes to BFCE for $10,961,581. Stip paragraph 233.

879. ACM filed a short partnership year return for the period December 1, 1991 through December 31, 1991. By this time, SH and CP together held more than a 99 percent interest in ACM. Exs. 4-D, 156- FO.

880. ACM booked the sale of the BOT LIBOR Notes at a loss of $1,983,458. Exs. 156-FO (pp. 3, 5), 322-PP (Notes to Financial Statements No. 3, "Contingent Payment Notes").

881. ACM reported a "tax but not book" short term capital loss on the sale of the BOT LIBOR notes in the amount of $84,997,111 on its Federal Partnership Return (Form 1065) for the taxable year ended December 31, 1991. Ex. 4-D (Schedule M).

882. CP claimed a tax loss of $84,537,479 for 1991 and filed an amended 1988 return carrying the loss back to 1988. Stip. paragraphs 6, 7; Exs. 8-H, 9-I.

A. THE REASON FOR SELLING THE BOT LIBOR NOTES

883. ACM sold the BOT LIBOR Notes in 1991 in order to realize the tax benefits of the transaction by realizing the capital loss embedded in the Notes. Tr. 347, 952.

884. The claimed non-tax purpose for distributing the BOT LIBOR Notes from ACM in 1991 was that since the Partnership was consolidated on CP's financial statements, CP no longer needed to hedge the assets of the Partnership, the CP debt. Further, because the LIBOR Notes were highly volatile, it was unwise for CP to hold them. Tr. 150, 355, 347; Ex. 174-GG.

885. Merrill had noted, on its August 8, 1989 description of the transaction that once CP was a 98 percent partner, it would be most reasonable for it to sell the LIBOR Notes since the hedge protection provided by the LIBOR Notes would no longer be necessary. Ex. 58-BF.

886. ACM did not consider distributing LIBOR Notes when a portion of KNX's interest in ACM was purchased by SH and CP and those Partnership assets were consolidated for CP's financial purposes. Tr. 355, 344; Exs. 298-NN, 299-NO.

B. THE VALUE OF THE BOT LIBOR NOTES UPON REDEMPTION

887. Upon the redemption of KNX, Merrill valued the BOT LIBOR Notes at $13,974,304. Ex. 155-FN (p. 5, line 1, "Current Value of Note on 11/29/91 (Including Accrued)"); Tr. 1272-87.

888. The difference between the December 15 sales price and the November 29 valuation consists of private placement origination of $781,250; $440,000 of friction associated with the LIBOR Notes' sale; the payment due on the LIBOR Note on 12/2/91 (Stip. paragraph 134 (December 2, 1991 payment)); and a $798,293 amount attributed to interest rate changes. Tr. 1333-35; Ex. AWF (last page).

889. Included within the amount attributed to interest rate changes was an $80,000 amount that, upon the redemption of KNX, resulted from discussions between den Baas and Taylor regarding the value of the BOT LIBOR Note. That $80,000 amount increased the value of the BOT LIBOR Note for purposes of the Revaluation Worksheet and thus the price to redeem KNX's interest. Exs. AWE (12th unnum. p., "12/13 - 12/5 Close Curve" at top), 443-AJW (10th unnum. p.), 155-FN; Tr. 1337-38, 3153-54; Stip. paragraph 231.

C. THE SALE OF THE BOT NOTES TO BFCE

890. Simultaneously with the sale of the BOT LIBOR Notes to BFCE, Merrill entered into a hedge swap with BFCE. Under the swap, BFCE was obligated to make payments to Merrill mirroring those made on the BOT LIBOR Notes then held by BFCE and, in return, Merrill was obligated to make ratably amortizing payments to BFCE on a notional amount of $10,961,581. Ex. WQ. This swap converted the LIBOR flows from the BOT LIBOR Note into a synthetic amortizing asset. Tr. 666- 67, 1717; Exs. WQ, AWM, AWO.

891. The price at which BFCE purchased the BFCE LIBOR Notes from ACM ($10,961,581) included an accrued interest factor of $144,157 (Ex. 156-FO, p. 5, line 2 ("Less: Accrued Payment") which, as a result of the provision in the swap providing for different effective dates for Merrill (Party A: December 17, 1991) and BFCE (Party B: December 2, 1991) was passed to Merrill. Ex. WQ. Merrill set the notional amount so that the value of the payments it made under the hedge swap with BFCE (assuming the step-up in basis points Merrill had to pay after a certain date did not come into play) would be equal to the value of the payments Merrill received under the hedge swaps with BOT. Ex. AZF (pp. 51-52).

892. A step-up in the LIBOR-based payments Merrill made to BFCE (50 basis points after December 1, 1992) under the December 1991 BFCE hedge swap gave Merrill an economic incentive to repurchase the LIBOR Note in one year. On December 1, 1992, Merrill had the right to call the BFCE LIBOR Note and terminate the swap. Tr. 1719-20; Ex. WQ (p. 3, "Other Provisions", para. 2).

893. On November 20, 1992, the BFCE-Merrill hedge swap was revised, increasing the step-up in payments from Merrill to BFCE to 100 basis points after December 1, 1993. The swap agreement does not indicate that Merrill received any consideration for agreeing to pay an increased step-up. Ex. WR.

894. BFCE was contacted by Pepe with a packaged transaction involving the purchase of the BOT LIBOR Note and a related hedge swap. The transaction would produce a known principal amount and a known return over BFCE's funding cost to BFCE. Tr. 1716, 1733.

895. Prior to KNX's withdrawal from ACM, ACM did not attempt to sell the BOT LIBOR Notes. Stip. paragraph 363.

896. Pepe considered BFCE a potential purchaser of the LIBOR Notes in October of 1991. Ex. AWE (4th unnum. p.).

897. Merrill solicited no one other than BFCE as a potential purchaser of the BOT LIBOR Notes. Stip. paragraph 364.

898. BFCE did not value the BOT LIBOR Note it purchased from ACM. Due to the swap with Merrill, whereby Merrill made payments to BFCE based on a notional amount equal to the purchase price, the purchase price was a given. Tr. 1737; Ex. WQ.

XXVI. COLGATE DID NOT CONSIDER ALTERNATIVES

899. CP considered no other alternative methods of "liability management" with Merrill. Ex. AZD (p. 15); Entire Record.

900. CP considered no other proposals which would incorporate the "liability management" benefits they claim support the purpose for ACM. Ex. AZD (p. 15); Entire Record.

901. As promised, Banker's Trust sent Pohlschroeder a tax idea similar to the stepped structure of Merrill's investment partnership concept. Banker's Trust proposed using a "NOL savings and loan association" instead of a foreign bank as the majority interest partner opining that such an entity provided more flexibility. Pohlschroeder sent the proposal to Belasco telling Belasco it was unsolicited. Ex. 421-AAT; Tr. 386-88.

902. CP's Treasury Department did not discuss alternative methods of "liability management" with the Board and finance committee. Exs. 88-CK through 89-CM; Entire Record.

903. At the time CP decided to enter into ACM, CP did not compare the transaction costs of ACM to transaction costs of alternative means of meeting its financial objectives. Tr. 157-58.

904. In considering how to meet a financial objective, large corporations did and should compare the total out-of-pocket cost of alternative means of accomplishing that objective, particularly when analyzing a potential high-cost transaction. Ex. AZD (pp. 15, 26).

905. Belasco's October 28, 1989 estimate of $8 million in transaction costs for ACM did not include ongoing Arthur Andersen audit fees for each fiscal year end, Merrill revaluation and advisory fees, or ongoing ABN Trust administrative fees. Exs. 407-AAA, AZD (p. 26); PF 391, 392, 393.

906. Belasco's October 28, 1989 estimate of $8 million in transaction costs for ACM underestimated legal and audit fees by approximately $300,000. Exs. 407-AAA, AZD (p. 26); Tr. 957-58; PF 386-390.

907. The costs of travel to Bermuda and other locations, as well as hotels, taxis, and meals, were not considered ACM transaction costs by CP. Tr. 1528-29.

908. Petitioner does not have specific information regarding the transaction costs associated with the purchase and sale of all the varied investments and assets of ACM. Stip. paragraph 648.

909. The internal cash flow and rate of return analyses included transaction costs borne by CP of 75 basis points on a $200 million installment sale of assets ($1.5 million) and, in some cases, a $1.75 million arrangement fee. Exs. 60-BH through 67-BO, AZD (p. 26, App. I & J).

910. The internal cash flow and rate of return analyses understated anticipated transaction costs by almost 300 percent. Ex. AZD (p. 26); PF 905-909.

911. The internal cash flow and rate of return analyses prepared by Merrill were the basis for Pohlschroeder's assertion in his October 3, 1989 memorandum that the transaction offered a six percent return. Tr. 421-24; Exs. 86-CJ, 61-BI, 63-BK.

912. Merrill's cash flows were the basis for the CP Board of Directors being advised, on October 12, 1989, that the ACM transaction offered a six percent return. Ex. 88-CL (CO116); Tr. 961.

913. At trial, Pohlschroeder did not know the term of KNX's interest upon which the six percent return was based. Tr. 421-24.

914. The internal cash flow and rate of return analyses which projected a six percent return assumed that the majority partner would remain in the Partnership for ten years. Exs. 61-BI, 63-BK.

915. The internal cash flows did not incorporate any "liability management" aspects. Tr. 424.

916. The internal cash flow and rate of return analyses failed to consider the opportunity cost of other investments, front-end costs and are devoid of economic meaning, particularly given Merrill's capabilities. Ex. AZF (pp. 30-31); Tr. 2423-24.

917. Between July 1, 1989 and October 1, 1989, the yield on a two year Treasury note fluctuated between 7.53 and 8.49 percent. Ex. AZF (App. B - "Analytical Record of Yields and Yield Spreads", Table I, p. 14).

918. CP's transaction costs to just acquire its own debt were the same whether acquired through ACM or directly by CP. Ex. AZD (p. 26).

919. CP's total reasonably anticipated transaction costs attendant to its participation in ACM were at least $9 million (640 basis points relative to the amount of CP debt acquired), or at least twice the transaction costs CP would have incurred if it had simply bought its own debt back directly and reissued shorter term debt. Ex. AZD (p. 26); PF 905-907.

920. At the time CP decided it would participate in ACM, CP had already paid the shelf registration fee and up-front legal costs for up to $150 million of unsecured debentures. Exs. AZD (pp. 14, 26), 435-AVM (CIII0572-76), 436-AVN (CIII0580-81), 449-AWZ (CIII0785).

921. CP could have reissued shorter term debt with transaction costs running approximately 200-250 basis points. Ex. AZD (p. 26).

922. Interest rate swaps can be entered into very inexpensively. Tr. 2083.

923. In July 1989, CP executed, at virtually no cost, $300 million of interest rate swaps, a good business move by CP which effectively converted approximately thirty percent of CP's total long term debt from fixed-rate to floating-rate interest. Stip. paragraph 31, Exs. 55-BC, AZD (p. 18), 450-AXA (CIII0835-36), 451-AXB (CIII0660); Tr. 1807-08.

924. The interest rate swaps transaction affected twice as much of CP's debt structure as ACM, without all the complexity and transaction costs of the ACM transaction. Ex. AZD (p. 18).

925. Pohlschroeder's assertion in his October 3, 1989 memorandum that entering into ACM, rather than purchasing debt directly, reduces CP's transaction costs is absolutely ludicrous. Exs. 86-CJ (p. 2), AZD (pp. 21, 25), PF 919, 920.

XXVII. DEBT MATURITY

926. Pohlschroeder's October 3, 1989 memorandum to Heidtke discussing the "ABN Liability Management Partnership" emphasized the goal of reducing the average maturity of CP's liability structure. Exs. 86-CJ, AZD (p. 28); Tr. 2151-52.

927. The average maturity of CP's debt was not a liability management goal or concern Heidtke discussed with Singleton when they met to discuss liability management for purposes of this case. Tr. 3248-49.

928. In corporate finance, debt maturity structure is not a competitive issue among consumer product corporations. While debt term or maturity is a factor, published authorities, executives, business schools, and Wall Street industry analysts simply do not consider average maturity significant in corporate finance decisions. Ex. AZD (pp. 11, 25); Tr. 2075.

929. Using proceeds from the sale of Kendall, CP retired its short-term debt, leaving it with essentially only fixed-rate long- term debt. Exs. 11-K, AZD (p. 6); Tr. 92-3, 99, 241. CP's interest cost as a percentage of sales was slightly lower between 1987 and 1990 than its competitors. Tr. 90. CP's interest cost was lower than Proctor and Gamble's in three of the four years and lower than Unilever's in two out of the four years. Ex. AZD (p. 17).

930. In the then current interest rate environment, which featured an almost flat yield curve and short-term corporate rates above nine percent, CP's use of Kendall sales proceeds to pay off short-term debt had almost no impact on CP's interest cost unless it had to issue new debt. Ex. AZD (p. 6).

931. In June 1989, CP adopted an ESOP which issued six series of notes for a total of $410.03 million due in 2001, 2005, and 2009 (the "ESOP Notes"). As of December 31, 1989, the ESOP Notes had an average maturity of 15.3 years and were guaranteed by CP. Proceeds of the ESOP Notes were used by the ESOP to purchase 6.3 million shares of Series B Convertible Preference Stock from CP. Stip. paragraph 22.

932. On April 27, 1989, after extensive presentations, both CP's Personnel & Organization Committee and CP's Finance Committee recommended to the Board of Directors that it authorize the adoption of the ESOP. Ex. 439-AVQ.

933. The notes issued by the ESOP were at very favorable rates for CP, from 8.2 to 8.9 percent. Exs. AZD (p. 19, App. A and C), 46-AT.

934. CP created the ESOP to borrow at tax-advantaged rates, to avoid hostile takeovers, and to reward and secure post-retirement medical benefits for employees. Stip. paragraph 22.

935. The ESOP was a defensive takeover mechanism. Tr. 97, 501.

936. The ESOP was announced to the public upon implementation. Tr. 502.

937. The creation of an ESOP was a good business move and did not create any business need for CP to participate in ACM. Ex. AZD (p. 19).

938. The ACM transactions did not shorten CP's average debt maturity. Tr. 2136; Exs. AZE (pp. 70-71), 51-AY.

939. Prior to consolidation, the activities of ACM reduced the average maturity of CP's debt by only two months. Ex. AZH (pp. 53-54).

940. Even if CP had done nothing to manage its debt maturity schedule over the period 1989-1991, CP's average debt maturity would have shortened by the mere passage of time. Tr. 2152 (Smith).

941. CP's average debt maturity increased over the period from 1989 to 1991, from 8.81 years to 9.67 years. Ex. AZE (pp. 70-71).

942. The Partnership's purchase of the Met Life Note, whose average maturity of four years was less than the average maturity of 8.81 years, actually increased (upon consolidation of ACM into CP) the average maturity of CP's remaining outstanding long term debt. Tr. 2094; Exs. AZD, AZE.

943. The ALCAR Study, prepared for CP in early 1989, found that the median long-term to total debt ratio and short-term to total debt ratio of CP's peers were 74 percent and 26 percent, respectively. ALCAR opined that CP's operating characteristics suggested that CP should have had relatively more long-term debt than its peers. Exs. 86-CJ (last page), 53-BA (p. 30).

944. ACM increased CP's short-term debt ratio by only several months. Tr. 2136-37.

945. Singleton opined that in the absence of the reduction in long-term debt through CP's investment in ACM, CP's short-term debt to total debt ratio would have been 17.2 percent at the end of 1991, as compared to the actual ratio shown on CP's financial statements of 19.5 percent. Singleton's 17.2 percent ratio is based on the Partnership not being consolidated on CP's financial statements, which it was. Tr. 2628; Ex. 517 (p. 43, n. 72).

946. Based on the consolidation of the Partnership on CP's financial statements, CP's short-term debt ratio decreased from 20 percent in 1990, the year prior to consolidation, to 19.5 percent in 1991, the year of consolidation. Tr. 2627-28, 2741-42.

947. There was virtually no change in CP's ratio of short-term to total debt ratio, as set forth on CP's balance sheet, as a result of the ACM Partnership. Exs. AZH (pp. 53-54) (Plotkin), 517 (p. 43) (Singleton). CP's long-term debt to total debt ratio increased. Tr. 2747.

948. The decrease in CP's short-term debt ratio between 1989 and 1991 was, almost completely, attributable to the large increase in the current portion of long-term debt, not the ACM Partnership transactions. Exs. 517 (p. 42-43) (Singleton), AZH (pp. 53-54) (Plotkin).

949. Pohlschroeder's October 3rd memorandum does not discuss the potential effect of ACM on CP's debt to capital ratio. Ex. 86-CJ.

A. THE PURCHASE OF THE MET NOTE

950. Because the principal payments on the Met Note were spread over six years and balanced in each and every year, the Met Note did not cause any gaps in CP's debt maturity profile, and retiring the Met Note did not improve CP's debt maturity profile. Tr. 2094; Ex. 23-W; PF 481.

951. In contradiction of Guideline 1 (long-term debt to capital ratio) and Guideline 2 (maturity structure) of Singleton's report, the retirement of the Met Note, whose average maturity (4.3 years) was less than the average maturity of CP's total long-term debt, actually lengthened the average maturity of the remaining CP debt outstanding. Tr. 2094; Ex. 517 (p. 27); PF 481.

952. Pohlschroeder did not discuss smoothing or leveling CP's debt structure in his October 3, 1989 memorandum. Ex. 86-CJ.

953. Singleton did not investigate the effect of the retirement of the Met Note on CP's long-term debt to capital ratio. Tr. 3246-48; Ex. 517.

954. In 1989, the 8.4 percent Met Note was a very attractive fixed-rate liability. Tr. 155; Ex. AZD (p. 27).

955. Met Life was a friendly debtholder. Tr. 154.

956. Met Life had held the Met Note since 1978. Tr. 154; Stip. paragraph 10.

957. ACM acquired the Met Note because it was the only CP debt available for purchase. Tr. 117; Ex. AZD (p. 27).

958. ACM's acquisition and retirement of the Met Note was a bad economic move by CP. Ex. AZD (pp. 22, 27).

B. ANONYMOUS PURCHASE OF DEBT

959. Merrill purchased certain of the CP debt acquired by ACM and then sold it to ACM. Tr. 797; Ex. 176-GL (p. 1); PF 494.

960. Merrill could have acted as agent to anonymously purchase CP's debt directly for CP, just as effectively as it acted as agent for ACM to purchase CP's debt. Tr. 1850, 797.

961. Merrill would have honored a request by CP to purchase CP debt anonymously because Merrill would have wanted to keep CP's business. Tr. 2252-53.

962. At the time ACM purchased the first $136 million of CP debt in November 1989, none of such debt was consolidated on CP's financial statements. Tr. 1822-25.

963. If CP had bought its own debt directly, such action would not have become public knowledge until sometime in early 1990, after CP's 1989 annual report was mailed. Tr. 1822-25.

964. After CP's 1989 annual report was mailed, ACM acquired $18.75 million of the total of $154.75 CP debt it acquired. Tr. 1823- 25; PF 481, 494, 496, 817-819.

965. Met Life makes public a schedule of its investments at the end of every year, thus the fact that it disposed of the Met Note would have become public information in early 1990. This information which would be useful information to a takeover artist, who could probably have determined who bought it. Tr. 2621-22.

C. THE PRICE OF COLGATE DEBT

966. At the time ACM was formed, there was very little, if any, takeover risk embedded in the yields of CP's long-term debt, as compared to other high-grade corporate bonds. Merrill's index of industrial corporate bond yields reflects that the Long Bonds were trading at the same spread as other high grade long-term corporate bonds were trading. Tr. 2092-93; Ex. 517 (Ex. 5 (the lower graph (spread between CP 9 5/8 percent and Merrill Industrial Corporate Bond Yields).

967. Any takeover risk inherent in CP's debt decreased from July and August of 1989 to October 1989. Tr. 1811-12; Ex. 517 (Ex. 5).

968. In August of 1990, the yield on the Long Bonds spiked, as compared to other corporate bonds. Ex. 517 (Ex. 5).

969. The spike resulted from Iraq's invasion of Kuwait, which, due to the potential international exposure, caused the price of debt of international corporations to decrease (and the yield to increase). Tr. 2089; Ex. 517 (Ex. 5).

D. ALTERNATIVES

970. Tucker concluded that, in order for CP to manage its average debt maturity, it could have readily traded interest rate futures or other interest rate derivatives. Ex. AZF (p. 28).

971. In 1989, structured transactions were available in the market which would have permitted CP to isolate and profit on the credit spread of CP, thereby replicating the Quality Component in the Partnership Agreement. Ex. AZG; Tr. 2241-2245.

972. By using a discount broker, the round-trip transaction cost of trading an interest rate futures contract is $20.00. Ex. AZF (p. 28); Tr. 1989 (Beder).

973. CP could have used defeasance as a way to remove the long- term debt from its balance sheet. Ex. AZF (p. 29).

974. Defeasance occurs when a company buys Treasury securities in such a combination that the cash inflows on the Treasuries match the cash outflows on the company's debt, and if the Treasury debt is pledged to fully collateralize the company's own debt, the company's debt is considered defeased and can be removed from the balance sheet. Ex. AZF (p. 29).

975. CP's 1989 consolidated balance sheet shows that CP had more than sufficient liquid assets to engage in a defeasance strategy. Ex. AZF (p. 29).

976. Beder's estimate of the costs of defeasance did not provide for any judgment regarding the most advantageous time to purchase Treasuries. Tr. 3326-29.

977. CP's actions in financing its acquisition of the Javex Company ("Javex") in 1990 increased (1) the average balance sheet maturity of CP's debt at that time, (2) the average interest rate paid when compared to the debt actually retired through the Partnership, and (3) the amount and percentage of CP's fixed-rate debt. Tr. 2177; Ex. AZD (p. 27).

978. The acquisition of Javex presented an excellent opportunity for CP to have utilized its unused $150 million shelf registration capacity and issued shorter-term fixed or variable rate debt. Ex. AZD (p. 27).

979. On April 26, 1990, subsequent to the Javex acquisition, Heidtke informed the finance committee that CP remained basically healthy with an estimated net debt-to-capital ratio at 12/31/90 of 45%, which should permit CP to retain its current debt rating of A/A+. Ex. 456-AXF.

980. CP's actions in financing its acquisition of Javex included actions in complete contravention to its purported liability management goals mentioned in Pohlschroeder's October 3, 1989 memo and the November 8, 1989 finance committee minutes. Tr. 2177; Exs. 86-CJ, 89-CM, AZD (p. 15).

XXVIII. COLGATE'S MINUTES

A. COLGATE'S BOARD MINUTES

981. During the years in issue, Harold Obstler ("Obstler"), educated at Columbia and Yale, was CP's general counsel, vice president, and corporate secretary. Tr. 1431-32.

982. Obstler reported directly to Mark, CP's chief executive officer and chairman of the CP Board. Tr. 1432.

983. As general counsel and corporate secretary, Obstler attended each CP Board, finance committee, audit committee, and personnel and organization committee meeting. Tr. 1433-34.

984. CP's Board and committees met about 10 times per year. Tr. 1434.

985. All members of CP's finance committee served on CP's Board. Tr. 1434.

986. Obstler prepared the agendas for CP Board and finance committee meetings. Tr. 1435.

987. Handouts were used for a majority of presentations to CP's Board. Tr. 1435.

988. Obstler prepared and signed the minutes of each CP Board, finance committee, audit committee, and personnel and organization committee meeting. Tr. 1436.

989. The CP minutes were not a high priority item. Tr. 3203.

990. As corporate secretary, Obstler took notes during each meeting to use to prepare minutes. Tr. 1437.

991. Obstler typically prepared the prior corporate meeting minutes about a week before the next meeting was to be held. Tr. 1438-39, 3193-94, 946.

992. Obstler used his handwritten notes, consulted with others, or used presentation materials distributed at the meeting to draft corporate minutes. Tr. 1439, 3194.

993. In preparing minutes, Obstler's usual practice was to contact the individual who made the presentation to find out what really did happen. Tr. 3202.

994. Then, Obstler would circulate a draft of the section of the minutes to the individual who made the presentation at the meeting. Tr. 3209.

995. Before corporate minutes were viewed by the Board or committee, drafts were circulated to CP's senior management, including Heidtke, Agate, and Mark. Tr. 3208-10.

996. It was not unusual for CP's senior management to suggest revisions in corporate minute drafts prior to the minutes being reviewed by the Board or committee. Tr. 3210-11.

997. The committee chairman or the Board chairman would ask for corrections or comments on the minutes of the previous meeting. Tr. 203.

998. The proposed final draft of the corporate minutes were placed in the directors meeting packages and provided to the directors at or shortly before the meetings. Tr. 3195.

999. CP's corporate minutes were signed after motion and approval by the Board or committee for which they were prepared. Tr. 1440-41, 3196.

1000. CP's corporate minutes were reviewed and relied upon by both inside and outside auditors in preparing quarterly and annual reports, and for SEC reporting purposes. Tr. 3211-12.

1001. Governmental agencies and members of the public rely on corporate minutes to reflect the actions of a company. Tr. 3029-34.

B. COLGATE'S FINANCE COMMITTEE MINUTES

1002. There are errors in CP's November 8, 1989 minutes of the finance committee, specifically in the section entitled "Merrill Lynch Partnership Update" reported to have been presented by Belasco. Tr. 945-46; Exs. 89-CM (p. C0122), AZD (p. 15).

1003. By the trial of this case, the errors in CP's committee minutes were known but not corrected by CP. Tr. 945-46; Entire Record.

1004. The November 8, 1989 finance committee minutes erroneously recite that ACM had sold money market notes for $175 million in cash and $35 million in deferred payments. Such transactions did not take place until November 27, 1989. Exs. 89-CM (p. C0122), AZE (p. 16), AZD (App. E); Stip. paragraph 126.

1005. The November 8, 1989 finance committee minutes erroneously state that the cash received upon the sale of such money market notes was invested in CP 8.4 percent notes due 1990-1998 and some of the CP 9 5/8 percent debentures due 2017, when in fact such purchases were made on or about November 17 and 27, 1989 for settlement on December 4, 1989. Exs. 89-CM (p. C0122), AZE (p. 16), AZD (App. E, F and G), 249-KR through 257-KZ; Stip. paragraphs 167, 178.

1006. The November 8, 1989 finance committee minutes erroneously recite the completed purchase of $327 million of CP's Eurodollar obligations, when in fact ACM's largest holding of CP Eurodollar obligations was $13.75 million acquired between December 4, 1989 and October 23, 1990. Exs. 89-CM (p. C0122), AZE (p. 16), AZD (App. H); Stip. paragraphs 173 through 176.

1007. The November 8, 1989 finance committee minutes state that ACM was formed with ABN, when, under the Partnership Agreement, it was formed with KNX. Exs. 89-CM (p. C0122), AZE (p. 16), 137-ET.

1008. Heidtke did not recall if the sale of the Citicorp Notes was discussed at the November 8, 1989 finance committee meeting. Tr. 202.

1009. Obstler did not recall matters discussed in various corporate minutes. Tr. 1441-47.

1010. Heidtke could not explain why the minutes of the November 8, 1989 finance committee meeting contained errors. Tr. 203.

1011. The $31 million of positive cash benefits referred to in the November 8, 1989 finance committee minutes was based on the prospective tax benefits of the Partnership to CP. Exs. 89-CM (CO122), 58-BF, 78-BR; Tr. 204.

XXIX. "BUSINESS PURPOSE"

1012. Except for the reference to the short-term and long-term debt ratios in Pohlschroeder's October 3, 1989 memorandum to Heidtke and the October 12, 1989 Board minutes, CP's ostensible liability management guidelines were never quantified in any of the documents supporting the reason that CP was forming the partnership. Tr. 2147, 2155 (Smith), 3237-38, 3242; Exs. 86-CJ (p. 7), 88-CL.

1013. The October 12, 1989 CP Board minutes recite that CP Treasury Department had made major changes to the Merrill investment partnership proposal that had been presented with a view toward minimizing the capital gains tax arising out of the disposition of the Kendall business in 1988, and that without such major changes, management would not have recommended the transaction. Ex. 88-CL.

1014. Pepe referred to the stated liability management goal of CP as "business purpose" and documented that phrase in notes for agendas to meetings. Exs. AVZ (001734 "Enhance business purpose;" 002740 "2) Further substantiate business purpose"), AWC (5th unnum. p. 6/24/91 "Business Purpose discussions"); 443-AWJ (p. 2, para. (c) "i.e., business purpose"); Tr. 1319-21, 1296; Stip. paragraph 657.

XXX. CONCLUSIONS OF THE EXPERTS

A. SMITH

1015. Respondent's expert Paul Smith, formerly the CFO of Eastman Kodak Company, has a wealth of experience in corporate treasury decisions regarding corporate liability management, the issuance of equities, swaps, international financing transactions, managing debt to capital ratios, blending long and short-term debt needs, managing interest rate risk, and evaluating various proposals or opportunities and their tax consequences. Tr. 2061-63, 2067-68; Ex. AZD (p. 73).

1016. CP's stated and quoted business and financial goals in 1989 included significant growth in volume and revenue through expansion of its successful consumer brand products throughout the world, and acquisition of new products with strong market shares to improve CP's global market power. Exs. AZD (p. 5), 11-K (pp. 2-3), 12-L (p. 3).

1017. In early 1990, CP continued its pattern of acquisitions by acquiring Javex, Canada's leading producer of bleach and liquid fabric softener for $172 million (US), Vipont Pharmaceutical for $100 million and a Portuguese and an Italian consumer products company for a combined additional $78.2 million (US). Exs. AZD (p. 5), 13-M (pp. 13, 30).

1018. When he became CEO in 1984, Mark set very aggressive financial return objectives, because of the threat of a takeover as a result of CP's poor financial return and stock price performance prior to 1985. Ex. AZD (p. 5).

