T.C. Memo. 1997-115

UNITED STATES TAX COURT

ACM PARTNERSHIP, SOUTHAMPTON-HAMILTON COMPANY, 

TAX MATTERS PARTNER, Petitioner v. 

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 10472-93. Filed March 5, 1997.

In 1988, C reported a $105 million capital gain. 

In 1989, M, an investment banking firm, approached

C with an elaborate scheme to shelter that gain from

Federal income tax. Pursuant to M's advice, A, C, and

M created an offshore partnership (P) in which their

respective initial interests were 82.63, 17.07, and

.29 percent. P served as the vehicle for a contingent

installment sale transaction (CINS transaction) that

would create approximately $100 million of capital

losses for C, a domestic corporation, and corresponding

capital gains for A, a foreign corporation that was not

subject to U.S. tax. Pursuant to the scheme, P

purchased securities and, approximately 3 weeks later,

sold most of the securities for cash and LIBOR Notes. 

The value of the total consideration received, in the

form of cash and LIBOR Notes, equaled the price that P

had paid for the securities sold. The transactions and

the returns connected thereto were the result of a
- 2 -

carefully crafted and faithfully executed sequence of

sophisticated and costly financial maneuvers that left

little to chance or market opportunities. P used the

contingent payment sale provisions of sec.

15a.453-1(c), Temporary Income Tax Regs., 46 Fed. Reg.

10711 (Feb. 4, 1981), to report the sale for Federal

income tax purposes. In accordance therewith, P

reported a large capital gain in the year of sale; most

of this gain was allocated to A. In a later year,

after P redeemed A's entire interest, P sold the notes

and reported a corresponding capital loss, most of

which was allocated to C. The loss was carried back to

1988 by C to offset its gain. Held: The Court will

disregard the CINS transaction for Federal income tax

purposes because it lacked economic substance.

Fred T. Goldberg Jr., Albert H. Turkus, Pamela F. Olson, 

William L. Goldman, Christopher Kliefoth, and Joni Lupovitz,

for petitioner.

Jill A. Frisch, Patricia A. Donahue, Edward D. Fickess, 

Sheila Olaksen, Elizabeth P. Flores, Brian J. Condon, and

James M. Guiry, for respondent.

CONTENTS

Findings of Fact

 1. The Contingent Installment Sale Transaction ....... 5

 2. Development of Colgate's Liability 

Management Partnership.................................. 10

 3. The Partners ...................... 24

 4. The Partnership Agreement ............... 29

 5. Initial Stage of Colgate's Partnership

Strategy ........................ 35

 6. Tax and Financial Accounting for the Results ...... 47

 7. Final Stage of Colgate's Partnership Strategy ..... 54

 8. Merrill's Collateral Swap Transactions ......... 59

 9. ABN's Investment Management .............. 70
- 3 -

Opinion

 1. Mechanics of a Contingent Payment Sale ......... 83

 2. Economic Substance ................... 85

a. Introduction .................... 85

b. Profit ....................... 98

c. Hedging Within the Four Corners 

 of the Partnership ................. 113

d. Interim Use for Idle Cash ............. 133

e. The Pattern of Ostensibly Market-Driven 

 Decisions ..................... 137

MEMORANDUM FINDINGS OF FACT AND OPINION

LARO, Judge: ACM Partnership (ACM or the partnership),

Southampton-Hamilton Co. (Southampton), Tax Matters Partner,

petitioned the Court under section 6226 to readjust respondent's

adjustments of partnership items flowing from the partnership. 

Respondent issued ACM a notice of final partnership

administrative adjustment (FPAA) that reflects adjustments to

ACM's partnership return of income for its taxable years ended

November 30, 1989 (FYE 11/30/89), November 30, 1990

(FYE 11/30/90), November 30, 1991 (FYE 11/30/91), and

December 31, 1991 (FYE 12/31/91). In relevant part, respondent

eliminated the capital gain reported by ACM in FYE 11/30/89 as

resulting from the transaction described herein, and she

disallowed the corresponding capital loss reported in FYE

12/31/91.

Respondent asserted a number of alternative theories in the

FPAA to support the adjustments. Primarily, respondent asserted,
- 4 -

the purchase and sale of the debt instruments at issue herein

were prearranged and predetermined, devoid of economic substance,

and lacking in economic reality. Alternatively, respondent

asserted, ACM's activities must be disregarded under the step

transaction doctrine, ACM's activities were not engaged in for

profit within the meaning of section 183, and the sale of the

subject debt instruments did not satisfy the formal requirements

for a contingent payment sale under section 15a.453-1(c)(1),

Temporary Income Tax Regs., 46 Fed. Reg. 10711 (Feb. 4, 1981).

Following respondent's concession of a number of these

alternative theories, the parties ask the Court to decide the

following issues:

(1) Whether respondent's adjustments to items of income and

loss reported by ACM on the subject transactions should be

sustained on the ground that the transactions lacked economic

substance. We hold they should.

(2) Whether, as alleged by respondent in her amendment to

answer, the foreign partner should be treated as a lender for

Federal income tax purposes. In view of our disposition of the

first issue, we do not decide this issue. Consistent with the

FPAA, as well as the manner in which ACM reported the foreign

partner on its returns, we assume that the foreign partner is not

a lender.

(3) Whether ACM's allocation of taxable gain on the sale

had substantial economic effect or was otherwise in accordance
- 5 -

1 During the period at issue, Merrill Lynch & Co., Inc., was

a holding company that, through subsidiaries and affiliates,

provided various financial services. We use the name "Merrill"

to refer generally to the affiliated group or a member thereof.

with the partners' interests in the partnership. In view of our

disposition of the first issue, we need not and do not decide the

validity of this allocation.

Unless otherwise indicated, section references are to the

Internal Revenue Code in effect for the years at issue, and Rule

references are to the Tax Court Rules of Practice and Procedure. 

Throughout this Opinion, we use the terms "purchase", "sale",

"contingent installment sale", and "contingent payment sale"

solely for purposes of convenience and clarity. Our use of these

terms is not meant to give legal significance to the underlying

and surrounding transactions.

FINDINGS OF FACT

Some of the facts have been stipulated. The stipulations of

fact and attached exhibits are incorporated herein by this

reference. When the petition was filed, ACM's principal place of

business was in Wilmington, Delaware.

1. The Contingent Installment Sale Transaction

ACM is one of 11 partnerships (section 453 partnerships)

formed over a 1-year period from 1989 to 1990 by the Swap Group

at Merrill Lynch & Co., Inc.1 Each section 453 partnership was

intended to be a vehicle for sheltering capital gains of one of

its partners. For purposes of this Opinion, the principal
- 6 -

transactions in which ACM engaged are collectively referred to as

the contingent installment sale transaction (CINS transaction).

The design of the CINS transaction appears to have

originated in discussions in early 1989 between Macauley Taylor

(Taylor), a managing director of Merrill's Swap Group, and

James Fields (Fields), a member of his staff. From the spring of

1989 through the summer of 1990, the Swap Group and Merrill's

investment bankers promoted the idea among Merrill's clients. 

Colgate-Palmolive Co. (Colgate) was one of Merrill's clients

that Taylor and his staff approached. Colgate's treasury

department regularly consulted Henry Yordan (Yordan), a managing

director in Merrill's Capital Markets Group, concerning

developments in the debt markets. Yordan was aware that Colgate

had reported a sizeable capital gain (approximately $105 million)

for its 1988 taxable year on its sale of the Kendall Co.