1019. The aggressive financial objectives Mark set for CP included increases in return on capital, return on equity, net income return on sales, earnings per share, and annual sales volume. Exs. AZD (p. 6), 12-L (p. 2).

1020. No specific objectives were ever stated in CP's annual reports for debt structure, debt maturity profiles, or debt to capital ratios. Exs. AZD (p. 6), 10-J, 11-K, 12-L, 13-M, 14-N.

1021. CP's 1990 annual report declared it had met and surpassed virtually all of its goals for the 1984-1991 eight-year plan, a full year ahead of schedule, and that CP had a new plan for further accelerated growth over the next succeeding five-year period. Ex. 13- M (p. 3).

1022. CP's participation in ACM did not facilitate its reaching any of its financial goals. Ex. AZD (p. 24).

1023. CP's participation in ACM, after taking transaction costs into account, did not reduce either CP's overall interest costs or interest rate risk. Ex. AZD (p. 21).

1024. CP's participation in ACM, did not make CP more competitive in its industry. Ex. AZD (p. 24).

1025. Except for creating a large capital loss to offset the Kendall capital gain, ACM did not help CP achieve any of its financial goals. Ex. AZD (pp. 21, 24).

B. CASE

1026. Case's conclusion that SH's capital account was reduced by the market value of the BFCE LIBOR Notes on December 13, 1989 was based on the assumption that the value was agreed to by the ACM partners in arm's-length negotiations. Tr. 1864.

1027. Case was told the value of the BFCE LIBOR Notes and BOT LIBOR Notes agreed to by the ACM partners included the $1,093,750 market spread incurred by ACM in connection with the sale of the Citicorp Notes for cash and LIBOR Notes. Tr. 1865; Ex. 518 (p. 15, n. 6).

C. TUCKER

1028. KNX's behavior as a partner was perverse because it entered the Partnership only to immediately exit the Partnership via swaps. Ex. AZF (p. 37); Tr. 2476.

1029. Tucker acknowledged that there was some risk that CP would default and that KNX would not get paid, but that risk was nominal and insignificant. Tr. 2477-78.

1030. Tucker believes that, from an economic perspective, the role of KNX was that of a lender because KNX entered the Partnership and then entered transactions that eliminated all risk save default risk. Tr. 2482.

D. PLOTKIN

1031. An independent equity investor entering into a partnership with SH would want to maximize its return, and would thereby seek profits by applying economic pressure on SH or CP. Ex. AZH (p. 56).

1032. CP's expectation of and realization of control over the ACM Partnership was disproportionate to the size of its Partnership investment and indicates that ACM was not, in fact, economically independent. Ex. AZH (p. 56).

1033. From an economic perspective, the characterization of KNX as a lender is consistent with KNX permitting SH and CP disproportionate control and accommodating SH's and CP's desires regarding ACM. Ex. AZH (pp. 4, 56-57, 62, 64).

1034. The characterization of KNX as a lender is consistent with the risks and rewards KNX undertook. KNX was exposed only to default risk and did not participate in any significant benefits of the Partnership. Tr. 2762; Ex. AZH.

1035. The characterization of KNX as a lender is consistent with the arrangements designed to protect KNX from fees and even provide KNX with a return on lost interest or opportunity costs. Ex. AZH (pp. 58-59); Tr. 2986-87.

1036. Plotkin opined that ACM was the borrower but that economically, CP could be viewed as the borrower due to the fact that it controls SH, and MLCS had a nominal interest in the Partnership. Tr. 2769-70.

XXXI. THE PATTERN

1037. E.S.P. Das, a vice chairman of investment banking at Merrill, earned an MBA from the University of Chicago and a Ph.D. in engineering from Brown University. In 1989, Das was a managing director in investment banking. Tr. 3124-25.

1038. In the summer of 1989, Taylor discussed with investment bankers at Merrill the use of an installment sale transaction within a partnership to defer or offset capital gains or to convert capital losses to ordinary losses. Tr. 706. During that summer, Taylor and Das discussed the concept of an installment sale within a partnership, including the associated tax benefits. Tr. 3125, 3131.

1039. Das discussed the concept of an installment sale within a partnership with Dun & Bradstreet ("D&B"), Schering-Plough Corporation ("Schering"), Allied Signal Inc. ("Allied"), Brunswick Corporation ("Brunswick"), American Home Products Corporation ("AHP"), and Borden, Inc. ("Borden"), and assisted them, as well as Paramount, in the formation of partnerships which sold private placements for cash and LIBOR notes in an installment sale transaction. Tr. 3126-32; Ex. ACX (Preamble Fifth Stip.).

1040. Das explained to his clients, D&B, Schering and AHP, that, given their cash position, the partnership concept offered flexibility in the amount and makeup of any investments their Boards authorized and in the timing of the investments, as their cash would not be locked-up if they wanted to use it. Tr. 3132-35. Using flipcharts, he explained that the installment sale would have tax gains and losses associated with it that added up to zero and if the client's percentage interest in the partnership increased between the time the gain was realized and the time the loss was realized, the client-corporation would realize a tax benefit. Tr. 3135, 3139-40.

1041. At the time of explaining the concept to D&B, Das knew D&B had capital gains. Tr. 3136.

1042. AHP and Schering did not have capital gains at the time Das explained the concept to them, however, they generated capital gains in 1990. Tr. 3136; Exs. AQQ (pp. 6, 48), AHI (p. 212).

1043. In 1990, AHP sold its worldwide household and depilatory businesses for $1.25 billion, which resulted in a $1 billion capital gain. Ex. AQQ (pp. 6, 48).

1044. In 1990, Schering sold its Maybelline cosmetics business resulting in a pre-tax gain of $150 million. Schering also sold two cosmetics companies in Europe resulting in a pre-tax gain of $70 million. The divesture of a Brazil operation resulted in a loss of $34.5 million. Ex. AHI (p. 212).

1045. In 1988, D&B sold its Official Airline Guides subsidiary for a pre-tax gain of $752 million. Ex. ADA (p. 519).

1046. In 1990, D&B sold Zytron, Petroleum Information And Neodata for a pre-tax gain of approximately $84 million. Ex. ADC (p. 259).

1047. In May 1988, Brunswick completed the sale of the filtration technology business of the Technical segment for $68.8 million resulting in a $42 million pre-tax gain. Ex. ANS (p. 42).

1048. In 1990, Brunswick sold the Industrial Products and Technetics Divisions of the Company's Technical segment for $213.1 million, for a $84.2 million pre-tax gain. Ex. ANU (p. 156).

1049. In October of 1989, Paramount sold Associates First Capital Corporation, its consumer/commercial finance business, for a gain of approximately $1.2 billion. Ex. AFS (p. 60).

1050. A 1987 sale of stock in Union Texas resulted in a capital gain to Allied Signal in the amount of $108 million. Ex. AQQ (p. 27).

1051. In 1988, Allied Signal had a capital gain in the amount of $165 million from the sale of Bendix Electronics and from the formation of a joint venture between Allied and Union Carbide. Ex. AOR (p. 243).

1052. In 1990, Borden sold Krylon and Galloway-West. Ex. ASZ (p. 50).

1053. Borden's taxes for 1990 were lower than expected on the sale of the Krylon aerosol paint business as a result of capital losses from an investment partnership. Ex. ASZ (p. 49).

1054. Allied and Borden asked Merrill to assist them in forming partnerships after hearing about other partnerships that Merrill had put together. Tr. 3127, 3129.

1055. Das approached other clients about engaging in an installment sale transaction within a partnership who did not engage in the transaction. Tr. 3138.

1056. Taylor or members of his group at Merrill arranged for ABN-related foreign entities to act as partners for eleven partnerships which, within a period of between three weeks and three months, purchased and then sold private placements for 75 to 85 percent cash and LIBOR Notes. Tr. 3137, 3126; Ex. ACX (Preamble Fifth Stip.); PF 1062, 1064, 1071, 1076, 1085, 1100, 1122, 1137, 1147, 1153, 1160. These partnerships ("Section 453 Partnerships") included ACM Partnership, Nieuw Willemstad Partnership, Nieuw Oranjestad Partnership, Kralendijk Partnership, Oud Philipsburg Partnership, Saba Partnership, Maarten Investerings Partnership, ASA Partnership, BOCA Partnership, Zeelandia Partnership, and Otrabanda Partnership. Tr. 1377-78, 3137, 3126, 1224-29; Ex. ACX; PF 1059, 1062-1164.

1057. Merrill earned approximately $20 million in engagement fees in arranging Section 453 Partnerships for four corporations. Exs. AOO, AQM, AQN, AQO, ASV, ASX, ANP, AUX, ACY, AVH, AKI, AVI.

1058. Taylor contacted den Baas to find a foreign partner for the first Section 453 Partnership, Nieuw Willemstad. Through contacts in Amsterdam, den Baas arranged for Taylor to contact de Beer at ABN Trust. Tr. 1214-15, 1224; PF 207.

1059. The Section 453 Partnerships retained Merrill to assist them in making investments. Tr. 3145-46; Exs. ADD, AFR, AHL, AKJ, ANQ, AOP, AQP, ASY, AUC, AUY.

1060. Taylor was the point person who, with members of his group, interacted with Merrill's desk to find issuers and purchasers of private placements for the Section 453 Partnerships. Tr. 3128, 3130, 3145-46.

1061. During the period 1988 through 1991, Taylor's compensation increased, on average, 20 to 30 percent a year. The ACM transaction impacted favorably on his compensation. Tr. 693-94.

A. NIEUW WILLEMSTAD

1062. D&B was a general partner of Nieuw Willemstad. Ex. AKI. D&B, A.C. Nielsen Company, and Tonneau Corporation, N.V. executed an engagement letter between Nieuw Willemstad and Merrill. Ex. ADD.

1063. By Revolving Credit Agreement dated as of September 28, 1989, ABN (Cayman Islands) made $750 million available to Tonneau Corporation, N.V., a Netherlands Antilles corporation. Under the Revolving Credit Agreement, notices to ABN were directed to den Baas and notices to Tonneau to de Beer. Ex. AFN (pp. 11-12).

1064. Merrill Lynch Capital Services, Inc. issued a LIBOR note dated October 27, 1989, to Nieuw Willemstad Partnership, which was booked as a notional principal contract, as Merrill booked its swaps. Tr. 1392-94; Ex. ADR.

1065. Merrill issued the LIBOR note and paid $42.5 million in cash in exchange for the private placements ($50 million of Fleet Norstar notes) it purchased from Nieuw Willemstad because it was unable to find a buyer for the private placements consistent with the timeframe required for the client. Merrill accommodated its client by buying the private placements itself. Tr. 1392-94; Ex. ADR.

1066. On November 7, 1989, Merrill's LIBOR note was assigned to D&B. Ex. ADR (p. 2). By Assignment Agreement dated as of December 5, 1989, D&B assigned Merrill's LIBOR note, as well as five other LIBOR Notes issued to Nieuw Willemstad, to Unibank. In addition to Merrill, the assigned LIBOR notes were issued by Sumitomo, Fuji, and Mitsubishi on October 27 and 30, 1989, and related to $275 million of floating-rate notes dated September 28, 1989. Exs. ADR (p. 3), ADS. Simultaneously, Merrill arranged for Unibank to enter into two hedge swaps with Merrill, relating to the assigned LIBOR notes. Exs. ADW, ADX, ADY (p. 3, "Other provisions:" para. 2), AED (revised confirmation), ADZ (p. 3, "Other provisions:" para. 2). Unibank called these two sets of transactions Swap Repos 1 and 2. Exs. AFJ, AFK.

1067. In Schickner's first request for approval of transactions involving the purchase of LIBOR notes and simultaneous hedge swap with Merrill, Schickner referred to the set of transactions as a Swap Repo. Ex. AEY; PF 1066.

1068. On November 10, 1989, it was Unibank's understanding that the transactions referred to as Swap Repos 1 and 2 would be terminated on January 17, 1990 and February 1, 1990. Ex. AEY.

1069. On January 15, 1990 and February 1, 1990 the hedge swaps between Merrill and Unibank were terminated. Exs. ADY, ADX, AEB, AEC. Simultaneously with the January 15, 1990 swap termination which related to the Fuji LIBOR notes issued to Nieuw Willemstad, the Fuji LIBOR notes were terminated. Exs. AEE, AEG, AEH, AEI. Merrill acted as valuation agent. Ex. AEE.

1070. On February 1, 1990, the LIBOR notes related to the February 1, 1990 swap termination between Unibank and Merrill were assigned to Generale Bank. Exs. AEJ, AEK, AEL, AEM, AEN. Merrill simultaneously entered into a hedge swap with Generale Bank, which was terminated on May 1, 1990. Ex. AEO. Simultaneously, the October 27, 1989 LIBOR note Merrill issued to Nieuw Willemstad, which had been assigned by Unibank to Generale Bank, was terminated. Ex. AEP.

1071. Five LIBOR notes issued as of October 27, 1989 to Nieuw Willemstad by Sumitomo and Mitsubishi relating to $375 million of floating-rate notes were assigned to A.C. Nielsen Company. By Assignment Agreement dated as of December 5, 1989, these LIBOR notes were assigned to Nissho Iwai. Ex. AET. Merrill simultaneously entered into a hedge swap with Nissho Iwai which was terminated on February 1, 1990. Ex. AEU.

1072. On February 1, 1990, Nissho Iwai assigned the five LIBOR notes to Unibank. Exs. AEV, AET. Merrill simultaneously entered into a swap with Unibank relating to the five LIBOR notes which was terminated on May 1, 1990. Ex. AEX (p. 3, "Other provisions:" para. 2.). Simultaneously with the termination of the hedge swap, the LIBOR notes were terminated. Merrill acted as valuation agent. Exs. AEQ, AER, AES, AFH. Unibank termed the set of transactions Swap Repo-3. Exs. AFL, AFH.

1073. Upon entering into the set of transactions it called Swap Repo-3, it was Unibank's understanding that it had a business understanding with Merrill that the transactions would be unwound in three months. Ex. AFF.

B. NIEUW ORANJESTAD

1074. Formed on or about November 16, 1989, Nieuw Oranjestad Partnership was capitalized in the amount of $500 million, of which $55 million was contributed by CPW Holdings, Inc. and CPW Investments Ltd., L.P. Staunton Corporation N.V. and Tagus Corporation N.V., both Netherlands Antilles corporations managed by ABN Trust, advanced to Nieuw Oranjestad $47 million and $398 million, respectively, 89 percent of $500 million. Exs. AFT, AFU.

1075. Tagus and ABN Curacao entered into a $450 million revolving credit agreement. Ex. AFU. Staunton and ABN Cayman entered into an approximately $50 million revolving credit agreement. Exs. AHD, AHC (2nd unnum. p.).

1076. Nieuw Oranjestad purchased $449.5 million of private placement floating-rate notes on November 21 and 22, 1989, all of which it sold on December 15, 1989, for cash in an amount equal to 80 percent of the par value of the private placements plus LIBOR notes maturing January 1995. Exs. AFT, AFV, AFW, AFZ, AGA, AGI.

1077. The private placements purchased by Nieuw Oranjestad matured in approximately 5 years and had shorter-term put options. Exs. AFV (Ex. A, p. 6), AFZ (Ex. A, p. 5; Ex. B, p. 5).

1078. Simultaneously with the sale of the private placements, Merrill entered into hedge swaps with the issuers of the LIBOR notes to Nieuw Oranjestad. The swap termination dates were the same as the maturity dates on the LIBOR notes and all of the swaps were terminated early, by April 4, 1991. Exs. AFX, AGC, AGJ. Under the hedge swaps, the payments Merrill was obligated to make mirrored the payments owed by the LIBOR note issuers to Nieuw Oranjestad. Exs. AFW and AFX; Exs. AGA, AGC; Exs. AGI, AGJ; PF 1076.

1079. On December 19, 1989, ABN and Merrill entered into big and small swaps, effective the date the private placements were sold by Nieuw Oranjestad for cash and LIBOR notes. Exs. AGM through AGR; PF 1076. Under the big swaps, which hedged the ABN controlled partners' interests in the LIBOR notes, ABN was obligated to make payments to Merrill mirroring 89 percent of the payments made to Nieuw Oranjestad under the LIBOR notes issued to Nieuw Oranjestad. Exs. AGI, AGO (Party B notional amount of $63,304,810 from Ex. AGO = 89% x $71,129,000, the notional of the Fuji LIBOR notes from Ex. AGI); Exs. AFW, AGM (Party B notional amount of $124,947,100 from Ex. AGM = 89% x $140,390,000, the notional of the Mitsubishi LIBOR notes from Ex. AFW); Exs. AGN, AGA (Party B notional amount of $63,610,970 from Ex. AGN = 89% x $71,473,000 the notional of the BOT LIBOR notes from Ex. AGN); Tr. 1376, 1216-29. The small swaps' notional was generally equal to the origination incurred upon the sale of the private placements, thus providing ABN with a return on that amount. Tr. 1376-77. By June 5, 1990, the swaps between ABN and Merrill were terminated, thus the foreign partners in Nieuw Oranjestad no longer held an interest in the LIBOR notes issued to Nieuw Oranjestad. Exs. AGM through AGR; Tr. 1216-17, 1218, 1222, 1225-29, 1375.

1080. The BOT LIBOR note issued to Nieuw Oranjestad was assigned to Nissho Iwai. Exs. AGG, AGH. On September 6, 1990, Nissho Iwai and Merrill entered into a swap whereby Nissho Iwai was obligated to pay to Merrill a stream of payments mirroring the payments made to Nissho Iwai on the assigned BOT LIBOR note in exchange for payments based on an amortizing notional amount. Exs. AGD, AGA. Simultaneously with the termination of the Nissho Iwai-Merrill swap, the hedge swap between Merrill and BOT entered into upon the issuance of the BOT LIBOR note and the BOT LIBOR note were terminated. Exs. AGD, AGC, AGH.

1081. BFCE was assigned the LIBOR note issued by Fuji Capital Markets to Nieuw Oranjestad and on October 11, 1990, entered into a swap with Merrill whereby BFCE was obligated to pay to Merrill a stream of payments mirroring the payments made to BFCE on the Fuji LIBOR note in exchange for payments based on an amortizing notional amount. Exs. AFW, AGL (p. 3, "Other provisions:" para. 2 reflecting that BFCE held Fuji LIBOR note). On April 2, 1991, simultaneously with the termination of the hedge swap between Fuji and Merrill entered into upon the issuance of the Fuji LIBOR note, the BFCE- Merrill swap was terminated. Exs. AGJ (last three pp.), AGL (last two pp.).

1082. BFCE was assigned the LIBOR note issued by Mitsubishi to Nieuw Oranjestad and on November 5, 1990, entered into a swap with Merrill whereby BFCE was obligated to pay to Merrill a stream of payments mirroring the payments made to BFCE on the Mitsubishi LIBOR note in exchange for payments based on an amortizing notional amount. Exs. AFW, AFY (p. 3, "Other provisions:" para. 2 reflecting that BFCE held Mitsubishi LIBOR note). On April 4, 1991, simultaneously with the termination of the hedge swap between Mitsubishi and Merrill entered into upon the issuance of the Mitsubishi LIBOR note, the BFCE-Merrill swap was terminated. Exs. AFY (last two pp.), AFX (last two pp.).

1083. The notional amount upon which Merrill made payments under the November 5, 1990 BFCE hedge swap was mathematically set, based upon the hedge swap entered into between Merrill and Mitsubishi upon the issuance of the BFCE LIBOR note, to insure that Merrill could not lose money if the swaps were terminated by April 2, 1991, before the step-up increased from 30 basis points to 50 basis points. Exs. AFX, AFY, AZF (pp. 50-52 for equation).

C. KRALENDIJK

1084. Formed on or about December 21, 1989, Kralendijk was capitalized in the amount of $1 billion, of which $225 million was contributed by Schering and $30 million from Schering Institutional Sales Corporation. Staddlestone, a Netherlands Antilles Corporation incorporated on December 19, 1989, whose managing director was ABN Trust, was capitalized in the amount of $6,000, advanced $750 million to Kralendijk. Exs. AHM, AHT (Item 21).

1085. Kralendijk purchased $1 billion private placement notes on January 18, 19, and 25, 1990, all of which it sold, on March 12 and 16, 1990, for cash in the amount of eighty percent of the par value of the private placements plus LIBOR notes maturing April, 1995. Exs. AHO, AHR, AHS, AHT, AHX, AIB, AIF, AIS.

1086. The private placement notes purchased by Kralendijk matured in approximately five years and had shorter-term put options. Two of the private placement issues were floating-rate notes; the third was a fixed-rate. Exs. AHO (Ex. A, p. 4), AHR (Ex. A, p. 5; Ex. B, p. 5), AHS (Ex. A, pp. 5-6).

1087. Upon the issuance of the fixed-rate private placements to Kralendijk, Kralendijk entered into a swap with Merrill to exchange the fixed-rate payments for floating-rate payments. Exs. AHO, AHP, AHQ.

1088. Simultaneously with the sale of the private placements by Kralendijk, Merrill entered into hedge swaps with issuers of the LIBOR notes. The swap termination dates were the same as the maturity dates on the LIBOR notes and all of the swaps were terminated early, by February 5, 1991. Exs. AHT, AHW, AHX, AIA, AIB, AIE, AIW, AIR, AIS; PF 1085. Under the hedge swaps, the payments Merrill was obligated to make mirrored the known payments owed by LIBOR note issuers to Kralendijk. Exs. AHT and AHW (Mitsubishi); Exs. AHX and AIA (BFCE); Exs. AIB and AIE (Sumitomo).

1089. Simultaneously with Kralendijk's sale of private placements to BOT, BOT entered into a hedge swap with Sumitomo (Ex. AIH) and Merrill entered into a hedge swap with Sumitomo (Ex. AIJ). The net effect of the two swaps was that Merrill was obligated to make payments to Sumitomo mirroring the payments required on the LIBOR notes BOT issued to Kralendijk plus a spread of .10 percent and Sumitomo was obligated to make payments to BOT mirroring the payments required on the LIBOR notes BOT issued to Kralendijk. In exchange, BOT was obligated to make payments to Sumitomo on an amortizing $20 million notional amount and Sumitomo was obligated to make payments to BOT on an amortizing $20 million notional amount. Exs. AIH, AIJ, ALI (664-71); PF 1085.

1090. Effective November 8, 1990, the swap between Sumitomo and Merrill was terminated. Ex. AIJ (5th unnum. page). Simultaneously, BOT and Merrill entered into a hedge swap whereby Merrill was obligated to make payments to BOT mirroring the payments required on the LIBOR notes BOT issued to Kralendijk in exchange for BOT's obligation to make payments to Merrill on an amortizing $18 million notional amount, the then unamortized notional amount under the BOT- Sumitomo-Merrill hedge swaps. Exs. AIH, AIJ, AIL, AIK. On January 2, 1991, the swap between BOT and Merrill was terminated. Ex. AIM.

1091. Simultaneously with the sale of the private placements by Kralendijk, ABN and Merrill entered into big and small swaps. Exs. AJV through AKG; PF 1085. Under the big swaps, which hedged the ABN controlled partner's interest in the LIBOR notes issued to Kralendijk, ABN was obligated to make payments to Merrill mirroring 75 percent (Staddlestone's percentage interest in Kralendijk) of the payments made on the LIBOR notes issued to Kralendijk. Exs. AJV and AIB (Party B notional amount of $120,660,000 from Ex. AJV = 75% x $160,880,000, the combined notional of the Sumitomo LIBOR notes from Ex. AIB); Exs. AJW and AHX (Party B notional amount of $39,960,000 from Ex. AJW = 75% x $53,280,000, the combined notional of the BFCE LIBOR notes from Ex. AHX); Exs. AJX and AHT (Party B notional amount of $99,615,000 from Ex. AJX = 75% x $132,820,000, the combined notional of the Mitsubishi LIBOR notes from Ex. AHT); Exs. AJZ, AIS, AIR, AIW (Party B notional amount of $100,365,563 = 75% x $133,820,000, based on the notional of the Merrill-Beta Finance hedge swap entered into upon the issuance of the Beta Finance LIBOR notes as the LIBOR note notional is incomplete); Exs. AJY and AJF (Party B notional of $39,480,000 = 75% x $52,640,000, the notional of the BOT LIBOR note from Ex. AIF); Tr. 1376, 1216-29. The small swaps' notional was generally equal to the origination incurred upon the sale of the private placements, thus providing ABN with a return on that amount. Tr. 1376-77. By June 11, 1990, the LIBOR note swaps between ABN and Merrill were all terminated, thus the foreign partner no longer had any interest in the LIBOR notes held by Kralendijk. Exs. AJV through AKG; Tr. 1216-17, 1218, 1222, 1225-29, 1375.

1092. On February 1, 1991, Merrill agreed to become the obligor on the LIBOR note issued by Beta Finance to Kralendijk in return for a payment of $1 million by Schering. Ex. AKH.

1093. On or about July 25, 1990, Schering assigned its rights under the BOT LIBOR note issued to Kralendijk to Unibank. Ex. AIZ, AJK. At about the same time, Schering affiliates assigned their rights under the LIBOR notes issued Kralendijk by Mitsubishi, Sumitomo, and BFCE to Unibank. Exs. AJI, AJK, AJL. Of the $1 billion private placements sold by Kralendijk in March of 1990, LIBOR notes relating to $750 million were assigned from Schering affiliates to Unibank on or about July 28, 1990. Exs. AJI, AJK; PF 1085.

1094. Simultaneously, Merrill and Unibank entered into swaps, termed Swap Repo-4 by Unibank, with respect to the BOT LIBOR note, the Sumitomo LIBOR notes, the BFCE LIBOR notes, and the Mitsubishi LIBOR notes. Exs. AJA, AJB, AJC, AJI, AJL. These swaps were terminated on January 2, 1991. Exs. AJA, AJB (last two pages).

1095. Simultaneously with the termination of the swaps between Merrill and Unibank, the LIBOR notes issued to Kralendijk by Sumitomo, BFCE, Mitsubishi and BOT were terminated. Exs. AJQ, AJU, AJM, AJN, AJO, AJP, AJR. Merrill acted as valuation agent upon the termination of the LIBOR notes and hedge swaps. Exs. AJM, AJN, AJO, AJP, AJR.

1096. The structure of the hedge swaps and LIBOR note purchases related to Kralendijk were identical to the BFCE LIBOR Note and hedge swap with Unibank related to ACM. Exs. AJE, AIZ, AJI through AJL, UW, VE, 275-LR, 276-LS.

1097. Unibank understood that the hedge swaps and LIBOR notes relating to Kralendijk would run three to six months. Ex. AJE.

1098. The hedge swaps and LIBOR notes purchased by Unibank which related to Kralendijk were terminated in less than six months. Exs. AJA, AJB, AJQ, AJU.

D. OUD PHILIPSBURG

1099. Heathcote Corporation, a Netherlands Antilles corporation whose statutory director was ABN Trust and who acted as a general partner of Oud Philipsburg Partnership, was incorporated on January 18, 1990 and capitalized in the amount of $6,000. Exs. AKL, AKU (Item 12, last page).

1100. Oud Philipsburg purchased $650 million of floating-rate private placement notes on February 21, 1990 which between March 28 and April 30, 1990, were sold for cash in the amount of eighty-five percent of the par value of the private placements plus LIBOR notes maturing April 1995. Exs. AKL, AKM, AKN, AKP, AKR, AKU, AKX, ALC, ALF.

1101. The private placements purchased by Oud Philipsburg matured in approximately five years and had shorter-term put options. Exs. AKL (774), AKM (Ex. A, p. 5), AKN (Ex. A, pp. 5-6).

1102. Simultaneously with the sale of the private placements by Oud Philipsburg, Merrill entered into, or, with respect to BOT, arranged hedge swaps with the issuers of the LIBOR notes to Oud Philipsburg, all of which were terminated by July 2, 1992. Exs. AKO, AKP, AKR, AKT, AKU, AKW, AKX, AKZ, ALB, ALC, ALE, ALF, ALH, ALI (pp. 672-676); PF 1100, 1104.

1103. In BOT's view, the transactions in which it engaged relating to the purchase of private placements from Oud Philipsburg for cash and LIBOR notes, including the hedge swaps and assets swaps, were virtually the same as the three previous LIBOR note transactions in which it engaged in ACM, Kralendijk and Nieuw Oranjestad. Ex. ALI (p. 672); PF 529, 536, 538, 539, 547, 548, 1076, 1078, 1080, 1089, 1090, 1102.

1104. In Oud Philipsburg, like in Kralendijk, Sumitomo was placed as a middleman between BOT and Merrill on the asset and hedge swaps, earning a 10 basis point spread from Merrill. Exs. ALK, ALH, ALI (pp. 672-76); PF 1089. On or about November 8, 1990, the hedge swap between Merrill and Sumitomo was terminated (Exs. ALH (p. 5); and BOT entered into a hedge swap with Merrill, which terminated on April 2, 1991. Exs. AMC through AME.

1105. On the dates the private placements were sold by Oud Philipsburg for cash and LIBOR notes, ABN and Merrill entered into big and small swaps. Exs. ANB through ANO. Under the big swap, which hedged the ABN controlled partner's interest in the LIBOR notes issued to Oud Philipsburg, ABN was obligated to make payments to Merrill which mirrored approximately 90 percent of the known payments made on the LIBOR notes issued to Oud Philipsburg. Exs. AKU, AND (Party B notional amount of $17,450,000 = 89.948% x $19,400,000 notional from Ex. AKU); Exs. ALF, ANE, ALK, ALH (Party B notional amount of $34,882,000 = 89.948% x $38,780,000 notional on hedge swap between BOT-Sumitmo-Merrill); Tr. 1376, 1216-29; PF 1100. The small swaps' notional was equal to the foreign partner's interest in the origination incurred upon the sale of the private placements, thus providing ABN with a return on that amount. Tr. 1376-77. The ABN- Nerrill swaps were revised and terminated on September 28, 1990. Exs. ANB through ANO. Thus, the foreign partners in Oud Philipsburg had no interest in the LIBOR notes issued to Oud Philipsburg after September 28, 1990. Exs. ANB through ANO; Tr. 1216-17, 1218, 1222, 1225-29, 1375.