(Kendall), and that Colgate might be receptive to the CINS

transaction. Through Yordan's introduction, a meeting was held

on May 15, 1989, at which Taylor and his staff described the CINS

transaction to Colgate's assistant treasurer, Hans Pohlschroeder

(Pohlschroeder). Merrill's representatives stated that, apart

from the few elements that were essential to secure the desired

tax consequences, the partnership structure could be adapted to

suit a variety of investment objectives.

Colgate's initial reaction to the proposal was skeptical. 

Pohlschroeder explained that Colgate did not have the required
- 7 -

cash to invest in the partnership, and that the cost of borrowing

to finance the investment was likely to exceed the return on a

pretax basis. Pohlschroeder also was not persuaded that the

partnership would serve a business purpose of Colgate. When

Pohlschroeder related the proposal to Steve Belasco (Belasco),

Colgate's vice president of taxation, the latter agreed: But for

the tax benefits, the transaction did not accomplish anything

useful for the company. Belasco also was concerned that the

transaction did not have sufficient economic substance to

withstand scrutiny, and that the transaction's legal, financial,

and accounting complexities would require broad interdepartmental

support within Colgate. Absent a connection to Colgate's

business, Belasco believed, the necessary support would not be

forthcoming.

Merrill's proposal was not the first that Colgate considered

to minimize the tax impact of the Kendall sale. During the

previous summer, while the sale was pending, a cross-functional

team from Colgate's treasury, accounting, and tax departments had

considered at least 11 tax-saving proposals, including investing

in low-income housing or property eligible for rehabilitation

credits and creating a charitable foundation. All of these

proposals were rejected.

After the initial meeting between Colgate and Merrill,

Fields, on behalf of Merrill, contacted a law firm for advice on

the tax consequences of a CINS transaction. In relevant part,
- 8 -

2 LIBOR is the primary fixed income reference rate used in

Euro markets.

the firm summarized the contemplated transaction as follows: 

A (a foreign entity), B, and C form the ABC Partnership (ABC) on

June 30, 1989, with respective cash contributions of $75, $24,

and $1. Immediately thereafter, ABC invests $100 in short-term

securities which it sells on December 30, 1989, to an unrelated

party. The fair market value and face amount of the short-term

securities at the time of the sale is still $100. In

consideration for the sale, ABC receives $70 cash and an

installment note that provides for six semiannual payments,

commencing 6 months after the sale. Each payment equals the sum

of a notional principal amount multiplied by the London Interbank

Offering Rate (LIBOR) at the start of the semiannual period.2

ABC uses the $70 cash and the first payment on the installment

note to liquidate A's interest in ABC and uses the subsequent

interest payments to purchase long-term securities.

Relying on section 15a.453-1(c), Temporary Income Tax Regs.,

46 Fed. Reg. 10711 (Feb. 4, 1981), the law firm advised Fields

that ABC would be entitled to report the sale of the short-term

securities on the installment method, and that ABC would recover

an equal portion of its basis in the short-term securities in

each year in which a payment on the note could be received. The

law firm advised Fields that ABC would recover $25 of its basis

in each of the 4 taxable years from 1989 through 1992, and that
- 9 -

ABC would have to recognize gain in each of these years to the

extent that the year's payments exceeded $25. To the extent that

the year's payments were less than $25, the law firm advised, ABC

would not be allowed to recognize a loss in that year, but ABC

would have to carry over that "loss" to a later year in which it

would otherwise recognize enough gain on the sale to absorb all

or part of the "loss". The law firm advised that any

unrecognized loss on the sale would be recognized in the final

year of payment.

 In a series of telephone calls in early July 1989,

Pohlschroeder revisited Merrill's proposal with Yordan, Taylor,

and Fields. Pohlschroeder communicated a number of concerns that

Colgate had regarding the management of its debt. Pohlschroeder

wondered whether there was a way to combine Colgate's financial

objectives with Merrill's proposal. On July 18, 1989, Taylor

called Pohlschroeder back with a suggestion for resolving the

problem. The gist of the conversation can be reconstructed from

Pohlschroeder's handwritten notes:

Mac

Invest. partnership

Based on bus. purpose

Economic profit

Is this partnership profitable?

Every single step to be substantiated

Invest in your own debt

Consolidation of effective control but not 

majority ownership
- 10 -

3 All other things being equal, the longer the maturity of a

debt instrument the more sensitive its value will be to

fluctuations in market interest rates. Hence, long-term debt

tends to carry greater risk than short-term debt of the same

issuer.

2. Development of Colgate's Liability Management Partnership

The notion that Colgate could use a partnership to acquire

its own debt was the breakthrough that overcame Colgate's

reservations, for it provided the opportunity to design an

elaborate superstructure of liability management functions around

Merrill's original tax shelter transaction. To understand the 

extent to which ACM was designed to serve these functions, we

first review the concerns of Colgate's treasury department in

this period.

A number of developments during 1988 and 1989 posed special

challenges for the management of Colgate's debt. In this period,

Colgate radically altered the maturity profile of its debt

through two actions. First, it used the proceeds from the sale

of Kendall in October 1988 to retire over half a billion dollars

of commercial paper constituting all of its U.S. short-term debt.

Second, it established an employee stock ownership plan (ESOP) in

June 1989, financed by issuing $410 million in long-term debt. 

The substitution of long-term debt for short-term debt

caused Colgate's average debt maturity to exceed substantially

the norm in its industry and increased its exposure to interest

rate risk.3 Colgate's treasury department expected the Federal
- 11 -

Reserve to ease monetary policy, causing interest rates to fall

in late 1989 or the first half of 1990. In a falling interest

rate environment, Colgate would earn a lower return on its cash

balances and short-term investments; yet, unlike its competitors

with relatively greater amounts of short-term debt, it would be

unable to cut its interest expense by refinancing. The

establishment of the ESOP had the further consequence of

prompting Moody's to downgrade Colgate's long-term debt from

A1 to A2 on the ground that the addition of so much long-term

debt reduced the company's financial flexibility. In the summer

of 1989, Colgate's treasury department was exploring ways to

rebalance the term structure of its debt and lower its exposure

to falling interest rates. Pohlschroeder raised these issues in

his discussions with Merrill's representatives in July 1989. 

The discussions also concerned the credit spread at which

Colgate's long-term debt was trading. The market's perception of

the credit worthiness of a corporation is reflected in the extent

to which the yield on the corporation's bonds exceeds the yield

on U.S. Treasury instruments of comparable maturity. The "spread

to Treasury" of Colgate's long-term debt had exceeded the average

for high and medium grade industrials throughout 1988 and, after

narrowing in the early part of 1989, had widened markedly during

the summer. One reason for this change was the downgrade in

Colgate's credit rating in June. Colgate's treasury believed

that another factor was widespread speculation that Colgate could
- 12 -

become the target of a hostile takeover or leveraged buyout. 

This led to the emergence of an "event risk" premium that caused

Colgate debt to trade at a discount relative to the price that

would otherwise obtain. In Colgate's opinion, the market was

overestimating the risks of holding Colgate's debt. Thus,

Colgate's debt was undervalued, and an opportunity existed to

capture subsequent improvements in its perceived credit quality

by repurchasing the debt. Yet, Colgate's flexibility to respond

to this arbitrage opportunity was constrained by the prospect

that a significant reduction in its balance sheet liabilities

would enhance its appeal to a potential acquirer.