1106. The LIBOR notes issued to Oud Philipsburg by BOT, Sumitomo, Fuji, Norinchukin and AIG were assigned to Nieuw Willemstad. Exs. ALN, ALX. On October 15, 1990, those LIBOR notes were assigned to Unibank for $69,020,439. Exs. ALX, ALP (p. 3, "Other provisions:" para. 2), ALY, ALZ.

1107. Simultaneously with the assignment of the BOT LIBOR note to Unibank, Merrill and Unibank entered into a swap whereby Unibank was obligated to pay to Merrill a stream of payments which mirrored the payments Merrill was obligated to make under the hedge swaps with the LIBOR note issuers in exchange for payments based on an amortizing notional amount. Exs. ALP, AKO, AKW, AMC, ALE. The Unibank-Merrill swap was terminated on April 2, 1991. Ex. ALP. Simultaneously with the termination of the swap between Merrill and Unibank and the termination of the hedge swaps between Merrill and Fuji (Ex. AKO), between Merrill and Sumitomo (Ex. AKW), between Merrill and BOT (Ex. AME), and between Merrill and AIG (Ex. ALE), the Fuji, Sumitomo, BOT and AIG LIBOR notes issued to Oud Philipsburg were terminated. Exs. AMG, AMK, AML, AMM, AMN, AMO. Merrill acted as valuation agent upon the termination of the LIBOR notes. Exs. AMQ, AMS through AMV.

1108. Upon the termination of the Unibank-Merrill swap, the Norinchukin LIBOR note was assigned to BFCE. Exs. AMJ, AMW.

1109. Upon the commencement of the transactions related to the LIBOR notes issued to Oud Philipsburg, termed Swap Repo-6 by Unibank, Schickner informed his boss that it was his understanding that the transactions would be unwound in six months. Exs. ALR (page 2), ALP, ALV, AMA. The transactions Unibank called Swap Repo-6 were unwound within six months on April 2, 1991. Exs. ARZ, AMA; PF 1106, 1107.

E. SABA

1110. On February 28, 1990, Saba Partnership purchased $200 million of floating-rate notes with a put option due February 15, 1995, from Chase Manhattan which it sold on March 23, 1990 for cash in an amount equal to 80 percent of the par value of the notes and four LIBOR notes which matured in approximately five years. The two LIBOR notes issued by Fuji had a notional of $25,765,000 and the two LIBOR notes issued by Norinchukin had a notional of $25,720,000. Exs. ANV (Ex. A, p. 5), ANW, ANX, AOA, AOB.

1111. Simultaneously with the sale of the Chase floating-rate note to Norinchukin, Merrill and Norinchukin entered into an asset swap, whereby the payments received by Norinchukin on the Chase Note were swapped for a stream of payments on the same notional at a rate of LIBOR plus a step-up. Ex. ANY; PF 1110.

1112. Norinchukin and Merrill also entered into a hedge swap, with the same termination date as the maturity dates on the LIBOR notes, whereby Merrill was obligated to make payments to Norinchukin which mirrored the payments Norinchukin owed on the LIBOR notes issued to Saba, in exchange for Norinchukin's obligation to make payments on an amortizing notional amount at a rate of LIBOR - 25 basis points. The hedge swap was terminated early, on July 2, 1991. Ex. ANZ; PF 1110.

1113. Simultaneously with the sale of the Chase floating-rate notes tc Fuji, Merrill and Fuji entered into an asset swap, whereby the payments received by Fuji on the Chase floating-rate notes were swapped for a stream of payments on the same notional amount at a rate of LIBOR plus a step-up. Ex. AOC; PF 1110.

1114. Fuji and Merrill also entered into a hedge swap, with the same termination date as the maturity dates on the LIBOR notes, whereby Merrill was obligated to pay Fuji a stream of payments which mirrored the payments Fuji owed on the LIBOR notes issued to Saba. In exchange, Fuji was obligated to pay Merrill fixed payments and payments on an amortizing notional amount at a rate of LIBOR - 30 basis points. The hedge swap was terminated early, on January 2, 1991. Ex. AOD; PF 1110.

1115. On the date the private placements were sold by Saba for cash and LIBOR notes, ABN and Merrill entered into big and small swaps. Under the big swaps, which hedged the ABN controlled partner's interest in the LIBOR notes issued to Saba, ABN made payments to Merrill which mirrored 90% of the payments made on the LIBOR notes. Exs. AOG, AOA, AOB (Party B notional amount of $46,296,000 from Ex. AOG = 90% x $51,440,000, the combined notional of Fuji LIBOR notes from Exs. AOA, AOB (last pages)); Exs. AOE, ANW, ANX (Party B notional amount of $46,377,000 from Ex. AOE = 90% x $51,530,000, the combined notional of the Norinchukin LIBOR notes from Exs. ANW, ANX (last pages)); Tr. 1376, 1216-29; PF 1110. The small swaps notional was equal to the origination incurred upon the sale of the private placements, thus providing ABN with a return on that amount. Tr. 1376-77; Exs. AOK, AOF, AOH.

1116. On August 17, 1990, the ABN-Merrill swaps were revised such that both sides of the swap were reduced by 50 percent (Revision of Party A notional amount $17,367,473 - $868,373.65 July 2nd payment = $16,499,100 x 50% = $8,249,550; Revision of Party B notional amount $46,377,000 x 50% = $23,188,500). Exs. AOE, AOF, AOG, AOH. The swaps were amended because the foreign partner's percentage interest in the LIBOR notes held by Saba changed or the foreign partner reduced its interest in the Section 453 Partnership. Tr. 1216-17, 1218, 1222, 1375. On August 20, 1990, the ABN-Merrill swaps related to the Fuji LIBOR notes were terminated. Exs. AOG (particularly the last two pp.), AOH, AOA, AOB; PF 1115.

1117. The Fuji LIBOR notes and one of the Norinchukin LIBOR notes were assigned to Brunswick Corporation. On September 6, 1990, Brunswick assigned the three LIBOR notes to BOT in exchange for $26,601,451. Ex. AOI. Merrill and BOT simultaneously entered into a swap whereby BOT was obligated to make payments to Merrill mirroring the payments made to BOT on the assigned LIBOR notes, in exchange for payments based on an amortizing notional amount of $26,601,451. Ex. AOJ. The swap was terminated on January 2, 1991. Ex. AOJ (last two pp.).

1118. Simultaneously with the termination of the swap between Merrill and BOT and the termination of the hedge swap between Merrill and Fuji (Ex. AOD), the Fuji LIBOR notes were terminated. Simultaneously with the termination of the swap between Merrill and BOT, the Norinchukin LIBOR note was assigned to BFCE in return. for consideration of $7,510,040. Exs. AOD, AON, AOL.

1119. Upon the assignment of the Norinchukin LIBOR note to BFCE, Merrill entered into a hedge swap with BFCE, whereby BFCE paid to Merrill a stream of payments which mirrored the payments made to BFCE on the Norinchukin LIBOR note in exchange for payments based on an amortizing notional amount of $7,510,040. Ex. AOM. On July 2, 1991, and simultaneously with the termination of the hedge swap between Merrill and Norinchukin, the swap between BFCE and Merrill relating to the Norinchukin LIBOR note was terminated. Exs. AOM, AOD.

1120. By September 14, 1990, the ABN-Merrill swap related to the Norinchukin LIBOR notes had been reduced by an amount such that ABN was, at that time, hedging five percent of the total notional amount of the LIBOR notes. The swap was terminated on June 21, 1991, thus, by that time the foreign partner had no interest in the LIBOR notes issued to Saba. Exs. AOE (last two pages), AOF (last two pages); Tr. 1216-17, 1218, 1222, 1375.

F. ASA

1121. ASA was formed as a New York partnership consisting of four partners: Allied, Allied-Signal Investment Corporation, Dominguito Corporation N.V., and Barber Corporation N.V. Ex. AOX (Item 22). Dominguito Corporation N.V., a Netherlands Antilles corporation whose managing director was ABN Trust, was incorporated on April 18, 1990 and capitalized in the amount of $6,000. Ex. AOX (Item 33).

1122. ASA purchased $850 million in floating-rate private placement certificates of deposit on April 25, 1990 which, on May 17 and 24, 1990, it sold for cash in the amount of approximately eighty percent of the par value of the private placements plus LIBOR notes maturing in approximately five years. Exs. AOU, AOX, APB; Exs. APE, APF (asset and hedge swaps with BFCE relating to the sale of $50 million private placements).

1123. The private placements purchased by ASA matured in approximately five years and had shorter-term put options. Exs. AOU (e.g., Item 1, Ex. A, p. 5), AOX (Items 18 (p. 7), 19 (p. 7), 20 (p. 7), 21 (p. 7)).

1124. Simultaneously with the sale of the private placements by ASA, Merrill entered into hedge swaps with Mitsubishi, an issuer of LIBOR notes to ASA. The hedge swaps had the same termination date as the maturity dates on the LIBOR notes and were terminated early, by September 16, 1992. Exs. APA, APD, AOX, APB; PF 1122. Under the hedge swaps, Merrill was obligated to make payments which mirrored the payments Mitsubishi owed on the LIBOR notes issued to ASA. Exs. APA (Notional Amount Party A) and Ex. AOX (last page of LIBOR notes); Ex. APD (Notional Amount Party A) and Ex. APB (last page of LIBOR note).

1125. On the dates the private placements were sold by ASA for cash and LIBOR notes, ABN and Merrill entered into big and small swaps. Exs. AQF through AQK; PF 1122. Under the big swaps, which hedged the ABN controlled partners' interests in the LIBOR notes issued to ASA, ABN was obligated to make payments to Merrill which mirrored 90% of the payments to ASA on the LIBOR notes. Exs. AOX, AQF (Party B notional amount of $321,665,400 from Ex. AQF = 90% x $357,406,000, the combined notional of the May 17, 1990 Mitsubishi LIBOR notes from Ex. AOX (last pages of LIBOR notes); Exs. APB, AQH (Party B notional amount of $46,366,200 from Ex. AQH = 90% x $51,518,000, the notional of the May 24, 1990 Mitsubishi LIBOR notes from Ex. APB (last page of LIBOR note); Exs. AQG, APF (ABN-Merrill big swap and BFCE-Merrill hedge swap); Tr. 1376. The small swaps notional was equal to the origination incurred upon the sale of the private placements, thus providing ABN with a return on that amount. Tr. 1376-77. By August 22, 1990, the swaps between ABN and Merrill were terminated, thus the foreign partners in ASA no longer held an interest in the LIBOR notes issued to ASA. Exs. AQF through AQK; Tr. 1216-17, 1218, 1222, 1225-29, 1375.

1126. The May 17, 1990 LIBOR note (IPA VIII) issued by Mitsubishi to ASA and the May 29, 1990 LIBOR note issued by BFCE to ASA were assigned to Allied. Exs. APP, APR. On September 6, 1990, Pepe of Merrill arranged for Allied to assign the LIBOR notes to Unibank in exchange for $17,502,543. Exs. APR, APN, APO, APP.

1127. Simultaneously with the assignment of the LIBOR note to Unibank, Merrill and Unibank entered into a swap whereby Unibank was obligated to make payments to Merrill which mirrored the payments made to Unibank on the assigned LIBOR notes. In exchange, Unibank was obligated to make payments based on an amortizing notional amount of $17,502,543. Exs. APG, APR, AOX; PF 1126.

1128. The Unibank-Merrill hedge swap was terminated on May 31, 1991. Exs. APG (last three pp.), APR (UB000129-31). Simultaneously with the termination of the swap between Merrill and Unibank, the hedge swap between Merrill and Mitsubishi (Ex. APD) and the Mitsubishi LIBOR note were terminated. Exs. APX, APR (UB000129-30), APY. Merrill acted as valuation agent. Ex. APZ.

1129. The BFCE LIBOR note purchased by Unibank on September 6, 1990 was also terminated on May 31, 1991, simultaneously with the termination of the September 6, 1990 Unibank-Merrill swap and the termination of the BFCE-Merrill hedge swap. Exs. APS, APF, APG; PF 1126

1130. Near the commencement of the September 6, 1990 transactions, termed Swap Repo-5 by Unibank, Schickner understood the transactions were spurred by companies which wanted to accelerate the tax strategy to beat any adverse IRS tax ruling that might be forthcoming as a result of publicity and that the transactions in which Unibank participated would be unwound in six months. Exs. API, APR; Tr. 1698-99.

1131. Schickner, in February 1991, requested permission to rollover the transactions he called Swap Repo-5 until May 1991, informing his boss that it was his understanding that Merrill requested that Unibank rollover the transactions until May 31 because Merrill wanted to unwind its full Mitsubishi position on May 31, 1991. Ex. APK. Permission to extend the term until May 31, 1991 was given. Ex. APM.

1132. Merrill unwound its full Unibank-Mitsubishi position on May 31, 1991. Ex. APD; PF 1126-1128, 1133, 1134.

1133. The May 17, 1990 Mitsubishi LIBOR note IV issued to ASA was assigned to Allied. Ex. APU. On November 21, 1990, Merrill arranged for Allied to assign the LIBOR note IV to Unibank in exchange for $15,822,310. Ex. APV. Merrill and Unibank simultaneously entered into a swap whereby Unibank was obligated to make payments to Merrill which mirrored the payments made to Unibank on the assigned LIBOR notes. In exchange, Unibank was obligated to make payments based on an amortizing notional amount. Exs. AOX, APW. ⁶ The swap was terminated on May 31, 1991. Exs. APW (last three pp.), AQE (UB000485-86).

1134. Simultaneously with the termination of the swap between Merrill and Unibank, the hedge swap between Merrill and Mitsubishi (Ex. APD) and the Mitsubishi LIBOR note IV was terminated. Exs. APR (UB000485-86), APX, APY. Merrill acted as valuation agent. Ex. APZ.

1135. It was Schickner's understanding by November 16, 1990 that the November 21, 1990 set of transactions, termed Swap Repo-8 by Unibank, would be terminated on May 31, 1991, which it was. Exs. AQD, AQE, AQB; PF 1134.

G. BOCA

1136. Boca was formed as a New York partnership consisting of four partners: American Home Products Corporation, AHP Subsidiary (10) Corporation, Addiscombe Corporation N.V., and Syringa Corporation N.V. Ex. AQS. Addiscombe Corporation N.V., a Netherlands Antilles corporation whose managing director was ABN Trust, was incorporated on April 19, 1990 and capitalized in the amount of $6,000. Ex. AQR.

1137. Boca purchased $1.1 billion of private placement floating- rate certificates of deposit on May 1 and 2, 1990 which, on May 24 and 29, 1990, it sold for cash in the amount of approximately eighty percent of the par value of the private placements plus LIBOR notes maturing June 1995. Exs. AQT, AQU, AQV, AQW, ARC, ARF, ARK.

1138. The private placements purchased by Boca matured in approximately five years and had shorter-term put options. Exs. AQT (Ex. A, p. 5; Ex. B, p. 5), AQU (Item 2, p. 5, Item 3, p. 5), AQV (Item 2, p. 5).

1139. Simultaneously with the sale of the private placements by Boca, Merrill entered into hedge swaps with the issuers of the LIBOR notes to Boca. The hedge swaps had the same termination date as the LIBOR note maturity date, and were all terminated early, by March 1, 1991. Exs. ARB, ARE, ARH, ARJ, ARO. Under the hedge swaps Merrill was obligated to make payments which mirrored the payments the issuers owed on the LIBOR notes issued to Boca. Exs. AQW (last pages of LIBOR notes) and ARB; Exs. ARC (last page of LIBOR note) and ARE; Exs. ARK (last page of LIBOR notes) and ARO; PF 1137.

1140. On the dates the private placements were sold by Boca for cash and LIBOR notes, ABN and Merrill entered into big and small swaps. Exs. ASN through ASU; PF 1137. Under the big swaps, which hedged the ABN's controlled partner's interest in the LIBOR notes issued to Boca, ABN was obligated to make payments to Merrill which mirrored 90 percent of the known payments made on the LIBOR notes issued to Boca. Exs. ASO, ARC (Party B notional amount of $47,016,000 from Ex. ASO = 90% x $52,240,000, the notional of Sumitomo LIBOR notes from Ex. ARC (last page of LIBOR note)); Exs. ASP, ARK (Party B notional amount of $188,576,100 from Ex. ASP = 90% x $209,529,000 the combined notional of the May 29, 1990 LIBOR notes from Ex. ARK (last page of LIBOR notes)); Exs. ASQ, AQW (Party B notional amount of $237,780,000 from ASQ = 90% x $264,200,000, the combined notional of the May 24, 1990 LIBOR notes from Ex. AQW); Tr. 1376, 1216-29. The small swaps notional was equal to the foreign partners' interest in the origination incurred upon the sale of the private placements, thus providing ABN with a return on that amount. Tr. 1376-77. The swaps between ABN and Merrill were terminated on or about August 3, 1990, thus, by that time, the foreign partners in Boca no longer had an interest in the LIBOR notes issued to Boca. Exs. ASN through ASU; Tr. 1216-17, 1218, 1222, 1375.

1141. On August 3, 1990, the Mitsubishi, BFCE and Sumitomo LIBOR notes issued to Boca were assigned to AHP and AHP Subsidiary (10) Corporation Exs. ARP, ARQ.

1142. On October 23, 1990, BFCE LIBOR notes I and II, Mitsubishi LIBOR notes II and IIIB /7/, and the Sumitomo LIBOR note all issued to Boca and subsequently assigned, were assigned to Unibank for $89,684,185. Ex. ARX; PF 1141. Merrill and Unibank simultaneously entered into a swap whereby Unibank was obligated to make payments to Merrill which mirrored the payments made to Unibank on the assigned LIBOR notes, in exchange for payments based on an amortizing notional amount. Exs. ARZ, AQW, ARF. The swap was terminated on March 1, 1991. Ex. ARZ.

1143. Simultaneously with the termination of the swap between Merrill and Unibank and the termination of the hedge swaps between Merrill and Mitsubishi (Ex. ARB), between Merrill and BFCE (Exs. ARH, ARJ), and between Merrill and Sumitomo (Ex. ARE), Mitsubishi LIBOR notes II and IIIB, Sumitomo LIBOR note and BFCE LIBOR notes I and II were terminated. Exs. ASA, ABA, ABC, ASM. Merrill acted as valuation agent upon the termination of the LIBOR notes. Exs. ASD through ASG, ASM.

1144. Upon the commencement of the October 23, 1990 transaction, termed Swap Repo-7 by Unibank, Schickner informed his boss that it was his understanding that the transactions would be unwound in 6 months, on March 1, 1991. Exs. ASH, ASI (p. 2), ASL, ASM. The transactions termed Swap Repo-7 were unwound on March 1, 1991. PF 1142, 1143.

1145. On November 6, 1990, Merrill arranged for the assignment of the Mitsubishi LIBOR notes I and IIIA to BOT. Exs. ARR, ARS. Merrill and BOT simultaneously entered into a swap whereby BOT was obligated to make payments to Merrill which mirrored the payments made to BOT on the assigned LIBOR notes in exchange for payments based on an amortizing notional amount. Exs. ARU, ARV. The swap was terminated on March 1, 1991. Ex. ARV. Simultaneously with the termination of the swap between Merrill and BOT, the hedge swap between Merrill and Mitsubishi entered into upon the issuance of the LIBOR notes (Ex. ARB) and Mitsubishi LIBOR notes I and IIIA were terminated. Ex. ARW.

H. ZEELANDIA

1146. Zeelandia was formed as a New York partnership consisting of four partners: BFI, Inc., BFI, Ltd., L.P., Toekan Corporation, a Netherlands Antilles Corporation, and Damacor Corporation, a Netherlands Antilles Corporation. Exs. ATB (Item 10). BFI, Inc. and BFI, Ltd., L.P. were directly or indirectly owned by Borden. Ex. ATJ (Item 11). Toekan Corporation N.V., whose managing director was ABN Trust, was incorporated on April 10, 1990 and capitalized in the amount of $6,000. Ex. ATA (Item 12).

1147. Zeelandia purchased $500 million of private placement floating-rate certificates of deposit and notes on May 2 and 4, 1990 which on June 12, 14, and 15, 1990, were sold for cash in the amount of approximately eighty percent of the par value of the private placements plus LIBOR notes maturing July 1995. Exs. ATB, ATC, ATE, ATH, ATJ, ATM.

1148. The private placements purchased by Zeelandia matured in approximately five years and had shorter-term put options. Exs. ATB (p. 5), ATJ (Item 2).

1149. Simultaneously with the sale of the private placements by Zeelandia, Merrill entered into hedge swaps with the issuers of the LIBOR notes to Zeelandia. The hedge swaps had the same termination date as the LIBOR note maturity date and, with the exception of the hedge swap with one LIBOR note issuer (Cargill), were terminated on April 2, 1991. Exs. ATD, ATG, ATL (not terminated), ATO; PF 1147. The payments Merrill was obligated to make under the hedge swaps mirrored the known payments owed on the LIBOR notes issued to Zeelandia. Exs. ATC and ATD (Sumitomo); Exs. ATM, ATO (Mitsubishi).

1150. On the dates the private placements were sold by Zeelandia for cash and LIBOR notes, ABN and Merrill entered into big and small swaps. Exs. ATP through ATW; PF 1147. Under the big swaps, which hedged the ABN's controlled partner's interest in the LIBOR notes issued to zeelandia, ABN was obligated to make payments to Merrill mirroring 90% of the known payments made on the LIBOR notes to Zeelandia. Exs. ATC, ATP (Party B notional amount of $48,126,600 from Ex. ATP = 90% x $53,474,000, the notional of Sumitomo LIBOR notes from Ex. ATC (last page of LIBOR note)); Exs. ATM, ATR (Party B notional amount of $74,128,500 from Ex. ATR = 90% x $82,365,000 the combined notional of the Mitsubishi LIBOR notes from Ex. ATM (last page of LIBOR notes)); Tr. 1376 1216-1229. The small swaps notional was equal to the foreign partner's interest in the origination incurred upon the sale of the private placements, thus providing ABN with a return on that amount. Tr. 1376-77. With the exception of the ABN-Merrill swaps that related to the Cargill LIBOR notes (Exs. ATS, ATW), the swaps between ABN and Merrill were terminated on October 10, 1990. Exs. ATP, ATQ, ATR, ATT, ATU, ATV. The ABN-Merrill swaps that related to the Cargill LIBOR notes were, by October 10, 1990 reduced by approximately 84 percent. Exs. ATS, ATW. Thus, the foreign partners had less than a six percent interest in the Cargill LIBOR notes and no interest in the other LIBOR notes issued to Zeelandia. Exs. ATP through ATW; Tr. 1216-17, 1218, 1222, 1375.

1151. On November 13, 1990, Merrill and Fuji entered into a swap relating to the June 12, 1990 LIBOR notes issued by Sumitomo; the June 14, 1990 LIBOR notes issued by BFCE; and the June 15, 1990 LIBOR notes issued by Mitsubishi. Ex. ATX (p. 4 of first confirmation, "Other provisions:" para. 2). The payments Fuji was obligated to make to Merrill mirrored the payments Merrill was obligated to make under the hedge swaps between Merrill and Sumitomo, Merrill and BFCE, and Merrill and Mitsubishi, entered into upon the origination of the LIBOR notes. On April 2, 1991, all of the swaps were terminated. Exs. ATX, ATD, ATG, ATO.

I. MAARTEN INVESTERINGS

1152. Maarten Investerings Partnership was formed as a New York partnership consisting of four partners: Escorial Corporation N.V., Aldershot Corporation N.V., CPW Holdings Inc., and CPW Investments Ltd., L.P. Exs. AUJ (Item 5), AUN (Item 6). Aldershot Corporation N.V., a Netherlands Antilles corporation whose managing director was ABN Trust, was incorporated on March 29, 1990, and capitalized in the amount of $6,000. Exs. AUJ (Item 14), AUN (Item 18).

1153. Maarten purchased $700 million of private placement floating-rate certificate of deposits and notes on April 4, 1990 which, on May 3, 1990, June 22, 1990, and July 5, 1990, it sold for cash in the amount of approximately seventy-five percent of the par value of the private placements plus LIBOR notes maturing in approximately two years. Exs. AUD, AUE, AUG, AUJ, AUN.

1154. The private placements purchased by Maarten matured in approximately five years and had shorter-term put options. Exs. AUD (Ex. A p. 5), AUE (Ex. A pp. 5-6).

1155. Simultaneously with the sale of the private placements by Maarten, Merrill entered into hedge swaps with the issuers of the LIBOR notes to Maarten, which hedge swaps terminated on the maturity date of the LIBOR notes or in approximately two years. The payments Merrill was obligated to make under the hedge swaps mirrored the payments owed by the issuers of the LIBOR notes to Maarten. Exs. AUG, AUH, AUJ, AUL, AUN, AUO; PF 1153.

1156. On the dates the private placements were sold by Maarten for cash and LIBOR notes, ABE and Merrill entered into big and small swaps. Exs. AUP through AUV; PF 1153. Under the big swaps, which hedged the ABE's controlled partners' interest in the LIBOR notes issued to Maarten, ABE was obligated to make payments to Merrill which mirrored 85% of the payments owed on the LIBOR notes issued to Maarten. Exs. AUP, AUG (Party B notional amount of $486,268,000 from Ex. AUP = 85% x $572,080,000, the notional of Sumitomo LIBOR notes from Ex. AUG (last page of LIBOR note)); Exs. AUQ, AUJ (Party B notional amount of 124,599,800 from Ex. AUQ = 85% x $146,588,000 notional of the BOT LIBOR notes from Ex. AUJ (last page of LIBOR notes)); Exs. AUR, AUN (Party B notional amount of $130,279,500 from Ex. AUR = 85% of combined notional of July 5, 1990 Sumitomo LIBOR notes from Ex. AUN)); Tr. 1376, 1216-29. The small swaps notional was equal to the foreign partners' interest in the origination incurred upon the sale of the private placements, thus providing ABE with a return on that amount. Tr. 1376-77. Through revisions of the swaps, the first of which occurred on October 18, 1990, the notional amount of the ABN-Merrill swaps upon which ABE was making payments was reduced to four percent of the notional on the LIBOR notes issued to Maarten by November 19, 1991. Exs. AUP through AUV. Thus, the foreign partners in Maarten had less than a four percent interest in the LIBOR notes issued to Maarten. Exs. AUP through AUV, AUG, AUJ, AUN; Tr. 1216-17, 1218, 1222, 1375.

1157. On October 18, 1990, the notional amount of the ABN- Merrill swaps upon which ABN was obligated to make payments under the big swaps was reduced to 58 percent of the notional on the LIBOR notes issued to Maarten. Exs. AUP through AUR, AUG, AUJ, AUN.

1158. By confirmations dated November 28, 1990, Paramount entered into swaps with Merrill relating to the LIBOR notes held by Maarten which terminated simultaneously with the maturity of the LIBOR notes issued to Maarten. Exs. AUW, AUG, AUJ, AUN. The payments Paramount was obligated to make to Merrill under the swaps mirrored 42 percent of the payments made upon the LIBOR notes issued to Maarten. Exs. AUW, AUG, AUJ, AUN.

J. OTRABANDA

1159. Bartolo Corporation N.V., a Netherlands Antilles corporation whose managing director was ABN Trust, was incorporated on June 20, 1990, and capitalized in the amount of $6,000. Ex. AUZ (Items 10, 11). Bartolo acted as general partner of Otrabanda Partnership. Ex. AUZ (Item 10).

1160. Otrabanda purchased $100 million of private placement floating-rate certificates of deposit with put options on June 29, 1990 which, on July 27, 1990, it sold for cash in the amount of 80 percent of the par value of the private placements plus LIBOR notes maturing in August 1995. Exs. AUZ (Item 1, Ex. A, p. 5), AVB.

1161. Simultaneously with the sale of the private placements, Merrill entered into a hedge swap with the issuer of the LIBOR notes, which had the same termination date as the maturity date of the LIBOR notes. The hedge swap was terminated early, on August 1, 1991. Ex. AVC.

1162. On the dates the private placements were sold by Otrabanda for cash and LIBOR notes, ABN and Merrill entered into a big and a small swap. Exs. AVE, AVF; PF 1160. Under the big swap, which hedged the ABN controlled partner's interest in the LIBOR notes issued to Otrabanda, ABN was obligated to make payments to Merrill equal to 90 percent of the notional amount on which Merrill made payments under the hedge swap entered into with the issuer of the LIBOR notes. Exs. AVE, AVC; Tr. 1376. The small swaps notional was equal to the foreign partner's interest in the origination incurred upon the sale of the private placements, thus providing ABN with a return on that amount. Tr. 1376-77. The ABN-Merrill swaps were terminated on November 1, 1990. Exs. AVF, AVF. Thus, by November 1, 1990, the foreign partners in Otrabanda had no interest in the LIBOR notes issued to Otrabanda. Exs. AVE, AVF; Tr. 1216-17, 1218, 1222, 1375.

1163. On November 28, 1990, Merrill and BFCE entered into a swap relating to a July 27, 1990 LIBOR note issued to Otrabanda. Ex. AVD (p. 3 of first confirmation, "Other provisions:" para. 2). On August 1, 1991, simultaneously with the termination of the hedge swap entered into upon the issuance of the LIBOR note to Otrabanda, that swap was terminated. Exs. AVC, AVD.