Through the collaboration of Merrill's Swap Group and

Colgate's treasury department, from late July to early October

1989, the partnership gradually took shape. Merrill's first

written exposition of the concept, entitled "Colgate Partnership

Transaction Summary", dated July 28, 1989, states: "the primary

mission of the Partnership is the acquisition and control of

Colgate debt". "Colgate Sub.", "A Corp.", and "B Corp." would

contribute $30 million, $169.3 million, and $0.7 million,

respectively. Colgate Sub. would act as managing general partner

with the authority to determine partnership investments. Over a

period of several months, the partnership capital would be used

to acquire long-term Colgate debt from investors. The

partnership would then exchange some of the long-term debt for

newly issued Colgate medium-term debt. Merrill noted that the
- 13 -

accounting treatment of the partnership was unclear. Despite

Colgate's minority interest, Merrill believed, the partnership

might have to be consolidated on Colgate's financial statements

if Colgate were deemed to control the partnership. Merrill

thought that either result might be advantageous. 

By the beginning of October 1989, the design had been

revised in two important respects. First, it had been determined

that the partnership would be most useful if its transactions

were initially kept off of Colgate's balance sheet and its

consolidation with Colgate for financial accounting purposes was 

deferred until such time as Colgate acquired a majority interest

in the partnership from the foreign partner. This would enable

Colgate to conceal its activities from the market as well as

choose more advantageous market conditions for retiring and

reissuing the debt. Second, Merrill had devised a mechanism by

which Colgate and the foreign partner could share the credit risk

with respect to partnership holdings of Colgate debt in different

proportions from the so-called treasury (i.e., interest rate)

risk. The efficiency of "allocating to each partner the risks

that it could bear" would make it possible for Colgate to receive

greater benefits from the partnership at less cost. Thus, it was

expected that Colgate could negotiate for the right to

appropriate all the benefit of the improvement in its credit

quality that it expected to occur over time, while negotiating

for an option to vary the partners' relative shares of the
- 14 -

treasury risk inherent in the debt so as to capitalize on

expected changes in interest rates.

A document entitled "Liability Management Partnership

Executive Summary", dated October 11, 1989, purports to identify

the main non-tax advantages of the contemplated partnership

structure at about the time that it was approved by Colgate's

senior management.

The proposed Liability Management

Partnership (the "Partnership") has been

developed specifically for Colgate-Palmolive

("Colgate") to enable it to most efficiently

manage the term structure of its liabilities,

using predominantly its partners' capital.

Normally an issuer's acquisition of its own

debt involves three events, the acquisition

of the debt, the retirement of the old issue

and the issuance of substitute financing. 

The Partnership provides the opportunity to

separate the timing of these events * * * by

(i) acquiring Colgate debt in the market

today, while it remains available, and (ii)

placing such debt in "friendly hands," to be

retired, modified or exchanged at an

advantageous time in the future.

* * * * * * *

Despite the current opportunity to

acquire its debt, Colgate does not wish to

immediately retire all of such debt and issue

substitute financing. This reluctance is

based in part on Colgate's current rate

outlook (i.e., anticipation of gradual return

to a positively-sloped yield curve) and in

part on Colgate's desire not to permanently

restructure all of such debt immediately.

* * *

* * * * * * *

The Partnership provides Colgate with

flexibility to exchange the Colgate debt held
- 15 -

4 During the period at issue, ABN New York was a subsidiary

of Algemene Bank Nederland, N.V., one of the Netherlands' largest

financial institutions. ABN Trust Co., Curacao, N.V., was

another subsidiary. For purposes of this Opinion, the name "ABN"

refers to Algemene Bank Nederland, N.V., or any one of its

subsidiaries, affiliates or branches.

by the partnership for newly issued Colgate

debt of different maturity. Such exchanges

may be effected as often and rapidly as

Colgate deems appropriate. If Colgate

attempted to refinance existing debt within a

short time frame by repurchasing it and

issuing new debt, transactions costs would

rise dramatically. * * *

* * * * * * *

The Partnership also allows Colgate to

effectively retire its debt, while leaving

the debt outstanding for accounting purposes,

and to take a position on rates by adjusting

the relative sharing of Treasury risk by the

partners. As Colgate bears a relatively

greater share of the Treasury risk (i.e.,

losses in value of the Colgate debt

attributable to interest rate increases) with

respect to its debt, it has economically

retired an increasing percentage of such debt

and effectively changed its position with

respect to interest rates.

The partnership's fulfillment of the liability management

purposes for which it was designed would depend on the identity

of Colgate's partners. Merrill undertook to procure them. 

During the summer of 1989, Taylor approached Hans den Baas (den

Baas), the head of the Financial Engineering Group at ABN Bank

New York (ABN New York),4 concerning the possibility of ABN's

participation in a partnership with Colgate. Taylor explained

that the partnership would be used to acquire Colgate long-term
- 16 -

debt for liability management purposes. He also stated that a

contingent payment sale was contemplated, and that ABN's

participation would be limited to 2-3 years. Den Baas forwarded

Taylor's inquiry to Peter de Beer (de Beer), head of the legal

department of ABN Trust Co., Curacao N.V. (ABN Trust), who would

be responsible for structuring the legal aspects of the

participation and negotiating the agreements. ABN Trust was

engaged in the business of forming and managing Netherlands

Antilles' entities to facilitate financial transactions. De Beer

agreed to meet Colgate representatives in Bermuda during the

middle of October 1989. He learned of the liability management

aspects of the proposed partnership only when actual negotiations

with Colgate began.

Based on prior dealings with Merrill, both den Baas and

de Beer were already familiar with the CINS transaction and the

defined role of the participating foreign partner. Taylor had

discussed the transaction with den Baas during its development

phase early in 1989. Taylor had previously approached den Baas

to solicit ABN's participation in a CINS transaction on behalf of

at least one other client. In that case too, den Baas had

referred him to de Beer, who had represented ABN in the ensuing

negotiations.

For a number of reasons, ABN was well suited for the role of

majority partner in Colgate's liability management partnership. 

An ABN affiliate created and managed the foreign partners for
- 17 -

each of the 11 section 453 partnerships promoted by Merrill. 

ABN New York provided financial engineering and other services to

the foreign partners in each of the partnerships. Whether or not

an understanding that ABN would collaborate as a copromoter

existed from the outset, ABN would have had an interest in

assuring the satisfaction of Merrill's clients in order to ensure

the continuity of a valuable relationship with Merrill. It is

unclear whether Colgate was aware of Merrill's relationship with

ABN, but Colgate already had an established relationship with

ABN. Acting as Colgate's lead bank in the Netherlands, ABN had

underwritten a large foreign bond issue and performed other

services in connection with Colgate's foreign operations. For

these reasons, ABN could be trusted to cooperate in keeping the

partnership "friendly", by yielding effective control to Colgate,

by protecting the confidentiality of Colgate's debt restructuring

activities, and by agreeing to relinquish its partnership

interest at such time as Colgate might wish to acquire it. ABN's

experience and sophistication in regard to European capital

markets would assist the partnership in acquiring Colgate's

Eurodollar debentures. As a major international bank, ABN

possessed the liquidity needed to finance the venture, and, as a

major derivatives dealer, it could accommodate, at little or no

cost, Colgate's desire for an option to adjust their relative

shares of interest rate exposure.
- 18 -

The third partner was to be an affiliate of Merrill. This

provided Colgate with further reassurance. An equity interest

would reinforce Merrill's incentive to continue to provide

support and to act in a manner consistent with Colgate's interest

when arranging the contemplated partnership transactions. 