1164. The notional amount on the November 28, 1990 BFCE-Unibank hedge swap was mathematically set, based upon the hedge swap entered into between Merrill and Sumitomo upon the issuance of the BFCE LIBOR note, to insure that Merrill could not lose money if the swaps were terminated by August 1, 1991, before the step-up increased from 30 basis points to 50 basis points. Exs. AVC, AVD, AZF (pp. 50-52 for formula).

XXXII. THE PATTERN OF EVENTS

1165. Taylor and Pepe, with the assistance of Merrill's fixed income desk, arranged for the Section 453 Partnerships to purchase private placements with a put option, from an issuer with a very strong credit rating. Generally, the private placements bore interest at a floating-rate. If not, the partnership entered into a swap converting the fixed-rate income stream from the private placement to floating-rate. PF 426, 1076, 1077, 1085-1087, 1100, 1101, 1110, 1122, 1123, 1137, 1138, 1147, 1148, 1153, 1154, 1160.

1166. Taylor and Pepe, with the assistance of Merrill fixed income sales personnel, arranged for the sale of over $5 billion of private placements for cash and LIBOR Notes by proposing hedge swaps with the issuer of the LIBOR Notes, converting the issuance of the LIBOR Notes into synthetic funding below LIBOR. Tr. 1380-81, 3130, 3145-46, 611-13, 623-24, 550-51 (Taylor describing Ex. 211-IQ, schematics reflecting a generic transaction (Tr. 548) from the perspective of the banks purchasing private placements for cash and LIBOR notes). PF 498, 513, 514, 523, 1076, 1077, 1085-1087, 1100, 1101, 1110, 1122, 1123, 1137, 1138, 1147, 1148, 1153, 1154, 1160.

1167. Every issuer of LIBOR notes entered into a hedge swap, analogous to the hedge swap between Merrill and BFCE in ACM Partnership. Tr. 1381, 1387.

1168. With four known exceptions, including the Maarten Investerings transactions, the hedge swaps arranged with issuers of LIBOR notes were terminated early and, at the latest, within two and one-half years. Exs. AFW, AFX, AGA, AGB, AGI through AGK, AHT, AHW, AHX, AIA, AIB, AIE, AIF, AIM, AIS, AIW, AKO, AKP, AKT, AKR, AKU, AKW, AKX, AKZ, ALB, ALC, ALE, ALF, ALH, ALI (672-676), ANX, ANZ, AOA, AOB, AOD, AOX, APA, APB, APD, APF, AQW, ARB, ARC, ARE, ARF, ARH, ARJ, ARK, ARO, ATC through ATE, ATG, ATH, ATL (not terminated), ATM, ATO, AVB, AVC, AVD, 207-ID (not terminated), 213-IZ, 284-MN; Ex. ACX (Preamble Fifth Stip.); PF 1167.

1169. Frequently, the purchasers of the private placements from Section 453 Partnerships also entered into an asset swap. Tr. 1381; Exs. AGB, AHU, AHV, AHY, AHZ, AIC, AID, AIT, AIU, AIV, AKP, AKS, AKY, ALA, AOY, AOZ, APC, APE, AQX through ARA, ARD, ARG, ARI, ARL through ARN, ATF, ATK, ATN, 206-IC, 214-JA; PF 1111, 1113. Such asset swaps may not have occurred when, for example, the private placement paid a LIBOR-based interest rate. Tr. 1381-82.

1170. In each of the Section 453 Partnerships, one or more foreign entities managed by ABN Trust or N.V. Fides acted as partners. Tr. 1374, 1213, 1224-28; PF 1056, 1062, 1063, 1074, 1084, 1099, 1121, 1136, 1146, 1152, 1159.

1171. Another investment banking house approached ABN to provide a foreign partner for a partnership that would invest in LIBOR notes. ABN declined to work with another investment banking house because of a confidentiality agreement between ABN Trust and Merrill. Tr. 1229- 30.

1172. Den Baas was responsible for hedging, if necessary, the ABN controlled entities' interest in investments held by the Section 453 Partnerships. Tr. 1214.

1173. There were no interest rate swaps between ABN and the foreign partners or ABN and Merrill with respect to the first Section 453 Partnership, Nieuw Willemstad Partnership. Tr. 1213, 1215-16, 1224-26, 1407.

1174. ABN used Treasuries to hedge the foreign partner's interest in the LIBOR notes held by Nieuw Willemstad, however, because the LIBOR notes were very volatile, Treasuries were not an effective hedge. Tr. 1226.

1175. In the other Section 453 Partnerships, den Baas arranged for hedge swaps between ABN and Merrill that mirrored swaps between the foreign partners and ABN. Tr. 1201, 1216, 1374, 1226; Exs. AGM through AGR, AJV through AKG, ANB through ANO, AOG, AOH, AQF through AQK, ASN through ASU, ATP through ATW, AUP through AUV.

1176. In each of the Section 453 Partnerships except Nieuw Willemstad, there were two swaps between Merrill and ABN, a big swap and a small or one-sided swap, which related to the foreign partners' percentage interest in the LIBOR notes held by the partnership. Tr. 1216-17, 1374-76; PF 1079, 1091, 1105, 1115, 1125, 1140, 1150, 1155, 1162.

1177. The small swaps were generally based upon the pro rata share that the foreign partner would have in the private placement friction. Tr. 1376-77.

1178. The small swap, providing ABN with a return on the origination, was expected by ABN. Tr. 1219. No counterparty, other than Merrill, would give ABN such a return. Tr. 1210.

1179. The two swaps between Merrill and ABN were both amended when the foreign partner's percentage interest in the LIBOR notes held by the partnership changed or the foreign partner reduced its interest in the Section 453 Partnership. Tr. 1215-17, 1222, 1375; PF 1176.

1180. The foreign partners originally held a majority interest in the partnerships, which was reduced to zero within about a two year or shorter period of time. Tr. 1222, 1229, 1390-91; PF 1079, 1091, 1105, 1115, 1116, 1120, 1125, 1140, 1150, 1155, 1162.

1181. In all but two instances, the ABN-Merrill hedge swaps relating to the foreign partners' interest in LIBOR notes held by Section 453 Partnerships were terminated within two years (plus two days with respect to the ACM Partnership). Of that group, the ABN- Merrill hedge swaps relating to the foreign partners' interest in LIBOR Notes were terminated in less than seven months. PF 1079, 1091, 1105, 1115, 1116, 1120, 1125, 1140, 1150 (one set not terminated- decreased to six percent), 1155 (not terminated-decreased to four percent), 1162, 759, 762, 764, 767.

1182. Often, the LIBOR notes were distributed by the Section 453 Partnerships. Tr. 1229, 1391; PF 1062, 1066, 1071, 1080, 1093, 1117, 1126, 1133, 1141.

1183. Where the LIBOR notes were distributed by the Section 453 Partnerships to a partner and then sold, the seller was the U.S. corporate partner or its affiliate. Tr. 1391, PF 1062, 1066, 1071, 1093, 1117, 1126, 1133, 1141, 1142, 1145.

1184. Pepe recalled no instance where the LIBOR notes were sold by a Section 453 Partnership while the foreign partner held a majority interest in the Section 453 Partnership. Tr. 1391-92.

1185. Upon the sale of the LIBOR notes, members of Taylor's group generally arranged hedge swaps with the purchasers of the LIBOR notes, which converted the LIBOR note to a synthetic asset paying a margin over LIBOR. Tr. 1383, 1386, 1389; Tr. 768, 771-72 (Taylor explaining Ex. AEZ, schematics used to explain the transaction to potential purchasers of LIBOR notes, such as Unibank (Stip. paragraph 447); Ex. AFF (p. 1, last paragraph); PF 1066, 1072, 1080, 1081, 1082, 1093, 1094, 1106, 1107, 1117, 1119, 1126, 1127, 1133, 1142, 1145, 1151, 1163.

1186. Many of the LIBOR notes were sold to Unibank. Pepe and Reiser arranged for the purchase of LIBOR notes by Unibank. Tr. 1394; PF 1066, 1072, 1093, 1094.

1187. Transactions termed Swap Repos by Unibank, entered into between Unibank and Merrill and Unibank and corporations relating to LIBOR Notes from Section 453 Partnerships, were similar to the transaction Schickner called the BFCE Swap Repo, the purchase by Unibank of the BFCE LIBOR Notes and hedge swap between Unibank and Merrill. Tr. 1694, 1696-97; Exs. AJE, API; PF 1066, 1068, 1072, 1093, 1094, 1096, 1106, 1107, 1126, 1127, 1133, 1142.

1188. Unibank purchased over $400 million of LIBOR notes during the period in issue. Stip. paragraph 187; Exs. UW; AFI through AFK, ADW through ADY (Swap Repos 1 and 2); AFL, AEV, AEX (Swap Repo-3); AJA through AJC, AJI, AJL (Swap Repo-4); APK, APO, APP (Swap Repo-5); ALV, AMA (Swap Repo-6); ARZ, ARK (Swap Repo-7); APW, APU (Swap Repo- 8).

1189. All of the Swap Repo transactions that Unibank entered into were liquidated within a three to nine month period consistent with Unibank's understanding. Tr. 1696-97; Exs. AJE, API; PF 1066, 1068, 1069, 1072, 1073, 1093, 1094, 1095, 1097, 1098, 1106, 1107, 1109, 1126, 1135, 1142-1144, 1188.

1190. In all of the transactions Unibank called Swap Repos, Merrill had the right to cancel the swaps and direct the sale of the LIBOR note. Exs. UW, ADY, ADZ, AEA, AED, AEX, AJA, AJB, ALP, APG, APW, ARZ. In all of the transactions Unibank called Swap Repos, Merrill acted as valuation agent and initiated the termination of the transactions. Tr. 1709; PF 1188, 1189.

1191. In August of 1990, based on his discussions with Merrill, Schickner believed that Merrill had a total of $200 to $300 million in transactions he termed Swap Repos in the pipeline for the Fall. Tr. 1698-99; Ex. API.

1192. Subsequently, Unibank purchased LIBOR Notes for approximately $175 million and engaged in swaps upon the purchase of those notes. Exs. ARZ, ARK, APW, APU, AMA, ALV; PF 1106, 1107, 1133, 1134, 1142, 1143.

1193. Pepe was aware of one Section 452 Partnership where the LIBOR notes were held to maturity. Tr. 1424.

1194. In Maarten Investerings Partnership, the term of the LIBOR notes was approximately two years. Exs. AUG, AUN; PF 1153.

XXXIII. PROCEDURAL MATTERS

1195. ACM, formerly known as CAM Partnership, filed a Form 1065 U.S. Partnership Return of Income for each of the tax years ended November 30, 1989, November 30, 1990, November 30, 1991, and December 31, 1991. Stip. paragraph 1.

1196. By Notice of Final Partnership Administrative Adjustment ("FPAA"), timely issued on March 12, 1993, Respondent determined adjustments to ACM returns as shown on the Schedules of Adjustments included in the FPAA and as described in the Explanation of Adjustments included in the FPAA. Stip. paragraph 2.

1197. On May 24, 1993, SH filed a timely petition in this Court. At that time, ACM's principal place of business was Wilmington, Delaware. Stip. paragraph 3.

RESPONDENT'S ULTIMATE FINDINGS OF FACT

1198. ACM was designed to exploit the contingent installment sale transaction regulations. Entire Record.

1199. There was an agreement among KNX, SH and Merrill that KNX would exit or reduce its interest in ACM earlier than provided for under the Partnership Agreement, and within time for CP to recognize the capital loss necessary to offset the Kendall capital gain. Tr. 1046-8; Ex. 137-ET; Entire Record.

1200. The parties structured the form of the ACM transaction for tax benefits and deliberately abstained from written, formal commitments regarding the actual economics of the deal, in an attempt to give substance to transactions that had none. Entire Record.

1201. The metamorphosis of Merrill's proposal from an "investment partnership" to a "liability management partnership" was a failed attempt to substantiate a "business purpose" for the installment sale transactions within CP's investment partnership. Entire Record.

1202. CP committed to the ACM transactions in the latter part of September 1989. Entire Record.

1203. Pohlschroeder's October 3, 1989 memorandum, the October 12, 1989 CP Board meeting minutes, and the November 8, 1989 CP finance committee minutes comprise the principal contemporaneous documentation regarding CP's purported business goals for participating in ACM; all three were prepared with the objective of documenting a business purpose for ACM transactions that had none. Entire Record.

1204. The non-tax impact of ACM on CP's ostensible liability management goals was de minimis in both size and impact when compared with CP's overall financial structure and debt management activities. Entire Record.

1205. The amount of profit that CP could have realized from the ACM transactions, even under the most favorable conditions, was de minimis when compared with the size of the tax deductions CP derived through ACM. Entire Record.

1206. KNX participated in ACM solely to accommodate CP's tax planning needs and not to share the risks and rewards of the ACM venture. Entire Record.

1207. KNX did not want to share in the credit risk attributable to the CP debt. Entire Record.

1208. The Preferred Income Allocation compensated KNX for any potential loss it could bear from an increased credit risk attributable to the CP debt to be held by ACM. Entire Record.

1209. The Quality Component wholly limited KNX's ability to share in any upside value from CP debt attributable to changes in. CP's credit. Entire Record.

1210. Through its CP debt swaps, KNX sought and became economically indifferent to changes in the value of the CP debt that might result from changes in interest rates. Entire Record.

1211. Through its hedge swaps with ABN, and ABN's hedge swaps with Merrill, KNX and ABN sought and became economically indifferent to changes in the value of the LIBOR Notes and limited their exposure to the contingencies associated with those notes. Entire Record.

1212. Structuring the Citicorp Notes as floating-rate notes with a put option protected KNX from any interest rate risk or credit risk (short of default) with respect to the Citicorp Notes. Entire Record.

1213. The Partnership's valuation methodology, as well as the structure of the Citicorp Notes, wholly limited KNX's ability to share in any upside potential from ACM's holding of the Citicorp Notes. Entire Record.

1214. Other than default risk, the risk of a lender, KNX bore no significant risks from its ACM participation. Entire Record.

1215. As a result of the structured transaction in which KNX engaged, KNX sought to and did wholly limit rewards from its participation in ACM. Entire Record.

1216. The CP debt purchased by ACM in 1989 was identified and available for purchase prior to the purchase of the Citicorp Notes. Entire Record.

1217. The purchase of the Met Note contradicted CP's liability management goals, financial objectives, and was a poor economic move. Entire Record.

1218. ACM purchased the Citicorp Notes solely for tax purposes. Entire Record.

1219. At the time ACM purchased the Citicorp Notes it was set that they would be sold by the end of ACM's claimed November 30, 1989 tax year. Entire Record.

1220. The Citicorp Notes would be and were sold at a loss. Entire Record.

1221. The costs or discount incurred upon the sale of the Citicorp Notes were attributable to originating the LIBOR Notes. Entire Record.

1222. The installment sale gain incurred upon the sale of the Citicorp Notes could not have had and did not have any real economic effect on the ACM participants. Entire Record.

1223. The LIBOR Notes were neither a traditional nor a financially astute choice as a hedge but rather were an extremely poor and expensive hedge, despite being recommended and obtained by sophisticated and financially astute individuals. Entire Record.

1224. The purpose for the LIBOR Notes was contrived in an attempt to substantiate a "business purpose" for ACM holding them. Entire Record.

1225. ACM sold the Citicorp Notes for cash and LIBOR Notes solely for tax purposes. Entire Record.

1226. The purchase and sale of the Citicorp Notes bore no relationship to the liability management goals or aspects of ACM Partnership. Entire Record.

1227. KNX would be and was protected from bearing any costs attributable to the origination and sale of the LIBOR Notes. Entire Record.

1228. By the arrangement protecting KNX from sharing costs and the one-sided or Small Swaps, KNX effectively sold the Citicorp Notes at par as ABN understood KNX would. Entire Record.

1229. Conditions in the credit advices from NACC and RMD were ABN's conditions for KNX's participation in ACM. Entire Record.

1230. ACM distributed and SH sold the BFCE LIBOR Notes solely to generate a capital loss in 1989 to offset SH's share of the installment sale gain and generate tax benefits to cover its out-of- pocket transaction costs. Entire Record.

1231. The partial purchase of KNX's interest in June of 1991, and subsequent redemption of KNX in 1991, bore no relationship to any of CP's liability management goals and were done solely for tax purposes. Tr. 148-49; Entire Record.

1232. ACM sold the BOT LIBOR Notes in December 1991 solely to generate a capital loss to offset CP's gain from the 1988 sale of Kendall. Entire Record.

1233. The timing of the ACM transactions was driven by the tax benefits to be obtained and bore no relationship to liability management goals or market forces. Entire Record.

1234. The fees paid by CP for the ACM transactions were paid for tax benefits. Entire Record.

1235. Through fees (termed origination and remarketing costs) borne by SH and CP and effectively paid to Merrill through swaps, Merrill had the financial wherewithal and incentive to, and did, create and sell the LIBOR Notes in accordance with the tax needs of its client. Entire Record.

1236. In order to deliver on representations it made to its clients and in return for fees, Merrill created a sham LIBOR note market with swaps. LIBOR notes issued in over five billion dollars of installment sale transactions were created to generate tax benefits and unwound once tax benefits were obtained. Entire Record.

1237. The purchase and sale of the Citicorp Notes by ACM (or at least the resale on a contingent installment sale basis) were prearranged sham transactions, devoid of the economic substance necessary for recognition for federal income tax purposes. Entire Record.

1238. If it is determined that the purchase and sale of the Citicorp Notes had substance, the allocation of the installment sale gain lacked substantial economic effect under section 704(b) and the installment sale gain should be allocated to Southampton and MLCS in accordance with their interests in the Partnership. Entire Record.

1239. Kannex was a not a partner in ACM but was, in substance, a lender who made a loan and not a capital contribution. Entire Record.

1240. The ACM transactions were part of a plan, consisting of certain unnecessary and meaningless transactions, which were focused only on the intended tax result. Entire Record.

1241. The transactions purportedly financing the purchase and sale of the Citicorp Notes were prearranged sham transactions, devoid of the economic substance necessary for recognition for federal income tax purposes. Entire Record.

POINTS RELIED UPON

[3] KNX became a partner in ACM to accommodate a transaction structured by Merrill to provide tax benefits to CP. Upon the formation of ACM, but outside the written partnership agreement, Merrill, CP and KNX intended and agreed that KNX would leave the Partnership or become a minority partner within time for CP to recognize the capital loss which would offset the Kendall gain. While cleverly structured and documented, the transaction lacks economic substance because it deviated from its apparent form.

[4] Promoting a structured transaction in steps, Merrill tailored a "business purpose" for the Partnership as well as the tax assets, the LIBOR Notes. For a $1.745 million fee from CP, Merrill arranged for ABN to finance ACM. ABN agreed in return for an opportunity to enhance ABN's relationship with CP by providing "something extra", the tax benefits. To accommodate the form of the transaction, KNX contributed $169.4 million to ACM but then reverse engineered out of all interest rate risks and rewards by hedging, as precisely as possible. To eliminate its credit risk in the CP debt held by ACM, KNX demanded a "me first" payment of $1.241 million a year.

[5] KNX agreed to purchase the floating rate notes because they were structured to trade at par. The put option provided additional security, in the event of any conceivable credit risk. Further, KNX would not agree to an installment sale unless it was at par. The Citicorp Notes were sold at a loss of $1,093,750, termed "origination." But by designed partnership accounting, adding the origination to the LIBOR Notes to put them at a value at which they could never be sold, the loss was borne solely by CP. Through a one- sided swap [which appears to be an oxymoron] from Merrill through ABN, KNX received a return on the origination costs, which precisely compensated KNX for its lost opportunity costs. KNX sought and was exposed to minimal risks or rewards from its ACM participation, and was always flexible to the tax angle needs. At the end of the day, after paying off its ABN loan and swap fees, KNX was back to zero, where it began. KNX's ACM participation was consistent with that of a lender.

[6] CP put aside any legitimate liability management goals if tax benefits were at stake. The Citicorp Notes had to be purchased and sold, and the LIBOR Notes distributed before the end of 1989. By 1991, KNX had to be bought out and the LIBOR Notes sold. Purchases of CP debt were delayed, alleged hedging ratios were ignored, and KNX was bought out before ACM had any measurable effect on CP's claimed goals. The bulk of the CP debt purchased, the $100 million Met Note, was a bad economic move by CP. Transaction timing was critical and of overriding importance for the tax benefits Petitioner's "liability management" partnership was designed around.

[7] The transaction costs CP paid for the creation and sale of the LIBOR Notes were funneled to Merrill through swaps, which, from the perspective of the third parties, synthesized the contingencies of the LIBOR Notes. Through these origination and friction costs it received, Merrill was able to control the LIBOR note market and deliver on the representations it made. Merrill created and then unwound LIBOR notes once its clients' tax benefits were obtained, as all the third parties understood that Merrill would.

[8] While the LIBOR Notes were purportedly a hedge of ACM's CP debt, KNX would have no part of such an inefficient hedge. Through ABN, KNX swapped its interest in the LIBOR Note payments with Merrill, for an amortizing stream of fixed payments that bore none of the LIBOR Notes' contingencies. Merrill then hedged the swap payments it received from KNX, against swap payments made to the issuers of the LIBOR Notes. Economically, Merrill was the middleman in a circle of 82.63 percent of the LIBOR Note payments which created $110 million of phantom tax loss.

[9] While deliberately eschewing written commitments, the partners' underlying agreement was that tax-neutral KNX would be allocated the installment sale gain but would exit ACM within time for CP to realize the loss. KNX would bear no costs or contingencies associated with the installment sale. The LIBOR Notes' sales were fixed, through fees CP paid to generate tax benefits, capital loss to carryback to offset the Kendall gain. That loss and the phantom gain had no economic effect -- they equalled zero. That was a focal point of the deal Merrill sold. Further, if the tax-neutral KNX could be made risk free, then CP could claim the loss. The facts show there was no economic substance to the installment sale transactions Merrill structured for CP's "investment partnership."

ARGUMENT

I THE ACM TRANSACTIONS LACKED ECONOMIC SUBSTANCE

A. THE STRUCTURE OF ACM WAS A SHAM

[10] As an extreme position but without conceding the lack of business purpose, Petitioner argues that to be respected for tax purposes, a transaction need not have a business purpose if the transaction has risk and profit potential. Petitioner thus focuses on the "liability management" aspects of ACM Partnership in attempting to show that ACM transactions had substance.

[11] Before considering the facts in the context of the two- prong test of Rice's Toyota World v. Commissioner, 752 F.2d 89, 91 (4th Cir. 1985), and the subsequent tax-independent purpose mandate of Sheldon v. Commissioner, 94 T.C. 738, 767-69 (1990), the economic substance inquiry articulated by Judge Learned Hand should be considered:

The question always is whether the transaction under scrutiny is

[12] Applying Judge Hand's logic to the situation we confront today, Petitioner's approach must fail. Without even analyzing the sophisticated financial terms of the Partnership Agreement or the parties, subjective motivations, the fundamental structure of the ACM transactions was a sham. The Partnership Agreement held out to embody the terms of the deal did not reflect the agreed term that made the deal worthwhile to CP -- that KNX would reduce its interest in time for CP to use the phantom capital loss to offset the Kendall gain.

[13] Two of the three principals effectively admitted to an arrangement outside the terms of the ACM Partnership Agreement. De Beer, who controlled the majority interest partner, specifically told the Court that there was an agreement that KNX would reduce its interest, to a minority participation, prior to the February 28, 1992 date KNX could elect to redeem its interest according to the Partnership Agreement. (PF 372-374). Heidtke also was aware of the "defined duration" of the deal relating to the "tax dynamics." (Tr. 177). CP's understanding of the two year term of the deal was further laid out in the uncannily accurate description of its steps, prepared by CP's accountant: KNX would be redeemed by October of 1991, and at the end of that year, CP would realize the capital loss. (PF 114).

[14] Although Taylor, the primary Merrill representative, indicated that he could be fired or fined by the SEC for agreeing to such an arrangement (Tr. 637, 677), he certainly planned and anticipated the timing. From the time he presented the investment partnership concept to CP in May of 1989, he sold the deal by showing the tax-neutral partner leaving the partnership within two years. (PF 55, 99). Moreover, as a representative of Merrill Lynch, which took pride in and earned handsome fees through its ability to deliver on deals it planned, it was in Taylor's interest for the transaction to work as he represented. As the MLCS Partnership Representative, he would hardly object to the result he had sold.

[15] The intent and purpose of the ACM transactions contradict the apparent transactions: From the outset, KNX's interest in ACM was transitory, held only to accommodate CP's requested form. The ACM transactions lacked economic substance because they were not in fact what they appeared to be in form. Chisholm, 79 F.2d at 15-16.

B. THE INSTALLMENT SALE TRANSACTIONS WERE PREARRANGED AND STRUCTURED

[17] The investment partnership Merrill marketed to CP in May of 1989, could be tailored to any client's needs. (Tr. 823). Whatever interests the clients had, Merrill would modify the financial assets in which the partnership would invest to meet those demands. Only the private placement and LIBOR Notes were necessary for the tax scheme. Moreover, the deal provided flexibility because those assets did not need to be held for long. Whenever the client wanted a loss, Merrill would sell the LIBOR notes.

[18] CP's cash investments were being handled by J.P. Morgan, but Pohlschroeder was tempted by Merrill's proposal which offered the opportunity to accomplish what he failed to do when Kendall was sold -- to shelter the $105 million Kendall capital gain. (PF 36-39). Pohlschroeder discussed the tax aspects of Merrill's proposal with Belasco, who expressed reservations regarding the form. (PF 62-64, 65).

[19] Subsequently, Taylor and Pohlschroeder discussed an investment partnership which would invest not in assets, but in liabilities. According to the notes of Pohlschroeder's phone conversation with Taylor, the "investment partnership" would have business purpose -- investing in "your own debt." Moreover, Merrill would ensure that "every single step" of the transaction was "substantiated." (PF 72, 74). Just as Merrill promoted the deal, the tax steps of the investment partnership were featured, then Taylor helped fashion the "business purpose." (PF 48, 56).

a. THE CITICORP NOTES WERE PURCHASED AND SOLD SOLELY FOR

[21] Citicorp was approached by Merrill to issue the Notes in mid-October. Although SH's attorneys began preparing to purchase the Citicorp Notes before ACM was even formed, the Notes were not a typical liquid, short-term investment, even by the Partnership's own investment guidelines. Those guidelines, adopted subsequent to the purchase of the Citicorp Notes, limited securities issued by a non- governmental entity to five percent of ACM's portfolio. (PF 416-17). Nevertheless, Petitioner claims that ACM parked all its cash in the unregistered Citicorp Notes to maximize ACM's investment return, while CP debt was identified for purchase.

[22] Putting aside the conflicting testimony regarding whether the Citicorp Notes yielded even a market return (PF 458-464), CP never investigated whether the Notes maximized ACM's return. Taylor provided Pohlschroeder with estimated transaction costs which would be incurred by SH upon the sale of the Citicorp Notes. In hindsight, those transaction costs were a reasonably accurate estimate. (PF 519). Pohlschroeder, however, never compared those transaction costs to transaction costs which would be incurred on alternative investments. Indeed, Pohlschroeder never even computed the after-cost yield on the Citicorp Notes, despite understanding that SH alone would bear all of the transaction costs. (PF 404, 452, 453, 575).

[23] Approximately six days after ACM purchased the Citicorp Notes, Merrill requested that BOT commit to purchasing those Notes from ACM. (PF 527). Both Citicorp Note purchasers, BOT and BFCE, had been solicited before ACM was even formed. Merrill's request for BOT's commitment occurred prior to the Partnership's purchase of the Met Notes, prior to the meeting between Met Life and ACM in Bermuda, and prior to any indication in the record that the purchase of the Euro Notes and Long Bonds had been arranged.

[24] Notwithstanding Petitioner's claim that the period of time ACM would hold the Citicorp Notes was uncertain, the cash flows show that the Citicorp Notes would be sold in quarter "zero" or by the end of November, as Taylor assumed. (PF 88, 429; Ex. 81-CB (p. 6)). ABN understood that the Citicorp Notes would be sold by November 29, 1989, prior to the end of ACM's first November 30 fiscal year. (PF 246). In a previous Section 453 Partnership transaction, Merrill had purchased private placement notes itself when it could not find a LIBOR note issuer to accommodate its client's timing needs. (PF 1064- 65.) The holding period for the Notes would be short. Thus, the claim that the Citicorp Notes maximized ACM's return was grossly exaggerated -- any potential increased return would be de minimis.

[25] Based on probabilities that Citicorp's credit would increase and the transaction costs paid upon the sale, Petitioner's expert Beder claimed there was a 32.70 percent likelihood that the Citicorp Notes would be sold at some profit on November 27, 1989. ⁸ (Ex. 519, Tables, pp. 12-13). Of course, if Citicorp' B credit quality did not increase during the holding period, there would be a loss. (PF 454, 575). See Arg. II B.1.a., infra. In addition, the amount of any profit is inconsequential in Beder's probability analysis -- in her theory, one dollar would do.

[26] For purposes of her probability analysis, Beder assumed transaction costs equal to a 5/8 spread, the origination costs incurred upon the Citicorp Note sale. Thus, Beder's transaction costs estimate does not include the transaction costs SH paid Merrill for finding the Citicorp Notes, included in Merrill's $1.745 million arrangement fee, or the significant legal fees SH paid to draft the private placement documentation required. (PF 385, 387). Nor does it take into account that SH would bear all the origination costs. See Arg. II B.3., infra. Nevertheless, even if Beder's estimates were correct, a de minimis profit, on a $205 million investment, does not justify the substance of the transaction. Sheldon, 94 T.C. at 768 (nominal profit, insignificant in comparison with the claimed deductions, did not justify the substance of the transaction); Krumhorn v. Commissioner, 103 T.C. 29, 53-55 (1994) ("[T]he fact that the entire transaction produce a nominal net gain will not impute substance into an otherwise sham transaction.").