Merrill would receive an advisory fee and transaction-based fees

for initiating the partnership's asset transfers. 

The ultimate challenge for Merrill in designing the

liability management partnership was to find a way to integrate

each step of the CINS transaction convincingly so that the

transaction, as a whole, would stand up for tax purposes. The

Swap Group devoted considerable effort to this task. Although

the basic insight was incorporated in the initial "Colgate

Partnership Transaction Summary" of July 28, 1989, it was refined

in subsequent revisions of this document. The version entitled

"XYZ Corporation: Revised Partnership Transaction Summary",

dated August 17, 1989, set forth an outline of 10 steps to be

taken by the partnership summarized as follows:

Step 1: The partnership is formed with contributions

from XYZ Sub., A Corp. and B Corp. of $30 million,

$169.3 million and $0.7 million, respectively. 

Step 2: The partnership invests $200 million cash in

short-term, floating-rate private placement securities

pending acquisition of long-term XYZ debt. The private

placement notes will be issued by highly rated issuers

and will provide the partnership a return greater than

comparably rated commercial paper or bank deposits. 

Step 3: The partnership sells the private placement

notes for a combination of cash, which will be used to
- 19 -

acquire XYZ long-term debt over a period of 6 months,

and LIBOR-based notes. "The purpose of the LIBOR notes

will be to partly hedge the interest rate sensitivity

of the long-term XYZ debt acquired by the Partnership." 

Depending on the maturity of the XYZ debt acquired,

Merrill anticipated a ratio of 70-percent cash ($140

million) to 30-percent LIBOR Notes ($60 million). 

Step 4: Some long-term XYZ debt is exchanged for newly

issued medium-term XYZ debt. 

Step 5: If a substantial amount of long-term debt was

exchanged, the partnership would likely reduce its

holding of the LIBOR Notes in order to rebalance its

hedge. "Such a reduction would be necessary because

the Medium-Term Debt, received in exchange for

long-term XYZ debt, is less interest rate sensitive

than the long-term XYZ debt. LIBOR Notes may either be

sold directly or distributed to one or more Partners in

a non-liquidating distribution." 

Steps 6 and 7: Partnership assets are disposed of in

the event that the desired investments cannot be made. 

Step 8: A Corp.'s partnership interest is "possibly"

redeemed at any time after 1 year following formation.

Step 9: The partnership is consolidated with XYZ for

financial accounting purposes. The document advises

that 

[i]t would be most reasonable for the

Partnership to sell the LIBOR Notes and any

other LIBOR-based assets if A Corp. is

redeemed. Since the principal asset of the

Partnership, other than LIBOR Notes and

LIBOR-based assets, is likely to be XYZ debt

and XYZ would be a 98% partner, the hedge

protection provided by the LIBOR Notes and

LIBOR-based assets is no longer necessary. 

Step 10: B Corp. is eventually retired after a period

of years.

In support of its characterization of the LIBOR Notes as a

risk management tool, Merrill performed a series of quantitative

analyses of the effect of a given change in the level of interest
- 20 -

rates on the value of Colgate debt and LIBOR Notes in the

partnership portfolio. These analyses purport to demonstrate

that the interest rate sensitivity of the interest-only LIBOR

Notes greatly exceeds that of fixed rate debt instruments of

equal maturity and is comparable to that of long-term fixed rate

debt. Thus, a 100 to 200 basis point increase or decrease in

interest rates would produce roughly equal and offsetting changes

in the value of $1 of LIBOR Notes, $2.34 of 9 percent 5-year

Colgate debt, and $0.88 of 9-5/8 percent 30-year Colgate debt. 

Pohlschroeder was impressed with Merrill's analysis. In an

October 3, 1989, memorandum written for the purpose of

recommending the "ABN Liability Management Partnership" to his

superior, Colgate treasurer Brian Heidtke (Heidtke),

Pohlschroeder explained how the composition of the partnership's

portfolio would be planned to serve the purpose of "risk

management within the partnership". "One aspect of importance is

the interest rate exposure on the asset of the partnership which

consists of Colgate debt. To minimize the exposure to ABN and

Colgate, it is planned to convert a portion of the short-term

notes to contingent LIBOR Notes as a hedge of the partnership's

fixed rate assets." Although the hedge ratio would be determined

through negotiations with ABN, he was confident that the

partnership could acquire $140 million of Colgate debt, and that

$60 million of LIBOR Notes would provide an appropriate level of

protection. The plan was to adjust "the LIBOR note hedge" as
- 21 -

needed in order "to achieve the ideal Colgate liability

structure." Pohlschroeder envisioned "two possible situations

arising in the future" which would call for the disposition of

some of the LIBOR Notes. One was the exchange of long-term debt

for medium- or short-term debt. "Because a shorter term

instrument is less volatile, a smaller notional amount of the

LIBOR Note is required for hedging purposes." A second situation

was a change in the treasury risk sharing ratios. "The

partnership is overhedged when Colgate decides to take more of

the treasury risk and ABN reduces its share of the treasury risk. 

Conversely, as ABN's participation goes up, it needs more of a

hedge in [the] form of the LIBOR notes."

Merrill provided Colgate with estimates of the expected

costs of the contemplated partnership transactions. The

"Perpetual Partnership Cost Component Analysis" reproduced in

modified form below was prepared based on market conditions

prevailing on September 1, 1989, and evidently assumed that the

partnership would remain in existence indefinitely after these

transactions were completed.
- 22 -

Perpetual Partnership Cost Component Analysis

( $ millions )

After Tax Pretax1

Net present value before

 transaction costs & advisory fee $25.47 ---

Cost Components:

 Origination of Citicorp Notes 1.32 $2.00

 Remarketing of LIBOR Notes 1.29 1.95

 Preferred returns to partners 0.74 1.12

 Premium on debt tender 0.48 0.73

 Legal expenses 0.17 0.25

 Advisory fee 1.32 1.75

Total 5.32 7.80

Net present value of partnership 

 investment 20.15 ---

1 In its review of these costs, as part of a separate

document, Colgate translated aftertax amounts into pretax amounts

using a 34-percent marginal rate. The original aftertax estimate

of Merrill's advisory fee ($1.32 million) would imply a pretax

amount of $2 million. The discrepancy between this and the $1.75

million figure reflected in this separate document was not

explained.

The "origination" cost refers to the transaction cost that 

the partnership would incur on the exchange of private placement

notes for cash and LIBOR Notes. The remarketing cost represents

the transaction cost that would be incurred on the sale of the

LIBOR Notes. The preferred return was an estimate of the

additional allocation of income that the majority partner was

expected to require. The advisory fee was payable to Merrill for

its services. Colgate's management understood that most, if not

all, of these costs would be borne by Colgate because all the

liability management and tax benefits of the partnership
- 23 -

transactions would enure to Colgate. They believed that the

costs, though high in absolute terms, were reasonable in relation

to the benefits that Colgate expected to receive from the

partnership.