[27] In fact, there was no gain. (PF 567). ACM deliberately took a first year economic loss on the sale of the Citicorp Notes to generate future and substantial phantom tax losses. ACM's subsequent attempt to hide the loss from the IRS corroborates Respondent's view that the installment sale had no substance. See Arg. III A.3.b., infra.

b. THE SOLE PURPOSE FOR THE LIBOR NOTES WAS TO GENERATE TAX

[29] Taylor realized that den Baas would hedge KNX's risks from the CP debt outside the Partnership structure. He told Yordan, prior to ACM's formation, that KNX agreed to take the Yield Component allocation because ABN intended to enter into hedge transactions to neutralize the CP debt interest rate risk. (PF 732, 735). Thus, despite the fact that the 83 percent partner had no economic reason for holding the LIBOR Notes -- it did not need two hedges -- Merrill sold the Partnership a hedge.

[30] ACM's purpose for the LIBOR Notes was concocted. The LIBOR Notes' substantive hedging effect is equally contrived.

[31] Den Baas, a sophisticated player in this deal, refused to use the LIBOR Notes to hedge KNX's interest in the CP debt. (PF 701). He considered the LIBOR Notes no more than a rough hedge of the CP debt because the term structures of the instruments were different. Because there is little correlation between long-term and short-term interest rates, the LIBOR Notes were a very ineffective and inefficient hedge of the longer maturity CP debt. (PF 705).

[32] The analyses of the hedging effect of the LIBOR Notes that Merrill provided CP were based on the assumption that there was only one interest rate in the whole economy. That, in itself, makes them suspect. The analyses of Merrill and its consultant, Petitioner's expert Capital Markets Risk Advisors, Inc., also erroneously assumed there is perfect correlation among all rates of interest whatever the term. But the yield curve rarely makes parallel shifts. (PF 721-23). As the experts all acknowledged, the yield curve shifts, twists and rotates: The shorter-term rate of interest that causes value changes in the LIBOR Notes and the longer-term rate of interest that causes value changes in CP Debt exhibit independent behavior. (PF 707). There is no substantive economic purpose for hedging CP debt with LIBOR Notes. (PF 702-08, 711, 714).

[33] No specific hedging goal was ever spelled out in the pre- formation memoranda. Moreover, ACM never adjusted its LIBOR Note holdings consistently with any desired economic effect. The amount of LIBOR Notes held by ACM was adjusted once during KNX's participation, in December of 1989, as Merrill had suggested during the promotion of the deal. (PF 612). The tax result was that SH completely offset its share of the phantom gain generated on the installment sale and realized tax benefits sufficient to recover its out-of-pocket transaction costs. (PF 647, 412).

[34] Economically, the December 1989 adjustment to the LIBOR Notes held by ACM decreased SH's ability to hedge against interest rate risk, an alleged benefit to the financial structure of the deal. According to Singleton, the LIBOR Notes permitted SH to lower its exposure to the interest rate (Yield Component) risk within ACM by shifting the range of interest rate exposures that SH could potentially face with respect to the CP debt towards zero. As a result, SH could effect pure exposure to the Quality (or credit) Component of acquired CP debt in its alleged attempt to profit from the narrowing of the CP credit spread. However, if that were the goal, then why did SH limit its flexibility to achieve zero exposure to interest rate risk (and thus pure exposure to the Quality Component), so soon after the Partnership began? (PF 626-637).

[35] The purported rationale for distributing the LIBOR Notes was attributed to Taylor by the minutes of the third partnership meeting:

[T]he debt exchange [of $4.7 million principal amount of

[36] Taylor's last comment is disingenuous and likely the reason he could not explain what he meant at the trial. (PF 621). As discussed above, Taylor realized that KNX was not using the LIBOR Notes to hedge CP debt. The reason KNX agreed to the allocation of the Yield Component was because den Baas could neutralize CP debt interest rate risk. (PF 362). Moreover, by at least this time, Taylor also believed KNX was hedging its interest in the LIBOR Notes very precisely, through the Big Swap he had arranged between Merrill and ABN. (Tr. 783-84; PF 759-66).

[37] As a result of KNX's hedges, the reduction in the alleged hedge provided by the LIBOR Notes hardly affected KNX -- but the reason had nothing to do with SH's election to adjust the Yield Component. The reduction in the LIBOR Notes ACM held was reflected in an amendment to the MLCS-ABN swaps. The change in the Yield Component allocation was reflected in the CP debt swaps. See Arg. II B.1.c.ii., infra.

[38] At the third Partnership meeting, Taylor also discussed the options of selling the LIBOR Notes to a third party or partners, or distributing the LIBOR Notes as a return of capital. Taylor opined that "[i]n order to effect the transaction efficiently," the Partnership should not sell the LIBOR Notes to a third party. (Ex. 165-EX). By this time, however, Merrill had already arranged for Unibank to purchase the LIBOR Notes: Unibank requested credit approval for the transaction a week prior to the LIBOR Notes' distribution to SH. (PF 667). Thus, the reason a sale of the LIBOR Notes by the Partnership would be inefficient, is lost. The "option" chosen, of course, was the only one of these "options" that was an identified step in Merrill's September 20, 1989 "Presentation to Colgate Palmolive."

[39] Moreover, by December 12, 1989, the date of the third Partnership meeting, ABN had begun syndicating its loan to KNX. ABN represented to third party banks, as early as December 5, 1989, that the only LIBOR Notes in which KNX had an interest were the BOT LIBOR Notes. (PF 640, 642, 644). The distribution and sale of the BFCE LIBOR Notes were pre-set and done only for tax purposes. The economic reasons given for the distribution were mere device.

[40] Subsequent to the distribution of the BFCE LIBOR Note, the Partnership again exchanged Long Bonds ($4.85 million principal amount) for $5 million principal amount of CP 8.06% notes due March 1, 1994. This time, however, the Partnership did not adjust its hedging ratio by distributing LIBOR Notes, although economically, the professed December 12, 1989 rationale would portend such an adjustment. (PF 615-18, 625).

[41] After KNX left the Partnership in December of 1991, ACM distributed the remaining LIBOR Notes purportedly because CP no longer needed the hedge, since the debt had been consolidated, and the Notes were too volatile to hold. Yet, six months earlier, CP had purchased enough of KNX's interest to consolidate over fifty percent of the CP debt, but never considered adjusting the holding of the LIBOR Notes as a result of that transaction. (PF 834, 886). The alleged economic reasons for the Partnership holding and adjusting its interest in the LIBOR Notes were only followed when they supported the tax goals.

[42] In June of 1991, and at the outset of the transaction, Pohlschroeder noted that there was an offset between the LIBOR Notes CP indirectly held through ACM and the interest rate swaps it entered into outside the Partnership. Whether Pohlschroeder discussed that offset with Taylor or considered the offset a hedge against the LIBOR Notes' volatility to SH is unclear. However, anyone legitimately concerned with the effect of the LIBOR Notes on CP's professed liability management goals would have examined that effect on CP's other swaps. CP's $300 million notional amount of interest rate swaps, which converted approximately 30 percent of its long-term debt from fixed to floating rate, was a good business move which genuinely impacted and limited its financial exposure on twice the amount of long-term debt acquired by ACM later that year. (811-14, 923).

[43] The ability of CP to very inexpensively engage in those swaps casts further doubt on the legitimacy of the LIBOR Notes as a hedge to CP. The ACM LIBOR Notes cost CP $1,093,750 to originate and close to $1 million to sell. ⁹ (PF 638, 888). The cost of the LIBOR Notes to CP; the inconsistencies and inaccuracies in the partners' documented "liability management" goals with respect to the Notes; and the substantive inefficiency or "noise" of any hedge provided by the Notes demonstrate that the LIBOR Notes were solely tax assets, which had no purpose or legitimate substantive effect.

2. MERRILL'S LIBOR NOTE MARKET IS A SHAM

[44] As discussed above, the timing with respect to KNX's exit from ACM was prearranged so that CP would recognize tax benefits. The LIBOR Notes were the assets which triggered the tax benefits. The timing and execution of the LIBOR Note transactions were thus pivotal to the tax strategy. The swap transactions arranged by Merrill and paid for by CP ensured that the critical steps of the transaction occurred as planned. Through the swap market, Merrill created a tax shelter market for the LIBOR Notes.

[45] Upon the sale of the Citicorp Notes, Merrill entered into asset and hedge swaps with BOT and BFCE. Through these swaps the $1,093,750 origination, the loss realized but not recognized upon the sale of the Citicorp Notes and borne solely by CP, was effectively paid to Merrill.

[46] Of the total discount, $504,563.50 was received by Merrill on December 20, 1989, because the effective date of the asset swap payments owed to Merrill by the banks was November 15, not the November 27 swap transaction date. The remaining discount was passed to Merrill through an up-front payment of $168,339 made by BFCE and over time, through the BOT hedge swap. Under the BOT hedge swap, the notional amount upon which BOT made payments to Merrill ($25 million) had a greater value at the inception of the swap than the net present value of Merrill's swap payments to BOT ($24,579,218), which were equal in value to the net present value of the BOT LIBOR Notes. (PF 602).

[47] If the asset swap could not be unwound, i.e., the Citicorp Notes could not be sold at par, the origination costs funneled to Merrill through the swaps would be used by Merrill to pay the step-up in basis points that Merrill was required to pay under the asset swaps after a specified period of time. Merrill was able to offer the purchasing banks an incentive (the step up) to enter the transaction from the origination costs passed to it through the swaps. (PF 548- 51, 603-04).

[48] Admittedly, the third-party issuing banks, BFCE and BOT, assumed the credit risk of Citicorp Notes. But Merrill, in effect, bet that Citicorp's credit, rated A1 senior by Moody's, would hold up. Merrill had an economic incentive to sell the Notes for the issuing banks -- if it could arrange such a sale at par, the origination costs would become additional profit to Merrill.

[49] Consistent with Merrill's financial incentive to do so, the banks understood that Merrill would sell the Citicorp Notes within a short time. (PF 552, 559-61). Merrill actually sold the Citicorp Notes for BOT within two months, and BFCE's Citicorp Notes were sold in less than one month. (PF 566, 562). The return computation that Pepe provided BFCE when it purchased the Notes, which assumed that BFCE would hold the Notes until December 20, 1989, was accurate almost to the day. (PF 560, 562). Merrill made over $600,000 upon termination of the asset swaps. (PF 605).

[50] The hedge swaps with the issuers and purchasers of the LIBOR Notes were structured so that the LIBOR Notes' payment contingencies would be of no economic consequence to anyone other than Merrill. As a result of the hedge swaps the banks were not required to bear the interest rate risk of the LIBOR Notes. Rather, in exchange for payments mirroring the payments owed on the LIBOR Notes, BOT and BFCE, the banks issuing LIBOR Notes, made payments based on a set amortizing notional amount. (PF 538-40).

[51] Because the notional amount of the LIBOR Notes never changed, the LIBOR Note payments increased or decreased based solely on changes in LIBOR. A small change in interest rates significantly affected the notional-based LIBOR Note payments and thus, the value of those Notes. The banks' payments under the hedge swaps, on the other hand, were based on a ratably amortizing amount. Because the amortized "principal" payments did not change as interest rates fluctuated, the value of the banks' swap obligations were not nearly as volatile as the value of the LIBOR Notes. (PF 541-45).

[52] The banks had virtually no concern regarding the contingencies or interest rate risk inherent in the LIBOR Notes. Reddy had to ask why BOT even valued the Notes BOT issued. BFCE, upon purchasing the BOT LIBOR Notes from ACM in December 1991, never valued them (PF 534-35, 555, 898).

[53] The rates paid by BOT (LIBOR -- 18.75 basis points) and BFCE (LIBOR -- 25 points) on the amortizing notional amount under the hedge swaps were less than the banks' LIBOR-based funding rates. The hedge swaps effectively converted the transactions, from the banks' perspective, to synthetic funding below the banks' normal funding rates. (PF 538, 556, 557, 540). That deal was too good to refuse.

[54] Similarly, Unibank and BFCE, the banks which purchased the BFCE and BOT LIBOR Notes, received, through Merrill hedge swaps, payments based on a set amortizing notional amount at a rate above their LIBOR funding rate (a synthetic asset). The interest rate risk they bore from the purchase of the LIBOR Notes was effectively transferred to Merrill because the payments they made under the hedge swaps mirrored the payments on the LIBOR Notes they purchased. (PF 661-62, 655, 890, 894)).

[55] In negotiating the LIBOR Note sales on behalf of SH and ACM, Merrill had a financial incentive to negotiate against its clients' interests. (PF 662-63, 681). It was in Merrill's financial interest that the price paid for the LIBOR Notes, the original amortizing notional amount upon which it made payments under the hedge swaps, be as low as possible. See Freytag v. Commissioner, 89 T.C. 849, 877-78 (1987), aff'd, 904 F.2d 1011 (5th Cir. 1990), aff'd on another point, 501 U.S. 868 (1991) (where the promoter is always a party to the transactions and stands to profit at the expense of the investors, the transactions must be closely scrutinized).

[56] Merrill set the price of the LIBOR Notes to ensure that it would not lose money. In Merrill's discussions with Unibank and BFCE, the purchasers of ACM's LIBOR Notes, Merrill negotiated the spread over LIBOR those banks would earn under the swaps. Merrill then backed into the notional amount, also the price to be paid for the LIBOR Notes. Merrill set that amount so that the value of the payments it made under the hedge swaps with the purchasers of the LIBOR Notes (assuming the step-up in basis points Merrill had to pay after a certain date did not come into play) would be equal to the value of the payments Merrill received under the hedge swaps with the banks issuing the LIBOR Notes. If Merrill terminated the hedge swaps, Merrill could not lose regardless of how LIBOR changed. Compare Freytag, 89 T.C. at 880-81 (prices were artificially generated by pricing algorithms). (PF 676-78, 891).

[57] Furthermore, Merrill could make money on the hedge swaps with the purchasers of the LIBOR Notes. The LIBOR Notes were sold to Unibank and BFCE at a discount, economically borne entirely by CP. This "remarketing cost" or "friction" was the difference between the price paid for the LIBOR Notes and Merrill's calculation of the net present value of those Notes on the sale date.

[58] For example, Merrill sold the BFCE Notes to Unibank for $9,406,180. The difference between the reduction to SH's capital account upon distribution of the LIBOR Notes on December 13, 1989 and the amount SH received for the Notes from Unibank on December 22, 1989 was $727,360. The $727,360 consisted almost entirely of transaction costs: the $312,500 paid to originate the BFCE LIBOR Notes and an additional $390,000 friction associated with the LIBOR Notes' sale. ¹⁰

[59] Under the hedge swap with Unibank, Merrill received a stream of payments mirroring the BFCE LIBOR Note payments with a net present value of $9.8 million, equal to that of the BFCE LIBOR Notes. ¹¹ Because the $9.4 million original amortizing notional amount upon which Merrill made payments was equal to the discounted value of the BFCE LIBOR Notes, the net present value of the stream of payments Merrill received was almost $400,000 (the $390,000 friction) greater than the net present value of the payments it made. While Merrill was required to pay Unibank a spread over LIBOR on the original amortizing notional, Merrill could capture the discount by terminating the hedge swaps before the spread it paid reached $390,000. Thus, Merrill had a strong economic incentive to terminate the LIBOR Notes. (PF 679, 683-85).

[60] This step was relatively simple. For after the distribution and sale of the BFCE LIBOR Notes in December of 1989, the LIBOR Note payment flow was circular: 1) From Merrill to BFCE (through a hedge swap), 2) from BFCE to Unibank (the LIBOR Note payment) and 3) from Unibank back to Merrill (through a hedge swap). Once the tax benefits had been realized, the swaps and associated LIBOR Notes could be terminated and Merrill could realize its fees. When the transactions were unwound, Unibank did not care how the LIBOR Notes were valued. Whatever it received from BFCE as a termination payment on the LIBOR Note, it passed to Merrill upon the termination of the hedge swap. (PF 695).

[61] The BFCE LIBOR Notes and hedge swap transactions were short term, just as BFCE and Unibank understood they would be. (PF 686-88, 672-74). In May of 1990, Merrill initiated the termination and was appointed valuation agent for the LIBOR Notes. Cf. Brown v. Commissioner, 85 T.C. 968, 977 (1985), aff'd sub nom. Sochin v. Commissioner, 843 F.2d 351 (9th Cir.), cert. denied, 488 U.S. 824 (1988) (promoter had authority to determine any price required under the contracts including cancellation prices). Merrill received profits of $416,655 on this leg of the transactions, in addition to its initial $1.745 million fee. (PF 689, 694, 696).

[62] Petitioner will argue that swaps are legitimate vehicles to hedge risks and should be respected. Respondent does not generally quarrel with this principle but rather, stresses that the swaps at issue were required because nobody wanted anything to do with the contingent LIBOR Notes that qualified the transaction for installment sale treatment. ¹² BOT questioned why LIBOR Notes were required, and wondered if the Citicorp Notes could be purchased with cash. (PF 529, 532). Schickner apparently did not realize Unibank purchased LIBOR Notes; rather, like Taylor, he considered the obligation economically equivalent to one side of a swap. (PF 658, 715). None of the participants would have entered into the LIBOR Note transactions without the structured swaps. While the third-party purchasing banks assumed the credit risk of the issuers of the LIBOR Notes, they were not willing to assume the interest rate risk that permitted the tax- motivated installment sale transaction to proceed. (PF 657, 894).

[63] The swaps at issue were paid for by CP and arranged by Merrill to synthesize the economic consequences in order to induce third parties to take an interest in tax assets. Through costs CP paid for the origination and remarketing of the LIBOR Notes -- fees paid for tax benefits -- Merrill was able to control the LIBOR note market it created to ensure that the transactions followed the plan. By passing the fees to Merrill through the swaps, Merrill had the money to induce third parties to participate and Merrill benefitted from unwinding the transactions. The creation of tax benefits drove the transactions, not market forces. Where the timing of transactions is critical and of overriding importance, even transactions intentionally and cleverly structured to be real are without substance within the meaning of established case precedent. Sheldon, 94 T.C. at 769.

[64] In each of the Section 453 Partnerships it organized, Merrill arranged hedge swaps with the issuers and purchasers of LIBOR notes. See Sheldon, 94 T.C. at 759; Ewing v. Commissioner, 91 T.C. 396, 419 (1988); Sochin, 843 F.2d at 355, aff'g sub nom. Brown, 85 T.C. 972 n.6 (an indicia of a tax shelter market is the presence of a common pattern of trades). Within a short period after LIBOR notes were sold by a United States corporate partner affiliate, often to Unibank, the issuers and purchasers of the LIBOR Notes agreed to terminate the LIBOR notes at Merrill's behest. ¹³ The related hedge swaps were simultaneously terminated. Of the over five billion dollars of installments sales Merrill arranged, the hedge swaps Merrill arranged in connection with the issuance of LIBOR notes were prematurely terminated in all but a very few instances and no doubt the LIBOR notes were unwound at the same time. (PF 1168, 1193, 1194). Such atypical closing methods, such as cancellations and assignments, are a further indication of sham, rather than real markets. See Ewing, 91 T.C. at 419; Freytag, 89 T.C. at 881-82; Brown, 85 T.C. at 1000; Forseth v. Commissioner, 85 T.C. 127, 151-52 (1985), aff'd, 845 F.2d 746 (7th Cir. 1988); (PF 1167-68, 1189-90). The swap repo characterization and "speculation" of the then relatively inexperienced Schickner turns out to be, in Respondent's view, unerringly true. See Glass v. Commissioner, 87 T.C. 1087, 1156 (1986), aff'd sub nom., Herrington v. Commissioner, 854 F.2d 755 (5th Cir. 1988) (in real markets there are no discernable patterns whereby one discernable group always follows a common trading strategy against an opposite group).

[65] Swaps between ABN and Merrill completed the circle of payments on the BOT LIBOR Notes issued to ACM. Economically, payments went from 1) Merrill to BOT (through the hedge swap); 2) from BOT to ACM (through the LIBOR Note payments); 3) to KNX (based on its percentage interest in the ACM LIBOR Notes); 4) to ABN (based on hedge swaps between ABN and KNX); and 5) back to Merrill (based on hedge swaps between Merrill and ABN). Through the ABN-Merrill swaps, Merrill hedged its position in the hedge swaps it entered with the LIBOR Note issuers. (PF 783). KNX and ABN ensured they would not be economically exposed to the interest rate risk on the tax assets driving the deal. (PF 760).

[66] In each pattern partnership deal except the first, ABN, the entity controlling the foreign partner, swapped out its interest rate risk on the LIBOR notes through hedge swaps with Merrill. In all of the deals, ABN and Merrill amended the swaps, commensurate with ABN's changed interest in the LIBOR notes held by the Section 453 Partnership, within a relatively short period of time. (PF 1176-81). Based on the available transactional documents, particularly the Unibank swap repos, the LIBOR notes were never sold in any section 453 partnership while the ABN controlled partner had any significant interest in those notes. The LIBOR note market was a closed circle of hedged transactions, controlled by Merrill. This LIBOR note market was a sham.

C. THERE WAS NO TAX-INDEPENDENT PURPOSE FOR THE ACM TRANSACTIONS

[67] De Beer, the managing director of majority partner KNX, considered ACM an "investment partnership." (Tr. 1028). Petitioner, however, claims ACM was a "liability management" partnership. Respondent submits that CP's purported business motive was window- dressing and managing liabilities provided no substance to the structured ACM transactions designed to create phantom tax losses from an installment sale.

1. CP'S BUSINESS PURPOSE FOR ENTERING ACM WAS CONTRIVED

[68] CP's reasons for the "liability management" partnership were memorialized in Pohlschroeder's October 3, 1989 memorandum to Heidtke, which was evidently used to justify the transaction to CP's Board. That memorandum discusses almost none of the specific CP liability management goals that Petitioner's expert Singleton opined on at the trial or that one would expect Heidtke, CP's Treasurer, to consider. (Tr. 3248-49). Rather, that memorandum focused on the use of the Partnership to reduce CP's average debt maturity. According to Pohlschroeder's memorandum, ABN "approached" CP and "offered to form" a partnership. According to the memorandum, ABN could be bought out once that objective was accomplished. (Ex. 86-CJ).

[69] ACM's effect on CP's average debt maturity was de minimis. ACM debt transactions reduced CP's average debt maturity by only a few months. Moreover, between 1989 and 1991, CP's overall average debt maturity increased from 8.81 to 9.67 years. ACM failed to achieve Pohlschroeder's documented goal. (PF 938-41).

[70] That result was ordained from the outset. Prior to ACM being formed, CP arranged to purchase the $100 million Met Note. See Arg. IV, infra. That purchase accounted for $100 of the approximately $155 million of CP debt ACM purchased, a result consistent with the total $140 million CP debt projections shown in the October cash flows. (PF 91).

[71] The Met Note matured in eight years and called for ratable principal payments of $12.5 million per year. The Met Note had an average maturity of four years, which was less than CP's average debt maturity of approximately nine. Thus ACM's purchase of the Met Note increased CP's average debt maturity, upon consolidation of the ACM Partnership on CP's financials. Further, when the Met Note was outstanding its ratable principal payments had the effect of smoothing CP's debt maturity schedule, now a CP liability management goal. The effective retirement of that Note, through the purchase by ACM and subsequent consolidation, contradicted CP's, as well as Pohlschroeder's, stated liability management goals. (PF 941-42, 950- 51).

[72] The purchase of the Met Note was also a bad economic move for CP. With short-term corporate rates above nine percent at the time ACM was formed, the 8.4% Met Note was an attractive fixed-rate liability, in admittedly friendly hands. (PF 954-55). Moreover, and contrary to the concerns expressed in Pohlschroeder's memorandum, CP's then current debt maturity profile did not put them at a competitive disadvantage. When compared with the two companies CP considered its principal competitors, CP's interest cost was actually slightly lower than Proctor and Gamble's in three out of the four years between 1987 and 1990, and lower than Unilever's in two. (PF 929).

[73] Neither Pohlschroeder's memorandum nor the CP Board minutes mentioned using ACM to profit from any decrease in the credit spread of the CP debt. There is no mention of any takeover concerns, let alone indications that takeover risk caused CP debt to trade cheaply. Respondent submits that SH's ability to profit from the credit spread in the CP debt (the Quality Component of the Partnership Agreement) stemmed from ABN's unwillingness to assume that credit risk. See Arg. II B.1.c., infra. In any case, at the time ACM was formed, CP had created the ESOP as an anti-takeover measure and CP's debt was trading at Tresury spreads commensurate with other corporate bonds. (PF 935, 966-67). The likelihood of CP profiting from a decrease in the spread on its debt was no greater than the likelihood of an investor profiting from such a decrease in any other high-grade corporate bond. ¹⁴

[74] While Pohlschroeder's memorandum did discuss using ACM to anonymously purchase CP debt, it did not assert that anonymous purchases would protect CP from raiders who might become interested in CP if they knew it had less debt. Rather, Pohlschroeder asserts that the price of CP debt would increase if the holders suspected CP's demand. But Merrill, if it wanted to keep CP's business, would have purchased the CP debt anonymously, on CP's behalf. ¹⁵ Moreover, of the $154.75 million of CP debt purchased by ACM, all but approximately $18.75 million was purchased in early December of 1989. The fact that CP was purchasing its debt would not have become public knowledge until after its year end SEC filings, long after the majority of the purchases were made. Finally, the Met Note purchase was hardly anonymous and a shrewd raider could have discovered to whom the Met Note had been sold. (PF 965). In short, the anonymity offered by ACM was not a legitimate goal.

[75] Although mentioned neither by Pohlschroeder nor to the CP Board, Petitioner now claims that ACM was advantageous because it reduced CP's leverage or debt to capital ratio, at 48.3 percent in 1989. According to the ALCAR Study, CP's target ratio was between 35 and 43 percent. (Ex. 53-BA). Singleton opined that CP's debt to capital ratio decreased from 44.5 percent in 1990, to 31.5 percent in 1991. ¹⁶ But that decrease results not only from the ACM Partnership debt transactions but also from CP's $441 million 1991 stock issuance, some proceeds of which were used to fund KNX's redemption. (PF 825-26). The actual effect of just the ACM debt transactions, while not revealed, is certainly less substantial. Moreover, at ACM's formation, it was clear that KNX's planned exit would have to be funded in a manner which gave CP the basis to claim the tax loss. (PF 97). While there are no memoranda discussing how the KNX buyout would be funded, questionable by itself, the use of a second CP partner was discussed. (PF 98). If the transaction were funded by borrowing, given CP had no cash to invest, then any effect of ACM on CP's debt to capital ratio could be effectively negated.

[76] In his October 3rd memorandum, Pohlschroeder claimed that the Partnership would enable CP to manage its interest rate risk through SH's option to adjust the Yield Component, its share of the interest rate risk attributable to the CP debt. ¹⁷ Petitioner presented much expert testimony on the purported advantages of this option, which was also suggested by Merrill. Beder opined that the option was potentially worth $799,000 to CP, and up to $1.181 million, if executed monthly. (Ex. 519, p. 19).

[77] In hindsight, SH opted to adjust the Yield Component at the wrong times, thereby shifting $4,102,454 of the total $5,744,233 in positive interest rate allocations to KNX. (PF 846). As a conservative company, opting to take positions on interest rate movements was not the practice of CP's Treasury Department. Heidtke stated that the five times CP actually exercised the option was quite often. (Tr. 142).

[78] The actual number of times the option was exercised is also exaggerated. The first time, upon the purchase of the Met Note, did not change any previous allocation and thus does not count. The second time, upon the distribution of the BFCE LIBOR Notes, was concocted to justify the BFCE LIBOR Note distribution. See, Arg. I.B.1.b., supra. The last time the option was exercised was upon the partial purchase of KNX's interest and, at that time, KNX's total redemption was contemplated. Subsequent to this adjustment, KNX consolidated its swap positions thereby indicating it expected no further adjustments. (PF 844, 860).

[79] CP also elected to adjust the Yield Component in August of 1990, when Kuwait was invaded, and once again, in February of 1991. Given the relatively infrequent use of the option, which could be expected, there were numerous other available means of managing interest rate risk. No such alternatives were considered or priced by CP prior to entering into ACM. The Yield Component provision does not bestow substance on the tax-motivated ACM transactions.

[80] According to Petitioner, the $205 million capitalization of ACM related, in part, to the amount of CP debt available, in addition to the tax benefits. Yet none of the cash flows prepared by Merrill estimate the Partnership investing in more than $140 million of debt. Despite Pohlschroeder's claim that CP had no cash for an "investment partnership", the September cash flows envisioned the Partnership investing $50 million in CP debt with the remainder in "financial assets." (PF 90). Perhaps this explains why on September 20, 1989, around the time Taylor believed CP committed to entering the deal, somebody at Merrill was still calling ACM an "investment partnership." (PF 118).

[81] Pohlschroeder's memorandum also opined that one advantage of using a partnership, rather than purchasing debt directly, was to reduce transaction costs. Given that CP would have to pay the same amount whether it purchased CP debt directly or purchased KNX's interest in that debt, Pohlschroeder's opinion is ludicrous. If CP genuinely was concerned about the maturity structure of its debt, it could have purchased and then reissued the principal amount of debt purchased by ACM at one-third of the transaction costs it paid for ACM. Further, CP had already paid the costs of a shelf registration that would have enabled new debt to be issued. (PF 918-21).

[82] While there is conflicting expert testimony on the cost and availability of alternative "liability management" tools at the time ACM was formed, CP never even compared the "liability management" benefits to the cost of any alternatives. That omission is critical in determining CP's Motives. Seduced by the projected $20 million net present value and Merrill's sales persuasion, CP's Treasury Department all but ignored the costs. The only witness who testified to having any concern regarding the transaction costs was CP's tax director. Unlike any corporate financial officers with whom Respondent's expert Smith was familiar, Pohlochroeder just accepted Merrill's estimates, never investigating potential alternatives or even verifying the estimates by determining the actual costs. (PF 889-904, 908). But then like many other tax shelters, the up-front out-of-pocket transaction costs were covered by the tax benefits CP realized in the year of entry; upon the sale of the BFCE LIBOR Notes. The costs of the transactions were not recorded on CP's financial statements; they were offset by a corresponding amount of tax benefits claimed. (PF 412).

[83] Pohlschroeder's memorandum, like CP's Board minutes, projected a six percent pre-tax return. ¹⁸ While CP normally analyzes transactions based on after-tax returns, Pohlschroeder's memorandum emphasized a pre-tax return which had no economic meaning. The six percent return did not take into account lost opportunity costs or all of the front-end costs. Furthermore, six percent was a below market rate return. The projected return was based on the assumption that KNX would remain in the Partnership for ten years, a result Petitioner conceded was never envisioned and de Beer expressly refuted. (PF 912-17).

[84] Pohlschroeder's October 3, 1989 memorandum, the basis for the recommendation to the Board, was an attempt to justify an otherwise admittedly naked transaction. (PF 66). Indeed, at the time the memorandum was written, Belasco had recommended the deal to Agate, and Taylor believed that CP had committed. (PF 148-49). While Agate had no recollection of the meeting he attended with Merrill, or little else about ACM, he did recall concerns regarding the transactions' "commercial justifications." But Agate recalled no steps he took to ensure that the ACM transactions had substance. (PF 140-42).

[85] The "commercial justifications" devised by Merrill, communicated by Pohlschroeder, and relied upon by some at CP, were window-dressing. Reducing average debt maturity was never a liability management goal of CP and reasons now offered to justify the ACM transactions were not set forth in Pohlschroeder's memorandum. The timing of the ACM transactions bore no relationship to CP's average debt maturity: KNX was bought out as planned, but before ACM caused any decrease in CP's average debt maturity. Pohlschroeder's October 3rd memorandum was an attempt to document a business purpose sufficient to withstand an IRS audit.

[86] In light of Pohlschroeder's role in this deal, his testimony is particularly enlightening. Despite every other witnesses' anticipations to the contrary, he told this Court he had no expectations regarding whether KNX would remain in ACM Partnership. (Tr. 412-13).

[87] Contrary to Pohlschroeder's assertions, ABN did not offer and indeed had no interest in becoming a partner with CP. ABN participated because it wanted CP as a client and formed KNX merely to accommodate the "tax angle" of Merrill's structure. See Arg. ID.1., infra. Contrary to Pohlschroeder's assertions, there were no legitimate business reasons for the ACM transactions. Merrill promoted a naked transaction and when Belasco rejected it, Taylor showed Pohlschroeder how to dress it up. CP's "business purpose" reflects Merrill's attempt to deliver on its promise that every single step of its tax deal would be substantiated. (PF 74).

2. CP'S BOARD AND FINANCE COMMITTEE MINUTES ARE UNRELIABLE

[88] As noted above, the justifications for ACM set forth in the October 12, 1989 CP Board minutes are merely extensions of Pohlschroeder's October 3, 1989 memorandum. But unlike in that "communication device", the tax benefits from the deal were presented to the Board. As in Merrill's initial presentation, the tax aspects of the transaction were presented first. ACM was discussed as a means of offsetting the $105 million Kendall gain. While the transaction could require CP to recognize over $17 million of phantom gain if the loss could not be realized within a specified time frame, the Board was told that that gain would be sheltered. CP, prior to ever meeting ABN, was quite comfortable that Merrill could deliver on the necessary timing of the transactions. (PF 163-67).

[89] Little was remembered about the specifics of the Board's discussions and nothing was remembered about the discussion of ACM at the next month's finance committee meeting. Apparently, there were no memorable discussions of any down-side financial or audit risks. (PF 179-190, 1008-10).

[90] In addition, there are no other detailed discussions of ACM recorded in any Board or finance committee minutes in the record. The specific comments regarding ACM were not recorded at the July 1991 finance committee meeting that occurred just a few weeks after CP paid over $100 million to purchase KNX's interests. Despite knowing that KNX would soon be entirely redeemed, the business purpose of a $100 million transaction was not recorded. (PF 191-92).

[91] CP's Board minutes artfully recite that its Treasury Department added "business purpose" to the structured deal promoted as a tax shelter, but the Board was never told that the partner was a thinly capitalized Netherlands Antilles corporation called Kannex. (PF 1013, 171). CP's corporate minutes were prepared at least a month after the meetings occurred, were not a high priority matter, and were not even corrected after CP knew they were wrong. CP's corporate minutes are neither reliable nor corroborated and provide no independent non-tax purpose for the ACM Partnership transactions.

3. THERE IS NO ECONOMIC SUBSTANCE TO THE ACM TRANSACTIONS

[92] CP earned a 2.5 percent return on its ACM investment through KNX's redemption. ¹⁹ This return is attributable to a decrease in interest rates, primarily in 1991, and an increase in CP's credit quality, both of which caused the value of the CP debt to increase. ²⁰ Due to the costs of the transactions and CP's miscalculations of its Yield Component elections, SH had a negative return until May of 1991. But, as of the end of December of 1991, CP had the potential to make approximately $5 million of profit. Of course to realize profit, CP would have to engage in an "exit strategy", or eventually recognize the built-in tax gain.

[93] Conceivably, CP could have earned a greater potential return. Had CP guessed right when it opted to adjust the Yield Component, or had the credit spread of CP debt or interest rates decreased more than they did, CP would have had a greater potential return. Conversely, CP's potential return could have decreased. On the other hand, CP's return, for the years at issue in this case, was rather fortuitous. As the Plotkin debate over the proper term to measure CP's return revealed, that profit was not realized and could change. (Tr. 2611, 2664-66).

[94] As Merrill's after-tax cash flows and the "exit strategy" revealed, the tax benefits were equated to cash. (PF 95-96). The contrived six percent projected pre-tax return was dwarfed by the $20 million present value of the tax benefits. The Sheldon test of comparing the profit potential with expected tax benefits applies: There must be some tax-independent purpose for the transactions. Sheldon, 94 T.C. at 767-69.

[95] CP's profit potential from the "liability management" aspects of ACM bore no relationship to the installment sale transaction the deal was designed around. Although the parties may have modified the "investment partnership" to include CP debt purchases, at all times the tax benefits to be generated by execution of the steps Merrill suggested remained the same.

[96] The Citicorp Notes were estimated to be, were likely to be and, in fact, were sold at a loss. In addition, the LIBOR Notes were expensive to "remarket." However, even if the installment sale were potentially profitable, that is not enough:

The potential for "gain" here, however, is not the SOLE standard

[97] In total, approximately $2 million of costs (both origination and remarketing) were attributable to the LIBOR Notes and paid for by CP. Each of the players in the LIBOR Note transactions -- ABN, BOT, BFCE, Unibank and mostly Merrill -- received a portion of the fees paid by CP to originate and then to sell those Notes. There is only one reason CP, falling within the highest echelon of sophisticated taxpayers, paid everybody to structure a transaction that was predicted to yield a below-market economic return. Cf. James v. Commissioner, 87 T.C. 905, 924 n.5 (1986), aff'd, 899 F.2d 905 (10th Cir. 1990) (subjective business-purpose test not applicable to sophisticated taxpayers who "should have known" the transaction could not produce economic profit).

[98] The LIBOR Notes, the essential asset for producing these tax benefits, do not withstand the two-prong test of Rice's Toyota World. 752 F.2d at 91. The substantive purpose for the LIBOR Notes is objectively rebutted by Petitioner's own partner, KNX, who refused to use LIBOR Notes to hedge CP debt. The subjective rationale for the Notes has changed since Pohlschroeder's memorandum and IRS interview, thus deserving no weight.

[99] An objective analysis of the ACM installment sale transaction demonstrates it was crafted for tax avoidance -- to generate the massive capital loss required to offset CP's capital gain. Merrill promoted the investment partnership to CP as a way to offset the Kendall gain. Concerned that the Merrill proposal had no substance, CP attempted to add, in Respondent's view duplicitously, a business purpose to the investment partnership. But CP was never concerned that KNX would become unfriendly or that KNX would not exit the Partnership, despite the fact it could control CP debt. (PF 173). Although the parties abstained from formalized commitments, the transactions were prearranged. Merrill would deliver on that deal it described at the initial presentation. And, despite the liability- management add-on, neither the purpose nor the substance of the installment sale within CP's "investment partnership" ever changed.

D. THE CONTINGENT INSTALLMENT SALE TRANSACTION WAS A SHAM WHICH

[101] Furthermore, KNX did not even keep any profits it earned from the transaction. KNX, an entity owned by foundations without any commercial purpose, had no business purpose for engaging in the ACM transactions. See Arg. II, infra.

[102] Starting with its strategy of using LIBOR Note transactions to refresh expiring NOLs, Merrill added the partnership structure and marketed the idea to companies in need of capital loss. At the request of CP, Merrill created a partner for ACM, a subsidiary of its swap dealer Merrill Lynch Capital Services, Inc. Taylor, the point person for more than five billion dollars of pattern evidence partnership installment sale transactions, was the MLCS Partnership Representative. (PF 1060, 1166).

[103] Merrill made over $20 million from engagement fees alone, promoting the investment partnership concept that Taylor explained to fMerrill's bankers and clients. (PF 23, 1038, 1057). The returns Merrill made from ACM, through the engagement and advisory fees, and through swap transactions, were reflected in the promoter's bonus each year. (PF 1061). MLCS did not become a partner to assist in "liability management" or earn Partnership profit. MLCS became a partner to accommodate CP, and thereby earn fees.

2. ACM'S CONTINGENT INSTALLMENT SALE HAD NO SUBSTANCE

[104] Petitioner argues that the tax losses CP claimed are the appropriate results of following Temp. Treas. Reg. Section 15A.453- 1(c). The structured machinations and side agreements used to induce KNX to participate prove otherwise.

[105] The Citicorp Notes, with an embedded put option, were themselves a structured transaction, designed to qualify for installment sale reporting. (PF 455, 456, 788-90). From the "get go", den Baas understood that the floating rate notes were designed to trade at par. (Tr. 1148-49). Be, and apparently ABN's Risk Management Division as well, also understood that the notes would be sold within a short time period and not at a loss. (PF 432, 433, 1149).

[106] Any risk, reflected in transaction costs, would not be borne by KNX. CP would pay the origination costs associated with that sale. KNX even received, through the Small Swap with ABN and then Merrill /21/, a return on the origination costs. (PF 767). Essentially, KNX received interest on its percentage interest in the $1,093,750 origination, which KNX would not recover until it was bought out of ACM. (PF 780). Through the swaps and reimbursement of the transaction costs, KNX effectively sold the private placement notes at par.

[107] The contingent installment sale regulation anticipates that the amount received be contingent. From the beginning, ABN required that any contingency be hedged. (PF 239, 701, 740-41). With respect to KNX's 82.63 percent interest, the contingency was eliminated by the swaps between KNX and ABN, and the mirror swaps between ABN and Merrill. KNX swapped its 82.63 percent interest in the contingent payments for amortizing payments on a notional principal amount ascertainable on the date of the Citicorp Note sale. (PF 759-62). On November 27, 1989, KNX knew that it would receive $28,443,655.20 (plus a LIBOR-based return), on its share of the value of the LIBOR Notes, through the Big Swaps. If the LIBOR Notes had the same attributes as the hedge swap payments made to Kannex, installment sale reporting would not have been permitted.

[108] KNX participated in a contingent installment sale but bore no risks from the contingencies. Economically, and through swaps, 82.63 percent of the contingent installment sale was not contingent but a mere circle of swap payments from Merrill to the LIBOR Note issuer, to ACM, to KNX, to ABN and then back to Merrill. See Arg. I.B.2., supra.

[109] In order to qualify for installment sale reporting, the property sold cannot be readily tradeable on an established market. Section 453(k)(2). Likewise, the property received, the contingent obligation, cannot be readily marketable. Section 453(f)(5). Through the use of swaps upon the issuance and exchange of LIBOR notes, Merrill made an artificially supported market for LIBOR notes to ensure that the tax transactions would proceed as planned. Merrill engaged in swaps which converted the contingencies of the LIBOR Notes to payments marketable to the issuers and purchasers. Merrill represented it could sell the Citicorp and LIBOR Notes and did so, using fees CP paid to create opportunities third-parties could not pass up.

[110] As a result of the advance of derivative products, products of the capital markets no longer limit the strategies in which a client may engage. Products are now structured to implement the strategies of the client. The derivative product specialists who structured this transaction are clever and ensured that they had up- to-date knowledge of the intricacies of the tax law.

[111] The goal was to benefit from the installment sale rule, but not be burdened by any contingencies. Through side deals, contradicting the form of the transaction, this result was obtained. Through the swap transactions structured between Merrill, ABN and KNX, the burdens of the contingent installment sale regulation were circumvented with respect to KNX's 82.63 percent interest. The tax benefits from the installment sale were guaranteed by a side deal, whereby KNX agreed to get out before the phantom loss was recognized. Additional "remarketing" costs paid by CP ensured that the LIBOR Notes would be sold.

[112] Petitioner's form, structured to exploit the contingent installment sale regulation, belies the economic facts and should not be respected for federal income tax purposes. The overriding principle to be analyzed is "whether what was done, apart from the tax motive, was the thing which the statute intended." Gregory v. Helvering, 293 U.S. 465, 469 (1935). Put another way, even transactions cleverly crafted to be real, to justify tax benefits, cannot provide substance to an otherwise naked transaction. United States v. Wexler, 31 F.3d 117, 122-24 (3d Cir. 1994), cert. denied, ___ U.S. ___, 115 S.Ct. 1251 (1995) (despite the lack of an express business-purpose requirement in section 163, deductions for interest on obligations resulting from sham transactions are not permitted even if the obligations are binding and enforceable). Both the timing and the form of the ACM transactions were dictated by taxes. The transactions financing the installment sale within ACM Partnership lacked economic substance.

KANNEX WAS IN SUBSTANCE A LENDER AND NOT AN ACM PARTNER

[113] KNX did not intend to join together with SH and MLCS to conduct, or share profits and losses of, the ACM enterprise. See Commissioner v. Tower, 327 U.S. 280, 287 (1946). KNX sought to minimize, as completely as possible, its entrepreneurial interest in the assets in which ACM invested. KNX did not intend to, and did not, profit from returns on those assets or share in any loss. KNX intended to participate in the enterprise only for a defined period of time. KNX did not share in the costs incurred by ACM to carry out the tax-motivated transactions. Respondent's determination that KNX was a lender and not a partner in ACM is consistent with the intent, understanding, and conduct of the parties.

[114] ABN, through the shelf corporation it totally controlled, agreed to finance the ACM venture in return for an amount which would enable KNX to earn a spread above LIBOR. By swapping out the interest rate risk on the CP Debt and the LIBOR Notes, KNX limited its risks and rewards from the venture and ensured its return. KNX's income preference was carefully designed to protect the capital it contributed. KNX's profits were repatriated to ABN, seemingly in return for the advisory services that ensured KNX that its loan to ABN would be repaid. Through KNX, ABN sought and derived a profit on the ACM transactions that was consistent with its banking business and wholly inconsistent with the purpose for ACM Partnership.

[115] ABN sought CP as a client and was willing to provide something more -- the opportunity to create tax benefits -- than just the financing CP needed. ABN was willing to go along with the form of the structured transaction because it had the sophistication to reverse any economic consequences from that form.

[116] Respondent does not ask this Court to determine that a partner in an investment partnership should not be treated as a partner simply because that partner enters into risk-reducing derivative contracts, decreasing or neutralizing the economic consequences of ownership. Rather, Respondent submits that the hedging strategies employed, as well as the terms of the Partnership Agreement demanded by ABN, corroborate Peter de Beer's view: KNX served as a partner solely to accommodate the tax planning goals of CP. See Culbertson v. Commissioner, 337 U.S. 733, 742 (1949); Alhouse v. Commissioner, T.C. Memo. 1991-652, aff'd sub nom. Bergford v. Commissioner, 12 F.3d 166 (9th Cir. 1993) (in determining whether a partnership will be respected for tax purposes courts have examined all factors throwing light on the parties' true intent). KNX did not enter into a joint venture for profit with CP and should be recharacterized as a lender.

A. THE PURPOSE OF KNX'S PARTICIPATION WAS SOLELY TO ACCOMMODATE CP'S

[118] Den Baas immediately did what any bank would do if a client approached it about a loan. Prior to even knowing that KNX would assume any credit risk on the CP debt to be held by ACM, den Baas caused Gallagher to analyze CP's credit. (PF 212, 218, 221). While Gallagher's knowledge of KNX was based only on what den Baas told her, the interest rate was not dependent on the status of KNX. The interest on the loan under the Revolving Credit Agreement between KNX and ABN Cayman Islands was set based on what CP would be charged for such a loan. (PF 308).

[119] In addition, when ABN's Risk Management Department approved KNX's loan, it established two lines of credit to "administrate." One line was to its client KNX. Consistent with the credit proposal, the other line was to "client" CP. (PF 250).

2. ABN CONTROLLED KNX

[120] Meanwhile, in the Netherlands Antilles, de Beer created KNX. (Tr. 989). KNX was technically owned by two foundations (stichtingen), entities with no commercial purpose and which borrowed the requisite minimal capital subscription to KNX from KNX or ABN Trust. ²² De Beer effectively controlled the stichtingen as well as KNX. (PF 298). Under a management agreement that was not substantively needed, ABN Trust was appointed managing director of KNX and made responsible for KNX's management decisions and affairs. (PF 302). By an agreement executed by den Baas, ABN New York made the financial decisions affecting KNX's interest rate and credit risks. (PF 303). Thus, although ABN agreed to finance ACM using the form required by CP, ABN retained exclusive control over KNX's participation. As discussed below, ABN restricted KNX's activities to such an extent that ABN's interests as a lender were effectively projected, through KNX, on ACM.

3. ABN CREATED KNX FOR CP'S TAX PURPOSES

[121] ABN capitalized on the opportunity to gain access to CP by financing the participation of the tax-neutral entity. De Beer harbored no illusions regarding why KNX was created: In response to the Court's question, did ABN ever really want to be a partner or was it participating to accommodate the transactions' form, de Beer answered that ABN was accommodating. (Tr. 1020). Absent the "tax angle", KNX would never have been a "partner." Indeed, CP would probably have gone to one of its main banks for a loan. KNX had no interest in participating in a partnership; rather it provided the "something extra" to secure CP's business. (Tr. 1020).

[122] The tax benefits, the "something extra" KNX's participation provided, resulted in rewards to ABN. Subsequent to ACM, ABN had access to Pohlschroeder and became a member of CP's revolving credit agreement. (PF 217).

4. KNX WAS NOT FORMED TO PROFIT

[123] ABN agreed to finance KNX only if certain conditions were met. (PF 235-42, 243-45). Although the conditions were sent to ABN New York, neither Gallagher, nor den Baas, who described the deal to Gallagher, identified the approval advices setting conditions. ²³ Similarly, nobody claimed knowledge regarding the CP Partnership memorandum of October 10, 1989, describing the deal for ABN's credit committees and referenced in the approval advices. (Tr. 1114-15, 1001, 672). One condition ABN set was that the timing of the purchase and sale of the various securities be adhered to as proposed to ensure the credit risk was no greater than outlined in that CP Partnership memorandum.

[124] In any case, placing conditions on KNX enabled ABN to control KNX's economic future. To control down-side risks, one significant condition ABN imposed was that KNX had to "fully" hedge all interest rate risk associated with its participation in ACM. While this condition protected ABN's capital, it wholly compromised any potential for upside profits KNX could earn.

B. ABN HAD NO MUTUAL PROPRIETARY INTEREST IN THE NET PROFITS OR

1. KANNEX'S RISKS AND REWARDS FROM ACM WERE INSIGNIFICANT

[126] During the period of KNX's participation in ACM, ACM held Citicorp Notes, LIBOR Notes, CP debt and time deposits or other short-term investments managed by ABN. A review of KNX's exposure to the interest rate and credit risk in these assets reveals the strategy ABN designed to hedge KNX's interest in ACM.

a. THE CITICORP NOTES

[127] The Citicorp Notes paid interest at a rate reset monthly to 15 basis points over the commercial paper rate. Den Baas always anticipated that ACM would purchase floating-rate notes because, if the credit of the issuer stayed constant, such notes were designed to trade at par. (PF 434-36).

[128] The Citicorp Notes were rated A1 by Moody's upon their issuance. (PF 438). ABN's credit department was specifically required to approve Citicorp's credit. (PF 239-40).

[129] The Notes had a five year maturity, but provided ACM with the option to put these notes back to Citicorp at par plus accrued interest on October 16, 1991. The put option further protected ACM from any decline in the value of the Notes that might occur as a result of the credit deterioration of an A1 issuer. It also protected ACM from any lags in the commercial paper rate. (PF 439-41). Thus, the only risk of loss incurred by KNX if ACM held the notes until the put date was the risk that Citicorp would default. ²⁴

[130] Citicorp's bankruptcy was an extremely remote possibility given its size and role in the economy. (PF 444). Furthermore, if the parties believed there was the remotest possibility of a Citicorp default, then ACM would never have parked all its funds in the Citicorp Notes. (PF 446). Moreover, the fact that KNX is exposed to some minor default risk does not alter the conclusion that KNX is in substance a lender. Lenders regularly accept default risk.

[131] Nor did the Citicorp Notes represent an opportunity for KNX to share in the rewards of an ACM investment. While Petitioner's expert Grundfest testified that the value of the Citicorp Notes could have risen above par if Citicorp's credit improved, he failed to identify a single instance in which a floating rate note with a put option sold above par due to improvements in the credit quality of the issuer. (Tr. 3105). Moreover, for purposes of the Revaluations, the Partnership carried the Citicorp Notes at cost, or par value. Thus, "[a]bsent an EXTRAORDINARY change of any . . . factors affecting the market value", when KNX got out, its percentage interest in the Citicorp Notes would be valued at par. Ex. 162-FU (emphasis added).

b. THE LIBOR NOTES

[132] The LIBOR Notes were volatile instruments and, based on past experience, den Baas was concerned about the Notes' interest rate risk. ABN thus engineered hedge swaps with KNX: KNX swapped out of its participation in the LIBOR Notes held by ACM in return for a stream of fixed amortizing payments plus floating rate payments based on the ratably amortizing notional amount. As a result of the Big Swap, KNX was assured of receiving a fixed amount corresponding to its interest in the value of the LIBOR Notes at their origination, and a return of LIBOR less 25 basis points on the ratably amortizing amount. KNX swapped out of any of the volatile interest rate exposure stemming from the LIBOR Notes.

[133] Credit risk stemming from the LIBOR notes was generally limited to default risk because the parties agreed that the issuers of the LIBOR Notes would have the highest possible credit rating. BFCE, a quasi-governmental agency, was considered a triple A credit. BOT, rated AA, was not far behind. (PF 517-18).

c. THE CP DEBT

i. CREDIT RISK

[134] Under the Partnership Agreement, KNX assumed minimal credit risk beyond the credit risk associated with a borrower's bankruptcy. ²⁵ The Agreement provided for a special allocation of gain or loss attributable to CP debt (the Quality Component) based on whether there was an improvement or deterioration in CP's credit. Essentially, KNX would not participate in any of the increased value of the CP debt attributable to the improved creditworthiness of CP. KNX would be allocated 15 percent of the decrease in value attributable to a decline in CP's credit, within a specified range. (PF 333, 338-39).

[135] Specifically, SH was allocated 84.7 percent of the Quality Component within a 50 basis point range set with respect to each particular CP debt instrument acquired. KNX was allocated 15 percent of the Quality Component, which percentage was almost inversely proportional to its Partnership interest. If the Quality Component was not within this 50 basis point sharing band, then KNX received no allocation. KNX and SH both had to approve the target acquisition price used to set that range.

[136] Until February 28, 1992, which, under the Partnership Agreement, was the date after which KNX could redeem its interest in ACM, the first $1,241,000 of income otherwise allocable to SH for each partnership taxable year was allocated to KNX. Such amount equalled 73 basis points on KNX's capital investment. The Quality Component in conjunction with this Special Income Allocation was analogous to a credit option given by KNX to SH. (PF 355-56, 358-59).

[137] CP, at the behest of its tax attorneys, insisted that ABN assume some of the downside credit risk on the CP debt. (PF 341, 353). But KNX would not agree to share in the credit risk on the terms proposed by CP. Instead, KNX demanded and received the Special Income Allocation. (PF 354). As Heidtke aptly observed, the Special Income Allocation was provided to ABN in lieu of covenants, ratio tests, and other mechanisms which "provide credit protection for the lender." (Tr. 133).

[138] KNX's return reflected a nominal sensitivity to credit risk because the $1,241,000 "me first" payment to KNX more than covered any potential adverse wealth effects from 15 percent of a 50 basis point decline (or 7 1/2 basis points) in the credit quality of CP's debt. In short, in the event of reasonably foreseeable degradations in CP's credit, KNX was covered. (PF 361). Indeed, den Baas specifically priced the Special income Allocation based on the cost to KNX of assuming the credit risk of different scenarios of CP debt. (PF 358). As an additional covenant, SH was obligated to maintain two percent of ACM's capital to further protect KNX from loss. (PF 368-70). From the outset, KNX intended to wholly limit its exposure to any change in CP credit risk, except that arising from bankruptcy, a risk borne by a lender.

[139] During the time KNX was a partner, the Quality Component allocations totalled $1,541,712. KNX, however, received only ($281) in Quality Component allocations. KNX received $2,304,424.00 as a result of the Preferential Income Allocation, which, based on his pricing of that allocation, was characterized as "a windfall" by den Baas. (Tr. 1173; PF 848, 850).

ii. INTEREST RATE RISK

[140] Under the Partnership Agreement, KNX was also allocated a share of gains and losses of the CP debt attributable to changes in interest rates (Yield Component). Upon five days notice, CP was permitted to change the percentage of the Yield Component allocable to KNX, within a set range. This term of the Partnership Agreement was not a problem for den Baas. He determined he could agree to the term because he would limit KNX's risk exposure through swaps, and just reposition KNX's swaps when the Yield Component was changed. (PF 362, 744).

[141] Consistent with its strategy of limiting its risks, KNX separately and continuously hedged the interest rate risk stemming from its interest in the CP debt held by ACM through a series of interest rate swaps with ABN. Under the swaps, KNX paid a fixed rate in exchange for a floating LIBOR rate, the base for the rate on its ABN loan. If the value of the CP debt increased, because interest rates fell, KNX would owe money on its swaps. If the value of the CP debt decreased, as a result of increasing interest rates, KNX would be owed money. In this way, KNX hedged as closely as possible against the possibility of rising long-term interest rates or, equivalently, declining CP debt values. Reciprocally, KNX relinquished the possibility of benefiting from declining long-term interest rates or, equivalently, rising CP debt values. ABN also hedged the interest rate risk it assumed through the swaps with other counterparties. (PF 737-38, 758).

[142] Because KNX received LIBOR-based payments under the swaps, KNX's return on the money it advanced to ACM was at all times pegged to LIBOR, and not to a fixed-rate return as an investor in CP debt. (PF 746-47). KNX's inflows, being LIBOR-tied, could in turn be used to secure ABN's loan to KNX because ABN's funding rate (the base rate on KNX's loan) was LIBOR flat (or less). KNX swapped out of its position in CP debt and into LIBOR-tied assets, thereby preserving ABN's capital.

[143] The amount of the Yield Component allocated to KNX changed as SH adjusted the allocations. Thus, in order to completely hedge KNX's share of interest rate risk, ABN had to adjust the interest rate swaps in response to changes in the allocation of the Yield Component. An examination of four swaps executed with respect to the Met Note provides an illustration of how KNX adjusted its interest rate swaps to account for changes in the Yield Component. (PF 743- 44).

[144] On November 17, 1989, ACM acquired the Met Note with a total face value of $100 million paying interest at a rate of 8.4 percent. The closing date for the transaction was December 4, 1989. (PF 481).

[145] KNX had contributed approximately 83 percent of ACM capital. Thus, before CP made any changes to the allocation of the Yield Component, KNX stood to share 83 percent of the Yield Component for the Met Note. In order to hedge the interest rate risk associated with the Met Note, KNX entered into a fixed-for-floating interest rate swap with ABN based on a[n] $83 million notional principal amount. Under this notional principal contract, KNX promised to pay ABN interest at a rate of 8.52 percent on an $83 million notional amount. In exchange, ABN promised to make monthly LIBOR-based payments on $83 million notional amount.

[146] The terms of the swap agreement were pegged to the terms of the Met Note. For example, interest on the Met Note was paid semi- annually, on March 1 and September 1. The payments KNX made on the Met Note swap were also semi-annual, corresponding to the payment dates on the Met Note. ²⁶ In addition, the termination date of the Met Note swap corresponded to the term of the Met Note. The swap termination date was September 30, 1993, set near the 4 year average maturity date of the Met Note. ²⁷

[147] Effective November 17, 1989, KNX's percentage of the Yield Component was reduced to 70 percent. (PF 843). As a result, KNX bore interest rate risk with respect to $70 million of the Met Note, rather than $83 million. Because of this change in interest rate risk, KNX entered into a floating for fixed-rate swap with ABN (the opposite-direction of the first Met Note swap) based on a $13 million notional principal amount. The net effect of the two swaps rebalanced the notional principal amount from $83 million to $70 million in order to accommodate KNX's changed interest rate exposure on the Met Note.