Liability management benefits would have been difficult to

quantify for purposes of this comparison. The tax benefits,

however, were calculable and greatly exceeded the expected

transaction costs. Although the Perpetual Partnership Cost

Component Analysis does not explain the derivation of the $25.47

million net present value that appears on the top line, this

figure must be attributable almost entirely to tax benefits. A

succession of summaries, cash-flow projections, and flip-chart

presentations that Colgate received from Merrill between August

and mid-October 1989, demonstrated how the sale of $200 million

private placement notes for $140 million cash and $60 million

market value of LIBOR Notes would result in $107 million taxable

gain for the partnership and a net taxable loss for Colgate of

approximately $90 million. If the foreign partner's interest

were acquired and the LIBOR Notes sold within the 2-year period

remaining for carryback of capital losses to the year of the

Kendall divestiture, the present value of the tax savings

achieved by this transaction, discounted at prevailing interest

rates of 8-1/2 to 9-1/2 percent, would be roughly $25 million.

In a series of internal meetings and meetings with Merrill

representatives during September and early October 1989, the
- 24 -

liability management partnership proposal was presented to

successively higher levels within Colgate's management. The vice

president of taxation was now comfortable with the economic

substance of the partnership. The treasurer concluded that this

was a "uniquely suitable transaction for us." They, in turn,

presented the tax and treasury aspects of the proposal to the

chief financial officer and to the president of the company, who

approved it. The decision was made to enter into negotiations

with ABN.

3. The Partners

ABN chose a form for its participation that would appear on

its consolidated balance sheet as a loan to a third party rather

than an equity investment. A Netherlands Antilles corporation

named Kannex Corp., N.V. (Kannex), would be formed to borrow

approximately $170 million from a bank and contribute it to the

partnership. Kannex's stock would be held by two Netherlands

Antilles stichtingen named Coign and Glamis. Stichtingen are

foundations under Dutch law, have no owners, and conduct no

commercial activities. Their sole purpose in this transaction

would be to hold Kannex's stock. Control over the foundations

would be exercised by their respective boards, of which de Beer

would serve as chairman and other ABN Trust employees as members. 

The foundations would appoint ABN Trust to act as sole managing

director of the corporation.
- 25 -

Financial arrangements for Kannex's participation were

initiated by den Baas at ABN New York. Based on information

about the proposed partnership that den Baas had received from

Taylor, ABN New York prepared a credit proposal on behalf of

Kannex, dated October 3, 1989. Since the borrower's only asset

would be an interest in a portfolio expected to consist largely

of Colgate long-term debt, ABN New York assessed Colgate's

creditworthiness. Under the terms of the proposed credit

facility, the bank would loan Kannex $170 million for 1 year at

an interest rate of LIBOR plus 30 basis points, corresponding to

the rate that the bank would have charged Colgate or a similarly

rated company for a line of credit. Colgate was listed as the

"client" on the credit proposal. This was because ABN New York

viewed the financing transaction as a means of fostering closer

banking relations with Colgate. As the credit proposal

explained: 

Colgate has been an important prospect for ABN New York

Branch because of its strong financial condition and

extensive international operations. Establishing a

relationship has proven difficult because of the

company's loyalty to its line banks. ABN's past

involvement has been limited to facilities for Colgate

subsidiaries. * * * We believe that the proposed

transaction would provide an excellent entry into the

parent's banking relationship.

Although the interest rate on the loan would provide an

acceptable return commensurate with the level of the credit risk

involved, ABN New York expected that the total returns to the

bank from the loan transaction would be appreciably higher. The
- 26 -

5 A bid-ask spread is the spread between the price at which

an instrument is bought and sold. The bid price is the price at

which dealers buy the instrument, and the ask price is the price

at which dealers sell the instrument.

bank would also earn sizeable profits off the bid-ask spread on

swaps necessary to stabilize Kannex's return from the assets in

the partnership portfolio so that it could repay the loan.5

Because of the size of the loan, approval was required at

three levels within the bank: The credit committee at ABN New

York, the North American Credit Committee (NACC) in Chicago, and

the Risk Management Dept. (RMD) in Amsterdam.

After approval by ABN New York, NACC reviewed the proposal

together with a memorandum describing the partnership. On

October 11, 1989, sent an advice to RMD recommending approval

subject to a number of conditions, of which three are noteworthy:

1) The timing of the purchases and sales of the

various securities be adhered to as proposed

such that the credit risk is no greater than

as outlined in partnership memo.

2) Interest rate risk is fully hedged.

3) Colgate's obligation to purchase Kannex's

interest in the partnership by 11/30/89 [sic]

is unconditional (will those proceeds be

assigned to ABN?)

RMD advised NACC and ABN New York of its decision: "We

agree on the condition that Merrill again verbally states to the

partners that they will buy the MTN's at par on November 29,

1989." The reference to "MTN's", or medium-term notes, evidently

denotes the private placement notes in which the partnership was
- 27 -

expected to invest the partners' contributions pending

acquisition of Colgate debt. The earlier oral assurance to which

RMD refers may have been one that Merrill made to the first

section 453 partnership in which ABN collaborated, the Nieuw

Willemstad Partnership. Failing to locate a buyer for the

partnership's private placement notes within the time frame

required by the partners, Merrill itself became the counterparty,

buying the private placement notes and issuing LIBOR Notes. A

second condition was that the loan to Kannex be syndicated in

order to reduce the credit risk.

ABN records indicate that the credit proposal was "approved

per RMD". There is no record of any modification to the NACC and

RMD conditions. Under ABN procedures, if credit conditions had

been changed, the changes should be reflected in NACC files. 

Although there are cases in which a branch fails to advise NACC

of changes in credit conditions or changes are made without

documentation, such cases are rare.

Kannex was incorporated in the Netherlands Antilles on

October 25, 1989, and issued shares with a total par value of

$6,000, held in equal proportions by Coign and Glamis. Kannex's

financial statements reflect accounts receivable for loans to the

foundations in the amount of $6,000, indicating that they

borrowed from the corporation the funds they used to acquire its

stock. By "Revolving Credit Agreement" dated November 2, 1989,

ABN's Cayman Islands Branch (ABN Cayman Islands) agreed to make
- 28 -

loans available to Kannex in the aggregate amount of $180 million

from November 2, 1989, through August 1, 1990. The shares of

Kannex stock held by Coign and Glamis were pledged to ABN as

security for the loans. Kannex entered into a management

agreement with ABN Trust and a financial services agreement with

ABN New York, executed by den Baas, under which ABN New York

agreed to provide advice on hedging strategies to reduce Kannex's

interest rate exposure and to provide other services at Kannex's

request. The agreement does not make provision for either the

amount or calculation of ABN New York's compensation. 

Southampton, a wholly owned subsidiary of Colgate, was

incorporated under Delaware law on October 24, 1989, for the

purpose of becoming a partner in Colgate's liability management

partnership. Belasco served as Southampton's president and

Pohlschroeder as its vice president and treasurer. During the

taxable years at issue, Southampton filed a consolidated return

with Colgate.

Merrill Lynch MLCS, Inc. (MLCS), was incorporated under

Delaware law on October 27, 1989. MLCS is the wholly owned

subsidiary of Merrill Lynch Capital Services (Merrill Capital),

which operates as the swap dealer for the Merrill Lynch Group. 