[148] Effective December 13, 1989, KNX's percentage of the Yield Component was reduced to 60 percent. As a result, KNX then bore interest rate risk with respect to $60 million of the Met Note, rather than $70 million. Because of the change in interest rate risk, KNX entered into another floating for fixed rate swap with ABN based on a $10 million notional principal amount. The net effect of the three Met Note swaps rebalanced the notional principal amount to $60 million, KNX's adjusted exposure to interest rate risk on the Met Note.

[149] On March 1, 1990, CP made a $12.5 million principal payment on the Met Note. This payment reduced the principal owed by CP on the Met Note to $87.5 million. SH subsequently increased KNX's Yield Component Sharing Percentage to 89.7 percent effective September 6, 1990. As a result, KNX bore interest rate risk on a principal amount of $78,488,000. To hedge the interest rate risk on its share of the Met Note, KNX adjusted the notional principal amount on its swap contracts with ABN from $60 million to $79 million by entering into another notional principal contract, under which KNX paid a fixed rate on $19 million and ABN made floating-rate payments on $19 million.

[150] The following chart displays how KNX's four interest rate swaps accounted for changed allocations of the Yield Component with respect to the Met Note:

Effective Notional  Net Notional  Face Amount Yield      KNX's

d. THE COLLATERAL

[152] The CP debt was physically held by ABN New York. Cash balances of the Partnership were managed by ABN, with the assistance of Merrill, and invested primarily in ABN time deposits. (PF 418-22). As with any lending arrangement, the collateral was physically secured.

2. KANNEX REPATRIATED ITS PROFITS

[153] Petitioner seeks to show that KNX intended to make a profit from its ACM investment, and that KNX's profit was tied directly to the profits of ACM. But at the end of the day, KNX's share of Partnership profits were in the hands of ABN. Moreover, those controlling KNX never expected KNX to profit from its ACM investment. KNX was permitted to borrow from ABN only if it fully hedged its interest rate risk.

[154] Thus, for KNX to make a profit on its investment, the return from that investment had to exceed its initial investment of $169.4 million, interest on the loan, plus the cost of hedging its interest rate risk. But the cards were stacked against KNX, in favor of ABN, because ABN engineered and set the termination fees for KNX's swaps.

[155] Because KNX had to hedge its interest rate risk as completely as possible, its net gain or loss from the structured transaction depended on the value of its swap position. Den Baas calculated KNX's return based on interbank swap rates as he viewed KNX's CP debt swaps as having brought KNX down to a LIBOR level funding rate. (PF 284, 746-48). As den Baas testified, KNX could make money if the yield on the CP debt (reflected in the Yield Component) changed and exceeded the net fixed swap rates KNX paid. ²⁸ (PF 749). But KNX sought to net zero. Den Baas, under a service agreement that disclosed no real fee, hedged KNX's interest in the CP debt "as closely as possible." (Tr. 1166). In theory, KNX gained a little or lost a little depending on the swap spread it paid to ABN. In theory, what KNX made from the swaps, ABN lost.

[156] In either case, the profits attributable to KNX's participation in ACM ended up with ABN. ²⁹ KNX's total stockholder's equity was $4,104,228.51 for the year ended November 30, 1991, immediately after the redemption. KNX's balance sheet for January 27, 1992, immediately prior to the commencement of KNX's liquidation, showed shareholder's equity of $17,277.99. ³⁰ Swap termination fees KNX paid to ABN account for the decrease in shareholder equity. (PF 865-66, 870).

[157] KNX paid ABN swap termination fees totalling $4,835,452, shortly after KNX was redeemed. (PF 867). During the period of KNX's participation in ACM, interest rates decreased and thus the value of the CP debt attributable to changes in interest rates increased. (PF 335, 385, 864). Upon termination of the swaps the net fixed-rate payments KNX was obligated to make were generally greater than the LIBOR based payments it was to receive. ³¹ (PF 860). Because KNX's and ABN's payment streams were on the same notional amount, when the swap positions were valued upon termination, KNX owed money to ABN. As a result of reverse engineering out of the interest rate risk attributable to the CP debt held by ACM, KNX's share of the increased value of that debt during its Partnership participation was paid to ABN.

[158] By artificially increasing the termination payments on certain CP debt swaps and the Big LIBOR Note Swap, KNX repatriated the earnings from its ACM participation to ABN, after paying the interest on its ABN loan. ³² (PF 871-75, 859). Den Baas' employee directed that the artificial portion of the termination payments on the CP debt swaps be credited to den Baas' New York Financial Engineering Group. (PF 824).

[159] In sum, after the purchase and redemption of KNX's interest in ACM, KNX's loan was repaid. KNX transferred the increase in the value of CP debt attributable to the decrease in interest rates to ABN via swap termination payments. It also effectively transferred the value of the option payment (the Special Income Allocation) KNX received for taking credit risk on the CP debt. KNX terminated its swaps and paid fees for the financial and hedging advice which reversed the economic consequences of KNX's participation in ACM.

3. KNX WAS PROTECTED FROM BEARING COSTS

[160] KNX was also protected from bearing its share of the costs of the ACM venture. KNX and ABN shared in almost none of the transaction costs attributable to the ACM Partnership transactions. Not only did SH pay the entire arrangement fee to Merrill, but SH or CP, not ACM, paid attorney and accounting fees upon formation of the Partnership; attorneys' fees associated with ACM's investments; and attorney and facility fees incurred in connection with the loan by Citibank to the Partnership in November of 1991. (PF 383-84, 386-90).

[161] In addition, KNX did not share in the origination costs incurred upon the sale of the Citicorp Notes for cash and LIBOR Notes. At all pertinent times, the LIBOR Notes were valued at an amount which included the origination costs, although the Notes could not be sold at that price. See Arg. III A.3.b., infra. Thus, SH bore the origination costs attributable to the BFCE LIBOR Notes; its capital account was reduced by the book value of the Notes, but it could not recapture the origination costs when it sold the BFCE LIBOR Notes to Unibank. Similarly, CP and SH bore the origination costs of the BOT LIBOR Notes; when KNX sold part of its Partnership interest and when ACM redeemed KNX's interest, KNX received payments that included its share of the origination costs. KNX was protected from bearing any LIBOR Note costs. ³³

[162] Several of Petitioner's witnesses testified that KNX might have borne a pro rata share of the origination costs and remarketing fees had ACM sold the LIBOR Notes while KNX was still in the Partnership. But it was never envisioned that the LIBOR Notes would be sold while KNX was in the Partnership. Further, from the first time transaction costs were discussed, before ABN was even identified, Merrill told CP that the transaction costs associated with the sales of the private placement and LIBOR Notes would be borne by CP. It was understood from the outset that all transaction costs associated with the origination and sale of the LIBOR Notes would be borne by CP. (PF 399, 400, 404, 406, 408, 411). This result is consistent with ABN's understanding that the Citicorp Notes would be sold at par. It is also consistent with the Partnership's implementation of its Accounting Policies. See Arg. III A.3.b., infra.

[163] KNX not only avoided the burden of sharing the costs of acquiring and reselling the LIBOR Notes. It earned a return on the portion of its capital represented by origination costs. (PF 780). The origination costs were carried on ACM's books as an asset because the LIBOR Notes were originally booked at cost and subsequently revalued based on that original cost. (PF 589). Thus, the Partnership had an "asset" in the amount of $1,093,750 upon which it could not earn a return. KNX, however, earned a return on this non-earning "asset." Through "one-sided" Small Swaps, Merrill made quarterly payments to ABN and ABN made identical payments to KNX of LIBOR less 25 basis points on a notional amount. ³⁴ The notional amount was equal to KNX's Partnership percentage interest in the origination costs attributable to the LIBOR Notes held by ACM. In this manner, KNX was assured a return on the origination costs KNX advanced to ACM. (PF 767). The parties "very precisely" structured this swap so that KNX would not even bear the lost opportunity costs from not having the use of its portion of the origination fee.

[164] In the instant case, the parties are not simply allocating costs among partners. Rather, the arrangement ensures that KNX's capital is returned with interest. Such a transparent Attempt to protect KNX's capital is beyond the pale of partnership transactions.

C. KANNEX RELINQUISHED MAJORITY CONTROL AND WOULD BE REDEEMED WITHIN

[166] CP, however, was convinced KNX would be flexible. Indeed, that is how Heidtke explained the arrangement to CP's Board. (PF 173- 74). Although de Beer's testimony concerning the liability management goals of ACM is vague, he clearly understood that KNX was created to accommodate CP. Thus, it is not surprising to find that KNX acquiesced in the debt management transactions, letting CP exchange Long Bonds for other CP debt, or defer principal repayments on the Met Note.

[167] Under the Partnership Agreement, SH and KNX had equal voting power since virtually all Partnership decisions required the consent of representatives of partners owning at least 99 percent of the capital of the Partnership. (PF 367). Such a voting rule could have severely handicapped CP had KNX sought to block transactions critical to CP's investment scheme. But as the minutes from the Partnership meetings reveal, KNX did not interfere with CP's plans.

[168] There is only one indication of matters in which KNX was interested: In setting the target price of the CP debt ACM purchased, KNX further limited its risks. For example, because the Met Note was acquired at less than the target spread SH assumed all of the credit risk until the Quality Component moved within the fifty basis point range above the target spread. By insisting on a high target spread, KNX could further reduce the probability that it would share in credit risk. (PF 482-88).

[169] KNX's acquiescent behavior extended to the critical question of the price at which it should be bought out. While KNX could have demanded a premium, no one expected it would. (Tr. 175). The reason is obvious -- ABN wanted CP as its client and through the credit option and the swaps, KNX assured itself of its targeted return.

[170] By side agreement, ABN Trust, as managing director of KNX, assured CP that KNX would not enter any lending arrangement requiring KNX to pay or perform until February 28, 1992. (PF 387). Essentially, KNX agreed not to encumber ACM's assets. KNX and ABN were willing to accommodate CP for the relatively short period of time necessary for CP to realize the tax loss.

[171] By side agreement, ABN received written assurances from CP that CP would not dispose of its interest in SH as long as KNX was a partner. (PF 380). These provisions further protected KNX and ABN from risks. ABN's "client" would always be CP and KNX's ACM.

[172] Under the terms of the Partnership Agreement, KNX was permitted to withdraw its money from the Partnership a full year prior to any other partner. (PF 371). All the partners expected KNX to withdraw in 1991 so that CP would obtain the tax benefits of the Partnership. (PF 375-77). Indeed, according to the managing director of KNX, the reduction of the foreign partner's interest was pre- ordained. (PF 372-74). The results of the other Section 453 Partnerships in which Taylor and den Baas participated corroborate this result: In each partnership, the foreign partner reduced its partnership interest within a relatively short period of time. (PF 1180).

[173] Thus, rather than use its position as majority contributor to maximize its control over the investment activities of the Partnership, KNX received a set of advantages and preferences that protected its capital: KNX did not share in transaction costs; KNX received the Preferred Income Allocation for accepting limited exposure to loss resulting from the deterioration of CP credit quality; and KNX was assured that it would be out of the Partnership within an arranged time.

[174] KNX did not receive preferential treatment with respect to the investment in CP debt. To the contrary, KNX was placed at a disadvantage. It did not share in gains due to improvements in CP credit quality. It had no control over its share of the Yield Component. In essence, the transaction was designed to allow CP, through ACM, to use KNX's money to accomplish CP's tax goal while protecting KNX's capital from risk of loss. Given these overarching goals and KNX's willingness to accommodate CP, the Court should find that KNX was not a partner but a lender to ACM.

D. THE GOAL OF KANNEX IN PARTICIPATING IN ACM PARTNERSHIP WAS

[176] Acquiring an interest in the assets held by ACM advanced no goals of KNX. Everything KNX did outside of the Partnership was completely inconsistent with the goals of the Partnership, but consistent with ABN's goals as a bank. KNX was not interested in the entrepreneurial risks or rewards of the ACM venture. KNX was characterized as a partner to absorb the $91 million of phantom tax gain recognized upon the sale of the Citicorp Notes so that CP could later claim the phantom tax loss.

E. ACM'S PROPER TAXABLE YEAR IS THE CALENDAR YEAR

[177] ACM filed November 30th fiscal year returns based on KNX's fiscal year. See Section 706(b)(1)(B)(i). If it is determined that KNX was not a partner of ACM, then on the determinative "testing days", SH was ACM's majority interest partner. See Section 706(b)(4)(A)(ii)(I). SH, a member of CP's consolidated group, is a calendar year taxpayer. Accordingly, the taxable years of ACM are the "majority interest" taxable years ending December 31, 1989, December 31, 1990, and December 31, 1991.

III

[179] The installment sale tax gain was not a real economic gain to the Partnership. KNX did not receive more economic value as a result of the allocation. The gain was not reflected in ACM's capital accounts and fails, per se, the economic effect test. Petitioner's expert, Case, argues that the allocation passes the economic effect equivalence test. But the economic equivalence test requires the same real economic effect that the technical capital account maintenance rules require. Thus, the economic equivalency test is irrelevant for an item that has no economic effect.

[180] ACM's allocation also fails the substantiality rules, which are specifically designed to test an allocation for tax effect, taking the different tax attributes of the partners into account. Splitting the allocation of the installment sale gain and loss was designed to create tax benefits, with no corresponding economic burdens or benefits, thus the allocation lacks substantiality.

[181] Under section 704(b), therefore, the $110,749,239.42 installment sale gain must be allocated in accordance with the partners' interests in the partnership. For this determination it is appropriate to look to how the Partnership planned, agreed, and did allocate the offsetting loss.

[182] From the time Merrill presented the investment partnership concept to CP, it was clear that the phantom capital gain at the front-end of the transaction created no economic benefit and the phantom loss at the back-end of the transaction caused no economic burden. Using large-board flip charts, Merrill showed that the capital gain recognized by the partnership in the first year, which for the most part disappeared through its allocation to the tax- neutral partner, was exactly offset by the capital loss recognized by the partnership and allocated to the U.S. corporate partner in a later year. (PF 45-50). As Merrill promoted the investment partnership concept, the capital gain and loss arising from the installment sale transaction totalled zero. (Tr. 3135). Further, through Merrill's exit strategy, the U.S. corporate partner could "make . . . [the] built-in gain [left in its partnership interest] go away under existing law. . . ." (Tr. 877).

[183] Merrill's schematics for CP, like those used in its May 15th presentation, highlighted the tax advantages of exploiting the contingent installment sale regulation. A significant difference between Merrill's promotional materials and the Treasury regulation, however, is that Merrill's promotional materials show no risk in the payments ultimately received by the partners. The cash flows net zero -- the cash and fair market value of the LIBOR Notes received from the sale exactly equalled the fair market value of the notes sold. The simple principle behind Merrill's explanation of the basis recovery rules, and probably that explained to CP's Board, was that phantom capital loss would be generated in an amount that offset the phantom capital gain. (PF 163-64).

[184] Merrill promoted the flexibility of the deal, explaining that loss could be recognized in the year of maturity or sale of the LIBOR notes, whenever the corporate partner preferred. Merrill's customized schematics for CP, which no one claimed responsibility for preparing, noted that recognition of the loss may be accelerated to any year subsequent to 1989 by selling the LIBOR notes. (PF 96, 118- 122). CP did just that. (PF 606, 878). In addition, by adjusting the term of the LIBOR Notes, the tax benefits could be adjusted: Because ACM's tax year ended on November 30th, setting the maturity date of the LIBOR Notes for December 1, 1994, increased the period over which basis would be recovered from five to six years and decreased the ratable basis amount to be recovered in 1989, thereby increasing the loss. Indeed, by just moving the boxes of the schematics representing the partners around, the transaction could generate whatever tax result a client needed: A capital loss to offset a capital gain; a gain to use an expiring loss carryover and a new loss to "refresh" the expiring loss. (PF 18-21).

[185] Flexibility was provided by adjusting either the percentage of cash to LIBOR notes or the amount of private placements sold. Initially, Merrill showed CP a sale of $200 million private placements for 70 percent cash and 30 percent LIBOR notes. (PF 88). That transaction would generate almost $31 million after-tax benefits, the amount of positive "cash benefits" from the transaction reportedly discussed by CP's finance committee. (PF 92, 94-96, 1011). In October 1989, the percentages changed to 80 percent cash and 20 percent LIBOR notes on the sale of $175 million in private placement notes. (PF 91). The changes in the percentage of cash to notes and in the amount of private placements sold produced as great a net tax benefit. ³⁵

[186] Thus, because the transaction generated no economic consequences, Merrill produced a deal as flexible as CP desired. One deal point remained constant and was mandatory for the transaction to succeed. Tax-neutral KNX, which would be allocated most of the capital gain at the front-end of the transaction in 1989, would "accommodate" CP by reducing its interest within time for CP to recognize the phantom capital loss, and carry it back to offset the Kendall gain. The duration of the arrangement among the partners was "defined." (Tr. 177). In other words, CP would buy KNX out.

A. ACM'S ALLOCATIONS LACKED ECONOMIC EFFECT

1. THE ACM CAPITAL ACCOUNTS WERE NOT DETERMINED AND MAINTAINED

[188] The partners' capital accounts were revalued fifteen times, at the end of each tax year, upon distribution of the LIBOR Notes to SH, upon changes in KNX's proportionate interest, and quarterly, at SH's request. As a result of impermissible revaluations, ACM's capital accounts were not determined and maintained in accordance with the mechanical requirements of the "safe harbor (economic effect) rule." Treas. Reg. section 1.704- 1(b)(2)(ii)(b).

2. THE $110.7 MILLION OF PHANTOM TAX GAIN DID NOT AFFECT ACM'S

[190] The $110.7 million tax gain resulting from the installment sale of the Citicorp notes was not reflected in ACM's capital accounts and did not have economic effect because it would not affect what a partner received from ACM. Treas. Reg. section 1.704- 1(b)(2)(ii)(a); Vecchio v. Commissioner, 103 T.C. 170, 190 (1994) (allocation of taxable income from installment sale may have no economic effect); Treas. Reg. section 1.704-1(b)(4)(ii) (tax credits not reflected in capital accounts have no economic effect).

3. ACM'S ALLOCATIONS DO NOT MEET THE ECONOMIC EFFECT EQUIVALENCE

[192] The allocation of the $110.7 million could not, did not, and was never intended to, affect what was to be received by the partners from ACM. Under no circumstances would the allocation increase KNX's capital account claim against the Partnership by its 82.63 percent share of $110.7 million: That allocation was not put into KNX's capital account.

[193] The economic effect equivalence test analysis of Petitioner's expert Case proves nothing with respect to the issue of the proper allocation of the installment sale gain. The economic equivalence test of section 1.704-1(b)(2)(ii)(i) of the regulations only cures allocations that affect the economic position of the partners. An allocation of an item that is not reflected in capital accounts, and has no economic effect, cannot be justified on the grounds that, for economic equivalence purposes, the capital accounts were adequately maintained for items that do have economic effect.

[194] The regulations specifically reach this result. For example, section 1.704-1(b)(4)(ii) of the regulations provides that "[a]llocations of tax credits . . . are not reflected by adjustment to the partners' capital accounts . . . . Thus, such allocations cannot have economic effect . . . [and] must be allocated in accordance with the partners' interest in the partnership. . . ." The fact that a partnership met the economic effect equivalence test would not affect the allocation of tax credits. Like tax credits, the $110.7 million of installment sale gain was not booked by the Petitioner into capital accounts. Thus, that gain had no economic effect and must be allocated in accordance with the partners' interest in the Partnership.

b. ACM'S CAPITAL ACCOUNTS DO NOT MEET THE ECONOMIC EFFECT

[196] ACM sold the $175 million Citicorp Notes at a loss of $1,093,750 (the "origination costs"), reflected in the difference between the $35,504,563.50 book value of the LIBOR Notes and Merrill's $34,410,813.50 net present value of the LIBOR Notes. Based on the proportional notional amount, the BFCE LIBOR Notes had a book value or "original cost" Of $10,144,161, but a market value of $9,831,661. Thus, the portion of the origination costs attributable to the BFCE LIBOR Notes was $312,500, the difference between the book value of the Notes and the Notes' initial market value. (PF 567, 569- 72, 592-93).

[197] On December 13, 1989, ACM distributed the BFCE LIBOR Notes to SH as a partial return of capital. (PF 606). The distribution of the BFCE LIBOR Notes to SH constituted a Revaluation Event under the Partnership Agreement. On the occurrence of a Revaluation Event, the Partnership was required to adjust the capital accounts based on the fair market value of the ACM assets at the date of the Revaluation Event. (PF 328).

[198] SH's capital account was reduced upon the distribution of the BFCE LIBOR notes by an amount that equaled the market value of the Notes plus the portion of the origination costs attributable to those Notes. Merrill valued the BFCE LIBOR Notes at $9,821,534 on December 13, 1989. However, on the Revaluation Worksheets for December 13, 1989, Merrill determined a $10,133,540 value for the BFCE LIBOR Notes, an amount equal to the original $10,144,161 cost or book value of the Notes less the change in their value since November 27, 1989. SH's capital account was decreased by $10,133,540, which amount included the $312,500 origination costs attributable to the BFCE LIBOR Notes. (PF 607-11).

[199] As a result of valuing the LIBOR Notes based on adjustments to cost, SH's capital account was reduced by an amount that included the entire portion of the origination costs attributable to the BFCE LIBOR Notes and did not represent the market value of the LIBOR Notes on December 13, 1989. As Pepe testified, ACM could not have sold the LIBOR Notes for an amount that included the origination costs. (Tr. 1328, 1334). The value of the LIBOR Notes under the Partnership's valuation methodology was not the fair market value of the LIBOR Notes. ³⁷

[200] The "adjustment to cost" valuation methodology was consistent with ACM's subsequently adopted Financial Accounting Policies. ³⁸ ACM's implementation of that policy reflects the pains the partners took to camouflage the economics of the deal, including manipulating their capital accounts, to ensure that KNX would not share in the transaction costs.

[201] Arthur Andersen, ACM's and CP's accountant, could not understand why ACM had not recognized the $1,093,750 loss for financial purposes, resulting upon the sale of the Citicorp Notes. (PF 576). The reasons were mainly tax driven: CP thought that reflecting the loss on ACM's financial statements might alert the Internal Revenue Service to the reasons the Partnership was constructed in the first place and thus the tax losses might be denied. (PF 582).

[202] One proposed solution was to reflect the LIBOR Notes on the balance sheet at a cost value that included the $1,093,750 origination costs. ³⁹ This alternative was problematic because it violated the Partnership Agreement, which provided that costs were to be allocated among the partners in proportion to the partners' capital accounts. (PF 328). In addition, the Partnership Agreement also provided that when partners' capital accounts were revalued, they were to be revalued based on the fair market value of Partnership assets, determined as if there were an actual disposition of such assets at their fair market value. Therefore, under the Partnership Agreement, the partners' capital accounts should have been reduced by each partner's pro rata share of the $312,500 origination costs attributable to the BFCE LIBOR Notes and then SH's capital account should have been further reduced by the fair market value of the BFCE Notes.

[203] On February 14, 1990, Arthur Andersen opined that reflecting the LIBOR Notes at a value that included the origination costs required a side letter providing that the LIBOR Notes were the one exception to the Partnership's valuation rules which otherwise required a valuation at market. (PF 586). ACM ratified this very valuation methodology as part of its Accounting Policies adopted at the fourth partnership meeting on February 28, 1990. ⁴⁰ (PF 589).

[204] The Partnership's valuation methodology concerning the LIBOR Notes was flawed economically because it violated fundamental principles of cost and accrual accounting. Essentially, upon valuation of the LIBOR Notes, the origination costs that were being amortized on a straight-line basis, were unamortized. The $1,093,750 origination represented a prepaid expense. Under proper accounting and economic practice, these costs should have been amortized. (PF 596-98).

[205] On December 13, 1989, the inherent loss in the BFCE LIBOR Notes was at least $312,500. KNX, SH and MLCS should have been allocated their respective percentage interests in the origination costs of the BFCE LIBOR Notes and then SH's capital account reduced by the fair market value of the BFCE Notes. ⁴¹ If that had been done, KNX's and MLCS's capital accounts would have decreased and SH's capital account would have increased. If ACM's capital accounts had been maintained in strict compliance with the "safe harbor" capital account maintenance rules, the resulting capital accounts would differ from those arrived at by ACM.

[206] As noted above, under ACM's Accounting Policies, the LIBOR Notes were to be revalued based on interest rate changes only upon the distribution of the Notes, the redemption of a partner or the liquidation of the Partnership. However, upon the partial sale of KNX's interest to SH and CP, the Partnership violated its own accounting policies. Although the partial purchase of KNX's interests by SH or CP was not a redemption or Partnership liquidation, for purposes of the June 27, 1991 Revaluation Worksheets, the LIBOR Notes were revalued based on interest rate changes. The $781,250 origination attributable to the BOT LIBOR Notes was added to the resulting value of the LIBOR Notes. (PF 829-30). As a result, when CP and SH purchased portions of KNX's interest they paid KNX for its proportionate share of the origination costs. ⁴² To ensure that KNX would not share in the origination costs, the Partnership violated its own policies.

[207] The ACM Accounting Policies, upon which the partners' capital accounts were sometimes based, violated the terms of the Partnership Agreement, fundamental accounting principles and the regulatory rule. A liquidation of the Partnership would not have produced the same economic results to the partners as would have occurred if the requirements of Treas. Reg. section 1.704- 1(b)(2)(ii)(b) had been satisfied.

B. THE ACM ALLOCATIONS LACKED SUBSTANTIAL ECONOMIC EFFECT

[208] Even if the allocation of the $110.7 million gain had economic effect, which it did not, the allocation would be invalid under the substantiality prong of the substantial economic effect test of section 704(b)(2).

[209] Because the $110.7 million was not reflected in the partners' capital accounts and the Partnership never intended to give KNX $110.7 million, there was no reasonable possibility that the allocation of that amount would affect substantially the dollar amounts to be received by the partners from the Partnership, independent of tax consequences. Treas. Reg. section 1.704- 1(b)(2)(iii)(a) (the "substantiality rules"). Petitioner's expert Case did not assert that ACM's allocations met the substantiality rules.

[210] The substantiality rules contain an overall tax effect rule that was not satisfied by the allocation of the $110.7 million to KNX. At the time the Partnership was formed, it was agreed that the allocation would substantially enhance the after-tax consequences to SH, in present-value terms, and that it would not substantially diminish the after-tax economic consequences to KNX. See Treas. Reg. section 1.704-1(b)(2)(iii)(a). De Beer specifically concluded that there would be no after-tax economic consequences to KNX, either under Netherlands Antilles or United States tax laws. (PF 285-88). He then agreed that KNX would leave the Partnership in time for CP to substantially enhance its after-tax consequences. (PF 372-74). For its part, Merrill promoted the deal in after-tax present-value terms (sometimes called "net cash benefits"), and its promotional materials were based on the premise that the tax-neutral partner would leave ACM within two years. (PF 55, 83, 92-95, 99, 119, 144).

[211] The investment partnership concept that Merrill developed and sold to CP required a majority partner with significantly different tax attributes than CP. The allocation of the installment sale gain exploited the significantly different nonpartnership tax attributes of CP, a United States taxpayer that had just reported approximately $105 million of capital gain from the Kendall sale, and the tax-neutral foreign partner, KNX. The substantiality prong of the section 704(b) regulations specifically considers the tax consequences that result from the interaction of the allocation with a partner's tax attributes that are unrelated to the partnership. Treas. Reg. sections 1.704-1(b)(2)(iii)(a) and 1.704-1(b)(5) Exs. 5 and 9. In example 9, the regulation looks to both the nonpartnership attributes of the partners and to their allocations over more than an eight year period to determine if the allocations in year one are substantial. The same approach applies here. ACM's allocation of the $110.7 million gain is a perfect example of an allocation that lacks substantiality because it capitalizes on the variance in tax status, without changing the non-tax economics of the transactions.

[212] Because the allocation of the $110.7 million taxable "gain" in 1989 lacked substantial economic effect, all $110.7 million of that tax gain must be reallocated in accordance with the partners' interest in the partnership ("PIP") or, more specifically, in accordance with the partners' interest in that particular item. See Section 704(b); Treas. Reg. section 1.704-1(b)(3)(i).

C. THE PHANTOM INSTALLMENT SALE GAIN SHOULD BE ALLOCATED TO

[214] The parties' underlying arrangement called for a CP- related entity to recognize almost the entire phantom tax loss from the sale of the private placement notes. That arrangement was one of the first points Merrill explained to Pohlschroeder in May of 1989 and that arrangement never changed. Each of Merrill's transaction summaries provided that 98 percent of the recognized loss on the sale of the LIBOR notes would be allocated to CP. (Exs. 57-BE, 58-BF, 59- BG). Merrill's September 20, 1989 "Investment Partnership Presentation" to CP showed the CP partner recognizing 97 percent of the loss. (Ex. 81-CE). The arrangement was relayed to CP'B Board of Directors at the October 12, 1989 meeting: Belasco told the Board that ACM would benefit CP by generating a significant capital loss to offset the Kendall gain. (PF 163, 166-67).

[215] As set forth in transaction summaries and the September 20, 1989 presentation, CP would achieve the tax benefit through the distribution of a portion of the LIBOR Notes to SH in 1989, which would immediately churn them to offset its share of the initial phantom gain. The remaining LIBOR Notes would be sold in 1991, after the tax-neutral foreign partner exited the partnership.

[216] CP's accountant, who met with representatives of CP and Merrill regarding ACM, understood that CP would recognize almost all of the phantom 10SB on the sale of the LIBOR Notes. Indeed, Rossi memorialized how CP should account for the book/tax differences that would arise from ACM due to the "large tax losses [that] will be realized", noting that "no book losses will be recognized." (Ex AYX). In his memorandum, Rossi laid out in steps the two year time period in which the losses would be recognized. Rossi further detailed the exit strategy CP would undertake, to forever defer the recognition of any of the phantom gain. (PF 103-09, 112-16).