Taylor was MLCS's president and Paul Pepe (Pepe), a member of his

staff, its vice president.
- 29 -

6 The original name of the partnership was CAM Partnership. 

At the first meeting of the Partnership Committee, for reasons

not disclosed in the record, the initials of Colgate and ABN

(A) were reversed, and the name became ACM.

4. The Partnership Agreement

Negotiations were conducted at two meetings held in Bermuda

on October 18 through 19, and October 27, 1989. The meetings

were attended by, inter alia, Heidtke, Pohlschroeder, and Belasco

from Colgate; Taylor and Fields from Merrill; de Beer and

den Baas from ABN. By agreement dated as of October 27, 1989

(the Partnership Agreement), ACM was formed as a general

partnership under New York law with its principal place of

business in Curacao, Netherlands Antilles.6 The partners'

initial capital contributions were determined to be as follows:

Partner Capital Contribution Percentage of Total

Kannex $169,400,000 82.63

Southampton 35,000,000 17.07

MLCS 600,000 .29

 205,000,000 1100.00

1 Includes rounding error of .01

The conduct of the business and affairs of the partnership

would be under the direction of a partnership committee (the

Partnership Committee) composed of a representative of each of

the three partners. In general, action by the Partnership

Committee required the assent of partners having an aggregate

capital account balance equal to at least 99 percent of the total

partners' capital. The affirmative concurrence of both Kannex
- 30 -

and Southampton was therefore necessary for most partnership

decisions. As its representative, Southampton appointed

Pohlschroeder. Kannex appointed de Beer, and MLCS appointed

Taylor.

The Partnership Agreement provided that, in general, 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 respective capital accounts. As

subsequent events would demonstrate, this general sharing

provision did not fully reflect the partners' original

understanding of the manner in which they would share the

economic costs of partnership transactions.

Upon the occurrence of specified "Revaluation Events", the

partnership would revalue its assets on its books, and any

unrealized income, gain, expense, or loss inherent in its assets

would be allocated among the partners as if realized in a sale of

the assets at their fair market value. These Revaluation Events

included: (i) a change in a partner's proportionate interest in

partnership capital; (ii) a sale or exchange by the partnership

of any Colgate debt instrument; (iii) an adjustment to the Yield

Component (as defined below) with respect to Colgate debt; (iv) a

contribution or distribution of partnership assets;

(v) liquidation of the partnership; (vi) the last business day of

each fiscal year; and (vii) after November 30, 1989, the properly

executed request of any partner.
- 31 -

7 Kannex's share was set slightly higher (83 percent) and

Southampton's slightly lower (16.7 percent) than their respective

capital interests.

To allocate gains and losses arising in connection with

Colgate debt instruments in the partnership portfolio for each

revaluation period, the Partnership Agreement distinguished

between that portion of any change in value attributable to

changes in the general level of interest rates (the Yield

Component) and that portion of any change in value attributable

to changes in the market's perception of risks specifically

associated with Colgate's credit quality (the Quality Component). 

Together, the Yield Component and Quality Component would capture

all of the fluctuation in market value of the Colgate debt held

by the partnership.

The Yield Component was initially allocated among the

partners based on their respective capital interests.7

Southampton could elect, however, to change its and Kannex's

relative shares of the Yield Component to any level it desired

within a specified range, on 5 days notice. It could increase

its own share to as much as 49.7 percent, thereby reducing

Kannex's share to 51 percent, and it could reduce its own share

to as little as 10 percent, causing Kannex to take 89.7 percent. 

The allocation of the Quality Component depended on whether

Colgate's credit had improved or deteriorated during the relevant

revaluation period. Improvement or deterioration was measured by
- 32 -

the change in the implied spread of the Colgate debt yield over

an index of the yield on U.S. Treasury securities. If Colgate's

credit improved, the spread would narrow; if Colgate's credit

deteriorated, the spread would widen. The Quality Component was

the change in the value of the Colgate debt attributable to this

change in the spread. The Partnership Agreement provided for the

following Quality Component allocations: (a) For the first 50

basis point decline in value, 84.7 percent of the decline was

allocated to Southampton, 15 percent to Kannex, as were

subsequent increases within this 50 basis point range; (b) all

declines beyond 50 basis points were allocated 99.7 percent to

Southampton, and all other increases were allocated 99.7 percent

to Southampton. MLCS's share of all changes was 0.3 percent.

The substantial risk shifting potential of the Yield

Component option, which was of substantial value to Colgate's

liability management scheme, proved relatively unproblematic for

ABN because of the bank's ability to hedge interest rate risks

outside the partnership through routine techniques employed by

financial intermediaries in the derivative markets. Indeed, in

its design of this option mechanism, Merrill's Swap Group took

for granted ABN's ability to make accommodations in this manner.

The Quality Component provision was a bone of contention for

the same reason that the Yield Component provision was not. A

credit derivative that could be used by the bank to hedge the

share of spread risk allocated to it under this provision was not
- 33 -

available in the market at that time. ABN was loath to accept

any spread risk for Kannex. On the advice of its tax lawyers,

Colgate insisted, and the parties finally agreed, on a sharing

formula that limited Kannex's exposure to 7-1/2 basis points

(15 percent of a 50 basis point range).

The parties agreed on one further special allocation under

the Partnership Agreement. From the date of the initial capital

contributions through February 28, 1992, the first $1,241,000 of

partnership income and gain for each fiscal year otherwise

allocable to Southampton would be allocated to Kannex. This

preferred return was not cumulative and was prorated daily. For

this purpose, gains otherwise allocable to Southampton did not

include unrealized gains resulting from revaluations of

partnership assets. ABN had insisted on a preferred return as

compensation to Kannex for participating in the spread risk of

the Colgate debt. ABN intended that the amount would also

include a small service fee for the adjustments that the bank

would have to make to accommodate Southampton's discretionary

management of interest rate exposure under the Yield Component

provision. As the price for these benefits and as a substitute

for the covenants and other legal protections that a lender in

the position of Kannex would require as a condition for investing

a great deal of money in Colgate debt obligations, Colgate

considered the $1.24 million preferred return to be reasonable.
- 34 -

Southampton was required to maintain at least 2 percent of

partnership capital. In the event that a substantial widening of

the credit spread on Colgate debt caused Southampton's capital

account to fall below the 2-percent threshold, unless prevented

by insolvency, Southampton would contribute enough additional

capital to continue to finance at least a certain minimum amount

of the preferred return.

Section 4.03 of the Partnership Agreement governed the

maintenance of the partners' capital accounts. The capital

accounts would be increased by the amount of the partners'

contributions, adjusted for allocations of partnership income,

gain, expenses, and loss, and reduced by the fair market value of

distributed property. Upon the occurrence of Revaluation Events,

the capital accounts would be adjusted to reflect the

mark-to-market revaluation of partnership assets.

Each of the partners was entitled to have its interest

redeemed at fair market value upon request. Kannex could request

redemption at any time after February 28, 1992. The other two

partners could request redemption 1 year later. The redemption

provision apparently was not the subject of negotiation. It was

the intention of the parties that Kannex would be redeemed within

2 years, before its formal right under the Partnership Agreement

ripened. The planned duration of Kannex's participation was

dictated by the period prescribed for carryback of the capital

loss to Colgate's 1988 taxable year. Colgate's plan afforded ABN
- 35 -

the convenience of limiting the extent of Kannex's risk exposure.