[217] Despite testimony to the contrary from den Baas, ⁴³ de Beer understood at the Bermuda meetings that KNX would never receive the phantom loss from the installment sale. From the perspective of KNX, the Partnership was created principally for tax purposes. (Tr. 1018). Based on his conversations with Taylor and Fields, de Beer understood at the time of the formation of ACM that Merrill and CP were trying to accomplish a "tax angle" through the Partnership involving transactions that would create a capital gain and at a later stage a capital loss. KNX would take the majority of the gain, and CP would take the capital loss. (PF 272-74).

[218] KNX would not be allocated the phantom loss because KNX would reduce its interest in ACM prior to February 28, 1992, in time for CP to use the loss. Heidtke, CP's lead negotiator in Bermuda, thought there was "defined duration" to KNX's participation in ACM of about two years and that this defined duration related to the realization by CP of the tax benefits from the ACM transaction. (PF 375-76). De Beer's and Heidtke's understanding was consistent with ACM's accountants, who, in a February 1990 memorandum, acknowledged that "ABN will leave the partnership in October 1991." (Ex. AZA (AA00117)).

[219] Given KNX's prearranged transitory interest, the phantom gain allocation does not comport with the partners' interest in that particular item. Treas. Reg. section 1.704-1(b)(3)(i). Based on the partners' arrangement, the phantom gain must be allocated to MLCS and SH, the partners (or affiliates) who were to be allocated the phantom loss. Treas. Reg. section 1.704-1(b)(2)(ii)(h) (partners' agreement includes all agreements among the partners, whether oral or written, and whether or not embodied in a document referred to by the partners as the partnership agreement).

[220] The phantom gain tax allocation had no economic effect. Under the regulations, certain items that do not have economic effect are allocated based upon allocations of related items that have economic effect. See Treas. Reg. section 1.704-1(b)(4)(ii) (tax credits that have no economic effect are allocated based upon deductions that have economic effect); Treas. Reg. section 1.704-2(e) (deductions attributable to nonrecourse liability must be allocated consistent with allocations of items attributable to the property securing the nonrecourse liability that have substantial economic effect).

[221] The only allocation related to the installment sale that had economic effect was the allocation of the transaction costs, which were borne entirely by SH and CP. The allocation of the transaction costs in ACM provides an objective measure of the partners' interest in the partnership with respect to the $110.7 million gain. The parties ensured that KNX bore none of these costs by adding the $1,093,750 origination costs to the market value of the Notes in determining the partners' capital account balances. While these costs may seem minimal in comparison to the installment tax gain, the costs were enormous as a percentage of the economic effect of that gain. While the allocation of costs may not always accurately indicate a partners' interest in a partnership, in this case, the allocation was manipulated in contradiction of Petitioner's own form. See Arg. III A.3.b., supra. ACM allocated the transaction costs to SH and CP while making it appear that the allocations were being made pro rata pursuant to the apparent Partnership Agreement. The parties ensured that the economic costs were borne by the parties who would and did receive the phantom tax loss.

[222] Outside the Partnership structure, Merrill further protected KNX from loss on the LIBOR Notes by hedging KNX's interest rate risk with respect to KNX's "share" of the LIBOR Notes held by ACM. In addition, through the Small "one-sided" Swap, Merrill ensured KNX a return or "interest" on the origination costs. These swap transactions, between Merrill, ABN and KNX, are properly considered in determining the agreements among the partners. Treas. Reg. section 1.704-1(b)(2)(ii)(h). ⁴⁴ As a result of the swaps, neither KNX, nor ABN, bore the interest rate risk attributable to the LIBOR Notes, the asset creating the contingency for installment sale method reporting. Merrill protected KNX from the only significant economic loss from the installment sale generating the phantom gain.

[223] The formal and informal agreements between the partners demonstrate that KNX held a transitory interest in the Partnership, that the phantom loss would not be generated until KNX's interest was reduced, and that the phantom loss would be allocated to CP affiliates. KNX had no interest in the phantom tax gain or corresponding loss of the Partnership. Thus, for this item, KNX's PIP was zero. Alternatively, the gain should be allocated consistent with the only portion of the installment sale transaction that did have economic effect, the transaction costs which were borne by SH and CP. In either case, the phantom tax gain should be allocated to SH and MLCS, in accordance with the partners' preplanned underlying economic arrangement.

D. THE REBUTTAL OF THE REGULATORY PRESUMPTION

[224] Section 1.704-1(b)(3) of the regulations provides a rebuttable presumption that the partners' interests in a partnership are presumed to be equal, on a per capita basis. For the reasons discussed above, that presumption is rebutted by Respondent: The installment gain should have been allocated to SH and MLCS, and not to KNX. If the Court finds otherwise, Respondent alternatively submits that given the arrangements in this deal, Petitioner failed to rebut the regulatory presumption that each of the partners had a one-third interest in the $110.7 million of gain recognized by ACM in 1989.

IV

[226] The first critical step was to find a tax-neutral partner which would adhere to the blueprint. That partner was KNX, whose departure was pre-set to accommodate the flip-charted plan. The parties agreed, outside the evident terms of the Partnership Agreement, that KNX would reduce its interest in time for CP to realize the phantom tax loss. See Arg. I A., supra. That agreement, in itself, supports collapsing the steps of the tax plan. See Security Industrial Ins. Co. v. United States, 702 F.2d 1234, 1245 (5th Cir. 1983) (discussing the step transaction doctrine and maintaining that taxpayers should not be able to evade the doctrine simply by abstaining from formal commitments).

[227] The next steps, the purchase and sale of the floating rate notes, began to be arranged before ACM was ever formed. (PF 435, 455, 456). The steps would not have been undertaken were it not for the tax ramifications. Indeed, in the face of declining CP debt spreads (PF 967), ACM's alleged goal of purchasing CP debt was deliberately delayed to implement the steps of the tax plan. See Kuper v. Commissioner, 533 F.2d 152, 156 (5th Cir. 1976) (the interdependence test applies "when it is unlikely that any one step would have been undertaken except in contemplation of the other integrating acts").

[228] In complete contradiction to any authentic liability management objectives, CP added the purchase of the Met Note to the partnership structure in an attempt to substantiate a non-tax objective. See Arg. I C.1, supra. Prior to the formation of ACM, CP determined that the Met Note was available. In the late summer or early fall of 1989, Pohlschroeder asked Met Life if it would be interested in selling the Met Note. On October 3, 1989, Pohlschroeder assured Heidtke that, as a result of his inquiry to Met Life, he was confident the Partnership could purchase approximately $140 million of CP debt. On that same date, Merrill's Yordan also wrote Heidtke, telling him he thought the Met Note was available. See also Arg. I C.1., supra. (PF 465, 470-474).

[229] On October 23, 1989, Pohlschroeder discussed pricing the Met Note with Yordan. (PF 475). On November 17, 1989, the Met Note was purchased at a spread below the target spread set by the Partnership. (PF 481, 485). Petitioner's claim that the Met Note might not have been acquired, is weakened by SH's agreement to initially bear the $400,000 negative allocation of the Quality Component resulting from the below-target spread. (PF 486).

[230] Further, the evidence suggests that Met Life would sell whenever CP was ready to purchase. Met Life had approached CP about adding an events risk clause to the Met Note in November 1988, which CP had rejected. (PF 471). Met Life was under pressure to secure its portfolio, which CP realized. (PF 472-73). Before travelling to Bermuda, Symington informed Pohlschroeder, on November 13, 1989, at what price the Met Note could be purchased. (PF 476, 478). The next day, still before the Bermuda meeting, Met Life prepared the Met Note for a November 17, 1989 CP-affiliate sale. (PF 477).

[231] The purchase of the Long Bonds and the Euro Notes was also delayed to permit the tax steps to be executed. In October of 1989, Yordan went to Bermuda to discuss the availability and prices of the Long Bonds and Euro Notes. (PF 490). At that time, Yordan knew who held some of the targeted CP debt. (PF 491). On October 27, 1989, Pohlschroeder requested that de Beer issue the standing order instructions to purchase the Long Bonds and Euro Notes, but not until after the Citicorp Notes were purchased. (PF 492).

[232] The Citicorp Notes were sold on Monday, November 27, 1989. By the very next day, Merrill agreed to sell the $31 million principal amount of Long Bonds it held to ACM, for settlement on December 4, 1989. ⁴⁵ (PF 495). By December 1, 1989, ACM agreed to purchase $5 million of the Euro Notes, with settlement dates of December 4, 1989 ($1 million) and December 8, 1989 ($4 Million). ⁴⁶ (PF 496).

[233] The Citicorp Notes were not purchased while ACM determined what CP debt was available. That was known and the debt was even priced, beforehand. The CP debt purchased in mid- and late November 1989 could have been accomplished at the Partnership's inception. Based on Pohlschroeder's instructions to de Beer, the risk was that the CP debt would be purchased before ACM could purchase the Citicorp Notes. The purchase and sale of the Citicorp Notes were meaningless steps in the allegedly legitimate CP debt transactions.

[234] Petitioner went to great lengths to have the pre- determined steps appear as considered Partnership transactions related to liability management goals. The minutes of the partnership meetings, written well in advance, never failed to clearly articulate the purported business purpose for each step. (PF 415). Pepe referred to the purported liability management goals as "business purpose" and reminded himself to "further substantiate" or "enhance" the business purpose at Partnership meetings. For the meeting coinciding with the partial purchase of KNX's interests, Pepe noted "business purpose discussions." (PF 1014). But as KNX's actions reveal, the purchase and sale of the floating rate notes, as well as the buy-out, were unconnected to CP's liability management goals.

[235] KNX, the majority partner, refused to hedge the CP debt with the LIBOR Notes, the Partnership's claimed reason for acquiring them. See Arg. I B.1.b., supra. ABN conditioned KNX's participation upon the timing of the transactions, directing that "the timing of the purchases and sales of the various securities be adhered to as proposed" so that KNX's credit risk was no greater than as outlined in the missing "CP partnership memorandum." (Ex. DQ). Whatever the timing of CP debt purchases, ABN understood that the sale of the floating rate notes would take place by November 29, 1989. That date is coincident to the assumption of Merrill's September 20, 1989 schematics. As the "Presentation" reflects, had the floating rate notes not been purchased and sold within the month of November, the mismatch of income and loss generated by the selection of the six year basis recovery period would not have been maximized. (PF 119, 246).

[236] Each step taken by ACM was carefully timed to ensure that the intended result was obtained. See American Bantam Car Co. v. Commissioner, 11 T.C. 397, 405 (1948), aff'd, 177 F.2d 513 (3d Cir. 1949), cert. denied, 339 U.S. 920 (1950) (factors considered in determining if the doctrine applies are the intent of the parties, the timing of the transactions and the "pragmatic test of the ultimate result"). Moreover, the timing of the transactions bore no relationship to any purported reasons for purchasing CP debt, but rather only related to the tax loss achieved.

[237] The LIBOR Notes were distributed as planned to shelter CP, a calendar year taxpayer, from the Partnership's initial year's phantom gain. The LIBOR Note issuers understood that some portion of the LIBOR Notes would be terminated in early to mid-1990. (PF 686- 87). The $4.7 million dollar exchange of Long Bonds for shorter-term CP debt used to justify the LIBOR Note distribution was contrived. See Arg. I B.1.b., supra. ⁴⁷ CP's accountant laid out the timing of the steps of the transactions without reference to their relationship to CP debt purchases. (Ex. AYX). Indeed, CP's accountant showed the LIBOR Note distribution occurring prior to the purchase of CP debt. (PF 114).

[238] Merrill also provided CP with the steps of the "exit strategy." (PF 103-08). By liquidating the Partnership into a newly formed corporation, redeeming MLCS, and then merging the new subsidiary into an active CP subsidiary, Merrill showed CP how to permanently shelter the Kendall gain. These steps were chronicled for 1992, after the October 1991 redemption of KNX was to occur. (PF 114).

[239] All of the interested CP parties, except Pohlschroeder, testified that the redemption of KNX in 1991 was anticipated. (PF 375, 377). De Beer, the attorney, testified that the reduction in KNX's interest was pre-set. The overriding intent and arrangement were always to follow the steps of the tax plan. Penrod v. Commissioner, 88 T.C. 1415, 1430 (1987) ("end result" test based on the actual intent of the parties as of the time the first step is taken).

[240] ABN's and Merrill's intent can be further deduced from their participation in the other Section 453 Partnerships. In each of the ten other pattern evidence partnerships, Merrill structured the purchase of private placements and then arranged, within at most three months, for their sale. (PF 1056). The sale was always at a high percentage (75-85%) cash to LIBOR Notes, structured almost identically to those issued to ACM. LIBOR notes were sold, generally by U.S. corporate partners after distribution, and after ABN's interest in those notes was extinguished. (PF 1182-84). Moreover, the foreign partners all left those partnerships, in most cases, in less than two years. (PF 1180).

[241] ABN's actions in those partnerships corroborate de Beer's testimony about ACM. De Beer, who formed approximately fifteen corporations like KNX during his tenure at ABN Trust, understood that KNX's role was structured solely to permit the tax benefits to be realized as planned. (PF 267, 269-79, 282).

[242] The advisory agreements between SH and Merrill and ACM and Merrill, provide for Merrill's exclusive engagement through December 31, 1991, the last date the capital loss could be carried back to offset the Kendall gain. (PF 383, 384). Merrill staked its reputation on the timing of the transactions it sold, and through its potential fees built into the swaps it structured, could ensure that the transactions would occur as planned. See Arg. I B.2., supra. Merrill intended for the steps of its "investment partnership" to do nothing of substance, because that would alter the flexibility of the tax plan. See Arg. III.

[243] CP readily admits a tax motivation, but insists that its "business purpose" justifies the claimed $110 million phantom tax loss. Respondent submits that even if this Court determines that certain ACM transactions were not shaped solely for tax avoidance considerations, the form in which the ACM transactions were cast was inconsistent with their true nature. See Packard v. Commissioner, 85 T.C. 397, 419 (1985). The structured tax steps were meaningless to CP's alleged liability management goals. The steps that existed only to alter the tax liabilities should be eliminated or treated as lacking substance for tax purposes.

CONCLUSION

[244] It follows that the determination of the Commissioner of Internal Revenue, as modified by Respondent's Amendment to Answer, should be sustained.

Stuart L. Brown

[245] This is to certify that a copy of Respondent's Brief was served on counsel for Petitioner, by mailing the same on May 2, 1996, in a postage paid wrapper addressed to William L. Goldman and Christopher Kliefoth, McDermott, Will & Emery, 1850 K. Street, NW, Washington, D.C. 20006, and to Frederick T. Goldberg and Albert H. Turkus, Skadden, Arps, Slate, Meagher & Flom, 1440 New York Avenue, NW, Washington, DC 20005.

[246] This is to further certify that the original of Respondent's Brief was mailed to the Court on May 2, 1996

Date: May 2, 1996

² "PF" refers to Respondent's Proposed Finding of Fact.

³ All of the Merrill swaps were entered into by MLCS, the Merrill subsidiary that acted as a swap counterparty. Tr. 661-62.

⁴ Shortly after this transaction, Sparekassen SDS merged with other Danish banks to become Unibank A.S. PFF 652.

⁵ UW and VE are the same document. Because different witnesses testified based on different exhibits, both exhibits are referenced in Respondent's findings.

⁶ The swap agreement refers to a Mitsubishi LIBOR Note dated May 23, 1990 (Ex. APW, p. 3), however, the Assignment Agreement (Ex. APU) specifically references the Mitsubishi LIBOR Note dated May 17, 1990.

⁷ While the October 23, 1990 Assignment Agreement between AHP and Unibank identifies the Mitsubishi LIBOR note as Installment Purchase Agreement I, it further states that it relates to $100 million aggregate principal amount FRCDs of Norinchukin (Tranche B). Ex. ARX. Because this same LIBOR note I was identified in the assignment to BOT (Ex. ARR) and the actual LIBOR note issued by Mitsubishi relating to the FRDCs of Norinchukin (Tranche B) is identified as IPA IIIB in the transactional documents (Ex. AQW), it appears that the October 23, 1990 Assignment Agreement misidentifies the LIBOR note. The notional amount upon which Unibank was obligated to make payments to Merrill under the hedge swap is based on the notional amount of the Mitsubishi LIBOR notes II and IIIB. Ex. ARZ.

⁸ Beder's analysis shows a 7.75% probability of selling the Citicorp Notes at a profit on November 24, 1989, and virtually no probability prior to that date. (Ex. 519, Tables IV-D, IV-E).

⁹ Both SH and CP, as a result of purchasing a portion of KNX's interest in June of 1991, bore these costs. See Arg. III A.3.b., infra.

¹⁰ The remaining $27,312 was attributed to interest rate changes between December 13, 1989 and December 20, 1989. (PF 683).

¹¹ The price at which Unibank purchased the BFCE LIBOR Notes from SH ($9,406,180) included an accrued interest factor. As a result of the provision in the swap between Unibank and Merrill providing that Unibank's payments to Merrill would commence on December 1, 1989, twenty-two days prior to the date upon which Merrill's payments to Unibank commenced, the accrued interest was passed to Merrill. (PF 682).

¹² After KNX left the Partnership, ACM partially justified its decision to sell the LIBOR Notes on the grounds they were too volatile to continue to hold. (PF 884).

¹³ Over $400 million of LIBOR Notes were sold to Unibank and terminated or reassigned within three to nine months. (PF 1188-89).

¹⁴ Notably, to get the "profit" out of the Partnership, CP would either have to engage in the exit strategy Merrill had devised or realize tax gain equal to its profit. CP anticipated that its basis in ACM, after the "anticipated" redemption of KNX and recognition of the tax loss upon the LIBOR Notes' sale, would be close to zero. (PF 114).

¹⁵ ACM did not acquire the CP debt directly. Merrill purchased some of the CP debt acquired by ACM and then sold it to ACM. (PF 494- 95).

¹⁶ Because the Partnership was not consolidated on CP's financial statements until 1991, any reduction in CP's long-term debt to capital ratio between 1989 and 1990 is unrelated to ACM. (Ex. 517, pp. 11, 42).

¹⁷ Although that term had allegedly not been negotiated at the time the memorandum was written, Pohlschroeder's memorandum sets forth three scenarios, performed by Merrill, whereby CP's interest in the Yield Component changes from 49 to 100 percent, the range of the actual Yield Component option. (Ex. 86-CJ, PF 336).

¹⁸ The finance committee minutes reflect that the transaction would generate $31 million in positive cash flows, an after-tax figure that presumably equates tax benefits with cash. (PF 1101).

¹⁹ This return combines SH's return, from the inception of the Partnership through KNX's redemption and CP's return from the KNX interests it purchased in June 1991, through KNX's redemption. (PF 852).

²⁰ During KNX's participation in ACM, Quality Component changes totalled $1,541,712, of which a negative $281 went to KNX. SH's option to adjust the Yield Component resulted in it being allocated $1,641,799 of the total $5,744,233 Yield Component changes. (PF 846-48).

²¹ Taylor testified that the one-sided swap between ABN and Merrill resulted from a mistake he made, at the expense of Merrill, that allowed ABN to negotiate the return on the origination reflected in the Small Swap. He further testified that the one-sided Small Swap was for a one year term. (PF 768). Den Baas testified he did not independently recall discussions with Merrill regarding the Small Swap but that the likelihood was very large that the swaps between Merrill and ABN mirrored the Big and Small swaps between ABN and KNX, which were for the complete term of KNX's interest in ACM. (PF 772- 75). Pepe did not recall negotiations for the Small Swap. (PF 770).

In all the other Section 453 Partnerships in which Taylor and den Baas participated that had small and big swaps (all but the first), the term of the small swap corresponded to the term of the big swaps. (PF 1176-79). Den Baas said that Merrill requested that the swaps between ABN and Merrill be split into two documents, and there is no explanation of why. (PF 774).

²² De Beer testified that the capital contributions of the stichtingen were borrowed from ABN Trust, however, KNX's financial statements show assets, characterized as accounts receivable or loans, in the amount of $6,000, the total amount of the stichtingen capital contributions. The notes to KNX's January 27, 1991 financials specifically identify the loans as those to Glamis and Coign. (PF 299).

²³ Den Baas was aware that ABN expected KNX's interest in ACM to be hedged; that ABN considered its position as ESOP trustee when evaluating the deal; that KNX required the floating rate notes be sold at par, and that the loan to KNX had to be syndicated, four of the conditions understood by ABN's credit committees. (PF 740-41, 251, 433, 248).

²⁴ On November 27, 1989, ACM sold Citicorp notes with a face value of $175 million at a discount of 5/8 or $1,093,750. This cost was borne solely by SH. See Arg. III A.3.b., infra.

²⁵ Before ABN consented to participate, its credit committees in Chicago and Amsterdam reviewed CP's creditworthiness. (PF 228-32, 234, 244).

²⁶ In February of 1991, KNX's payment dates on subsequent Met Note swaps changed to April 1 and October 1. However, the pattern of setting the payment dates on KNX's swap payments to the payment dates on the CP debt is reflected in all of the CP debt swaps in which KNX engaged. (PF 743).

²⁷ The Met Note called for ratable principal payments, thus an average maturity date was used for the KNX Met Note swaps. The termination date on the other KNX CP debt swaps also generally corresponded to the maturity date of the hedged CP debt. For example, the term of the KNX Long Bond swaps precisely corresponded to the maturity date of the Long Bonds. (PF 743).

²⁸ KNX received monthly LIBOR-based payments on a notional amount equal to its percentage interest in the CP debt based on the Yield Component allocation. It paid a then fixed-rate equivalent (based on Treasuries) to the monthly LIBOR rate it received plus a swap spread. If KNX's percentage interest in the yield of the CP debt (reflected in the Yield Component which constantly changed inversely to interest rate changes and in the same direction as changes in the value of the CP debt) were more than the combined fixed rate and swap spread it paid, KNX could make the difference. If its percentage interest in the Yield Component of the CP debt were less than the combined fixed rate and swap spread, KNX could lose money. Where KNX had immediate consequences from an ACM revaluation, such as upon purchase or redemption of its interest, Merrill and ABN New York Financial Engineering discussed the yield on the Treasury index used to value the CP debt for purposes of the Revaluation Worksheets. (PF 749-55).

²⁹ ABN's North American Credit Committee inquired whether the proceeds from KNX's participation in ACM would be assigned to ABN. (Ex. DQ (Condition 3)).

³⁰ Of that remaining amount, $6,000 represents the contributions of Coign and Glamis to KNX. (PF 866).

³¹ Because the bulk of the CP debt was acquired in late 1989, the original fixed-rate payments KNX made on its swaps were set then. Thus, because the floating LIBOR payments KNX received moved with the market direction of interest rates and the fixed-rate payments stayed the same, KNX owed money when the swaps were terminated.

³² KNX's January 27, 1992 balance sheet also shows a $550,606.50 lose, primarily attributable to "swap portfolio revaluation." For settlement November 29, 1991, simultaneously with the redemption of KNX from ACM, the swaps between Merrill and ABN and ABN and KNX were terminated. There is a $500,000 difference between the termination fee Merrill paid ABN and the termination fee ABN paid KNX, which appears to account for much of the "swap revaluation." (PF 868, 764).

³³ Additionally, SH bore the entire amount of the approximate $400,000 in remarketing fees associated with the sale of the BFCE LIBOR Notes. CP and SH bore the burden of the remarketing fees when the BOT LIBOR Notes were sold.

³⁴ It is clear that the one-sided Small Swap between KNX and ABN was for the complete term of KNX's interest in ACM and in all likelihood, the Merrill-ABN Small Swap had the same term. (PF 775); see also n.14.

³⁵ Fields calculated a net tax loss of $9.58 million in year one, based on the difference between the percentage of phantom gain CP would recognize from the sale of the floating rate notes (17.07% of $110.83 million) and the loss it would recognize upon the sale of the distributed LIBOR Notes ($9 million fair market value -- $37.5 million tax basis). The remaining basis in the LIBOR Notes ($108.33) would generate roughly $83 million in capital loss (assuming a $25 million LIBOR Note value). At a 34 percent rate, the entire transaction could produce roughly $31 million in tax benefits. (Ex. BT; Tr. 822-23).

³⁶ Upon the sale of the LIBOR Notes in December 1991, the Partnership recognized an $84,997,111 capital loss but reflected only a $1,983,458 book loss on its revaluation and audited financial statements. That loss reflects the origination and remarketing costs attributable to the BOT LIBOR Notes and an economic loss attributable to the decrease in interest rates over the term the Partnership held the BOT LIBOR Notes. (PF 880-81, 887-89).

³⁷ Moreover, on December 22, 1989, when the LIBOR Notes were sold by SH, the sales price ($9.4 million) was equal to the cost of the BFCE LIBOR Notes ($10.144 million) decreased by not only the origination ($312,500) but also by "remarketing costs" (approximately $400,000) incurred upon the Notes' sale. Leaving interest rate changes aside ($27,312), SH sold the BFCE LIBOR Notes a little more than one week after they were valued for capital account purposes, for an amount which was $700,000 less than distribution value for capital account purposes. If the December 22, 1989 sale were at fair market value, then under the capital account maintenance rules, the value of the LIBOR Notes should have been further reduced upon distribution to SH. In any case, the fact that the BFCE LIBOR Notes' sales price was reduced by the origination cost proves that SH's capital account was not decreased by the fair market value of property distributed by the Partnership. (PF 645, 683-84).

³⁸ Under ACM's Accounting Policies, the original cost of the LIBOR Notes was amortized on a straight line basis and the effect of changes in interest rates on the value of the LIBOR Notes was not taken into account upon most Revaluation Events. The LIBOR Notes were revalued based on interest rate changes only upon the distribution of the Notes, the redemption of a partner, or the liquidation of the Partnership. To arrive at a LIBOR Note value based on interest rate changes, Merrill compared their market value for the LIBOR Note plus the attributable origination to the then current book value of the LIBOR Notes. The book value of the LIBOR Note was then adjusted by that difference. The effect of the policy on ACM's capital accounts was that Merrill's valuation of the LIBOR Notes based on the then current interest rate environment was inflated by the attributable origination costs. (PF 589-90, 592-94, 607-09, 829-30, 887-88).

³⁹ Cp's and ACM's accountants understood that CP was going to bear the transaction Costs related to the sale of the Citicorp notes for cash and LIBOR notes. All the alternatives Arthur Andersen and CP considered to avoid IRS scrutiny of the $1,093,750 loss on ACM's balance sheet were based on the premise that CP alone would bear that cost, when one-third of the LIBOR Notes were distributed to SH and when the remaining two-thirds were sold after "ABN" left the partnership. (PF 583-84).

⁴⁰ It is unclear how and if Arthur Andersen's suggested "exception" to the Partnership's valuation rules was incorporated into ACM's Accounting Policies. Pohlschroeder, with whom Rossi dealt, claimed that he was not involved in determining ACM's accounting policies and that they were prepared by Merrill. Rossi testified that he recalled no contact with Merrill regarding ACM's accounting policies. (PF 578-79, 587-88).

⁴¹ A partner's capital account must be decreased by the fair market value of property distributed to him. Treas. Reg. section 1.704-1(b)(2)(iv)(e)(1). First, however, the capital accounts of all partners must be adjusted to reflect the manner in which the unrealized income, gain, loss and deduction inherent in the distributed property (that had not been reflected in the capital accounts previously) would be allocated among the partners if there were a taxable disposition of such property for its fair market value on the date of distribution. Treas. Reg. sections 1.704- 1(b)(2)(iv)(e), 1.704-1(b)(5) Ex. (14)(v). The inherent loss in the BFCE LIBOR Notes was $312,500. The ACM partners' capital accounts should have been adjusted to reflect the allocation of this unrealized loss in a manner consistent with each partner's interest in the Partnership. Thus, KNX, SH and MLCS should have been allocated 82.68%, 17.03% and 0.29%, respectively, of the $312,500 unrealized loss or deduction on the BFCE LIBOR notes. Ex. 144-FC (p. 3, "Current Capital Account Balances" 12/13/89).

⁴² Because the $781,250 origination attributable to the BOT LIBOR Notes was included in the value of the LIBOR Notes, when the BOT LIBOR Notes were sold in December 1991 following the redemption of KNX from the Partnership, SH and CP bore almost the entire (over 99%) $781,250 origination. (PF 878, 887-88).

⁴³ Den Baas testified that at the time of entering into the ACM Partnership, he did not recall that anyone informed "us" that there would be a large gain to KNX and that he did not become aware of the allocation until he saw KNX's K-1 after the end of 1989. (PF 289). This testimony conflicts with de Beer's testimony that the tax aspects were discussed in the presence of all participants at the first Bermuda meeting at which den Baas was present. (PF 343, 348). In addition, Taylor believed that den Baas was aware in September 1989 that a tax-neutral partner was required because there would be an acceleration of income that the tax-neutral partner would absorb. (PF 202-06). Den Baas, however, testified that when he asked his friend Taylor for an explanation of the tax implications, Taylor, who explained the "tax angle" to de Beer, refused to provide den Baas with an explanation. (PF 272, 290-91).

⁴⁴ MLCS, the ACM Partner, is a wholly owned subsidiary of Merrill Lynch Capital Services, Inc., the swap counterparty with ABN. See Section 267(b), cross-referenced by Treas. Reg. section 1.704- 2(b)(2)(ii)(h); (PF 3, 320). Substantively, as discussed in Arg. II, supra, KNX is controlled by ABN.

⁴⁵ As discussed in Argument I, supra, the CP debt ACM purchased with the assistance of Merrill, was purchased by Merrill and then sold to ACM.

⁴⁶ It is not clear why the settlement dates differed.

⁴⁷ The only other debt exchange occurred just after the IRS audit began and that too was of a minimal amount ($4.85 million). (PF 117, 615).