5. Initial Stage of Colgate's Partnership Strategy

The first meeting of the Partnership Committee (First

Partnership Meeting) was held in Bermuda on October 27, 1989. 

The first noteworthy item of business was to appoint Merrill as

qualified appraiser of partnership assets and to authorize both

Merrill and ABN to make necessary arrangements for the purchase

of three specified issues of Colgate debt: (1) $100 million

principal amount of 8.4 percent private placement notes due in

1998 (Met Note) held by the Metropolitan Life Insurance Co. (Met

Life); (2) $35 million principal amount of 9.625-percent notes

due in 2017 (Long Bonds); (3) $5 million principal amount of

9.5-percent Eurodollar notes due in 1996 (Euro Notes).

Next, the Partnership Committee resolved that "in order to

maximize the investment return on its assets pending the

acquisition of Colgate-Palmolive Bonds", the partnership

authorized Merrill to arrange for the purchase, in the form of a

private placement, of $205 million of 5-year floating rate notes

with an investor put option exercisable after about 15 to 24

months. Finally, according to the minutes, Pohlschroeder

reported that he had communicated an offer to Met Life to

purchase the Met Notes at a price within a stated price range,

and that Met Life undertook to consider the proposal and review

it with tax and legal advisers and, if interested, would come to

Bermuda on November 17 in order to complete negotiations. The
- 36 -

Partnership Committee authorized ABN Trust to conduct "such

further discussions from outside the U.S. as are necessary with

Metropolitan prior to such meeting."

During the proceedings in Bermuda, Taylor and Fields, on two

separate occasions, presented Pohlschroeder and Belasco with

revised estimates of the present value of transaction costs that

were likely to be incurred in connection with the anticipated

partnership transactions. According to one estimate, the total

amounted to $6.95 million before tax, including $1.31 million

origination cost on the sale of the private placement securities

and issuance of the LIBOR Notes and $1.0 million for remarketing

of the LIBOR Notes. The other estimate was higher: A total of

$7.91 million before tax, including origination and remarketing

costs of $2.0 million and $1.1 million, respectively. Colgate

and Merrill did not discuss the costs of alternative short-term

investments for the partnership's cash balances pending

acquisition of Colgate debt.

On November 2, 1989, the partners' cash contributions in the

amount of $205 million were deposited in the partnership bank

account at ABN New York paying interest at a rate of 8.75 percent

annually. The funds were withdrawn, at no cost, on the following

day. By Private Placement Note Purchase Agreement between ACM

and Citicorp, dated November 3, 1989, ACM acquired from Citicorp

at par $205 million principal amount of floating rate notes due

October 19, 1994 (Citicorp Notes or the Notes). The Citicorp
- 37 -

Notes paid interest at the commercial paper rate plus 15 basis

points, paid and reset monthly. The initial coupon was set at

8.78 percent and the first reset date was November 15. The Notes

were rated AA by Standard & Poors. The holder had the option of

tendering the Citicorp Notes for repayment on October 16, 1991,

at 100 percent of the principal amount. The Citicorp Notes were

not registered under the Securities Act, 15 U.S.C. sec. 77a

(1933) and were not traded on an established securities market. 

At the time of purchase, it was contemplated that the

Citicorp Notes would be sold at the end of the month. Indeed,

arrangements to sell the notes were already well underway. In

several meetings beginning in late October, Pepe and other

Merrill representatives discussed a proposed structure for the

sale with the Capital Markets Group of the Bank of Tokyo's (BOT)

New York Agency. Parallel discussions were held with the New

York Branch of Banque Francaise du Commerce Exterieure (BFCE). 

During the first week of November, Merrill disclosed the specific

terms of its proposal to each bank. The banks would purchase

$175 million of the Citicorp Notes, paying 80 percent of the

price ($140 million) in cash and the remainder with an

installment purchase note providing for a 5-year LIBOR cash flow

having a present value of $35 million. In addition, the banks

would enter into collateral swaps with Merrill Capital that

provided the banks with risk protection and an attractive return. 

Merrill had already prepared the legal documentation for the
- 38 -

transactions. By facsimile dated November 9, BOT Capital Markets

Group sent an urgent request for credit approval to the head

office in Tokyo, attaching "all details of the transaction". 

Merrill required that the agreements be executed within a few

days and any delay was likely to result in loss of the deal. On

November 10, Merrill informed the banks that, at the asset

seller's request, the transaction would be divided between them: 

BOT would purchase $125 million of the Citicorp Notes and BFCE

would purchase $50 million.

If the amount and timing of the partnership's cash needs

were so clearly foreseen at the beginning of November, it was in

large part because by this time preparations for the acquisition

of Colgate debt were also well advanced. The Met Note, Long

Bonds, and Euro Notes that the Partnership Committee directed

Merrill and ABN to acquire had been targeted for acquisition

months earlier. Merrill's first "Partnership Transaction

Summary", prepared in July, had contemplated that the partnership

would purchase these three issues, using approximately $140

million cash from the sale of the private placement notes. 

During the summer, Pohlschroeder had told Fields that he knew

that Met Life would be willing to sell the Met Note and could

probably be induced to sell it immediately. He had arrived at

the conclusion as a result of recent unsuccessful attempts by the

insurance company to renegotiate the loan agreement. Both the

Long Bonds and Euro Notes were identified as good candidates
- 39 -

because substantial amounts of these public issues were held by

institutions. Based upon his own study of market activities and

consultation with traders during the first 6 to 9 months of 1989,

Pohlschroeder was able to estimate how much of the Long Bonds and

Euro Notes were available. Colgate's treasury department had

Yordan perform further research on availability and price. By

the beginning of October, Pohlschroeder felt confident that the

partnership would meet Colgate's debt purchase target of

approximately $140 million. 

The only genuine question in regard to the Met Note was

price. In late September, Pohlschroeder contacted Met Life to

indicate a possible interest in purchasing the Met Note. On

October 23, a few days before he returned to Bermuda to conclude

the Partnership Agreement, Pohlschroeder prepared himself for

negotiations with Met Life by conferring with Yordan. His notes

from that conversation conclude with a reference to the date

November 17, which is circled. As the minutes of the First

Partnership Meeting reflect, Pohlschroeder contacted Met Life

again from Bermuda to invite a representative of the insurance

company to negotiate a sale of the note in Bermuda on 

November 17. The statement in the minutes that Pohlschroeder had

communicated an offer on specific terms appears to have no basis

in fact, however. It is clear that Pohlschroeder refused to

enter into any discussion of terms on that occasion. During the

3 weeks prior to the meeting scheduled for November 16 and 17,
- 40 -

Pohlschroeder received a telephone message from Met Life stating

the insurance company's asking price. He did not return the

call. There were no negotiations prior to the scheduled meeting,

either by Colgate within the United States, or by ABN Trust, the

partnership's authorized representative for this purpose, outside

the United States.

Yordan attended the meeting of the Partnership Committee in

Bermuda on October 27 in order to advise the partnership

concerning availability and prices of Colgate's Long Bonds and

Euro Notes. At this time, Pohlschroeder prepared notes regarding

standing orders that ACM intended to issue to Merrill for the

purchase of the Long Bonds and Euronotes. The notes apparently

reflect a decision as to the timing of these transactions: 

"Peter de Beer, Curacao will give instructions from C to M.L.

after Citi's purchase".

The second partnership meeting was held in Bermuda on

November 17, 1989. A representative from Met Life came to

Bermuda at this time to negotiate the sale of the Met Note. The

negotiation was not lengthy; price was the only issue, and the

parties split the difference between their respective offers. By

Note Purchase Agreement dated November 17, 1989, and effective

December 4, 1989, ACM purchased $100 million principal amount of

the Met Note for the aggregate purchase price of $99,291,000 plus

accrued interest.
- 41 -

Pohlschroeder reported the successful conclusion of the

agreement to the Partnership Committee. According to the

minutes, he pointed out that the partnership would now require

cash in order to perform its obligations under the Note Purchase

Agreement with Met Life. In addition, this investment "would

create a risk to the Partnership in the event that interest rates

increased because the Met Bonds had a fixed rate of interest." 

Pohlschroeder recommended "that the Partnership hedge its risk by

purchasing notional principal contracts with a floating rate of

interest." By resolution of the Partnership Committee, Merrill

was authorized to arrange the sale of $175 million principal

amount of the Citicorp Notes to one or more of BOT, BFCE, and

Mitsubishi Bank "for cash and other LIBOR-based consideration,

upon substantially the terms of a draft Installment Purchase

Agreement presented to the meeting".

One other significant item of business at the second

partnership meeting was the adoption of the "Investment Policy

Guidelines" (Investment Guidelines). Weeks before the formation

of the Partnership, Pohlschroeder had reported to Heidtke that

Colgate would ensure in the Partnership Agreement that the

company's own cash management policies would be used as guidance

to maintain "liquidity * * * required to facilitate the buyback

of long-term debt". As it turned out, the partners were not yet

ready to adopt such policies at the time the Partnership

Agreement was executed. The primary objective of the belated
- 42 -

8 The term "notional principal amount" means that the

principal amount is not actually exchanged; rather, parties agree

to exchange payments based on the notional amount.

Investment Guidelines was "to preserve principal". To this end,

temporary cash balances were to be invested in a portfolio of

short-term money market instruments selected so as to achieve

both a high degree of liquidity and diversification. Upon the

liquidation of most of its investment in unregistered 5-year

notes of a single issuer, the partnership would be in a position

to implement its Investment Guidelines.

On November 27, 1989, ACM sold $175 million principal amount

of the Citicorp Notes to BOT ($125 million) and BFCE ($50

million). The aggregate consideration consisted of cash in the

amount of $140 million and eight notes requiring quarterly

payments of 3-month LIBOR for 20 quarters commencing March 1,

1990, on a notional principal amount of $97.76 million (LIBOR

notes).8 The LIBOR notes were not registered under the

Securities Act of 1933 and were not readily tradable on an

established securities market. At the time of the transaction,

Standard & Poors rated the senior debt of BOT AA and that of BFCE

AAA.

The aggregate amount of the consideration paid by the banks

included the discount, or origination cost, that Merrill

determined it would need to charge for its role in the

arrangement and intermediation of the transaction. The discount
- 43 -

was 5/8 percent of the par value of the Citicorp Notes, or

$1,093,750. The banks issued the LIBOR Notes at a price equal to

the aggregate consideration less the cash. The notional

principal amount of the Notes was the amount that was required at

current market swap rates to give the expected LIBOR cash flows a

present value equal to this price.

The following table summarizes the various costs associated

with the Citicorp Notes and LIBOR Notes:

Citicorp Notes aggregate par amount $175,000,000

Transaction price 99.375%

Transaction value 173,906,250

Accrued interest (12 days @ 8.65 percent) 504,564

 Total consideration 174,410,814

BOT BFCE TOTAL

Citicorp Notes par value $125,000,000 $50,000,000 $175,000,000

Accrued interest 360,403 144,161 504,564

Cash payment (100,000,000) (40,000,000) (140,000,000)

Cost of LIBOR Notes 25,360,403 10,144,161 35,504,564

Origination cost (781,250) (312,500) (1,093,750)

Issue price/present value

 of LIBOR Notes 24,579,153 9,831,661 34,410,814

Notional principal of 

 LIBOR Notes 69,850,000 27,910,000 97,760,000

On the same day that the partnership acquired the LIBOR

Notes for the stated purpose of hedging the partners' exposure to

interest rate risk associated with the Colgate debt, Southampton

served notice of an adjustment to the Yield Component sharing

ratio. Desiring greater exposure, Southampton increased its

share of the Yield Component from 16.7 percent to 29.7 percent. 

ACM invested the $140 million cash received in the sale in

several commercial paper issues (time deposits and certificates
- 44 -

of deposit (CD's)) maturing December 4, 1989, and bearing

interest at 8.15 to 8.20 percent. Upon maturity, these funds

became available at no transaction cost to finance the following

purchases of Colgate debt between December 4 and 8: 

$100 million principal amount of the Met Note for

$99,291,000 plus accrued interest;

$1 million principal amount of Euro Notes for

$1,025,500 plus accrued interest;

$4 million principal amount of Euro Notes for

$4,102,000 plus accrued interest;

$31 million principal amount of Long Bonds for

$31,493,396 plus accrued interest.

During November, the groundwork was being laid for the

disposition of some of the LIBOR Notes that ACM would acquire in

the sale. A memorandum that Merrill prepared for Colgate

entitled "Analysis of Partnership Hedging Activity," dated

November 13, 1989, purports to demonstrate quantitatively how

either an increase in Southampton's share of the interest rate

volatility of the Colgate debt from 30 percent to 50 percent or

an exchange of the Long Bonds for a new issue of 5-year Colgate

debt would warrant a reduction in the amount of the LIBOR Note

hedge in the partnership portfolio by approximately $10 million. 

Merrill reasoned that, in either case, ABN's interest rate

exposure would fall by about 30 percent, and a 30-percent

reduction in the size of the partnership's hedge would leave the

bank's net exposure unchanged. Sometime in November, Pepe

approached Neil Schickner (Schickner), head of the Capital
- 45 -

9 During 1989, Sparekassen was the largest savings bank in

Denmark. Later, in the same year, it merged with the two other

banks to form Unibank. We refer to the bank at all times as

Sparekassen.

Markets Desk at the New York Branch of Sparekassen SDS

(Sparekassen).9 Pepe proposed a transaction involving the

purchase of the BFCE LIBOR Notes by Sparekassen and collateral

swaps that provided Sparekassen with risk protection and an

attractive return. Schickner was already familiar with the

transaction structure; at about the same time, Pepe offered him

one or two similar deals in connection with other section 453

partnerships. On December 5, in order to conclude the deal,

Schickner notified the bank's headquarters in Copenhagen that he

was reserving a credit line in the amount of $10 million.

The third partnership meeting took place on December 12,

1989, in Curacao. On behalf of Southampton, Pohlschroeder served

notice of an adjustment in the Yield Component, whereby

Southampton elected to increase its share of interest rate

exposure to 39.7 percent. Next, the Committee voted to accede to

a Colgate proposal to exchange $4.7 million aggregate principal

amount of the Long Bonds plus $4,165 cash payment for $5 million

aggregate principal amount of new 3-1/2 year fixed rate debt. 

Macauley Taylor next stated that the debt exchange

contemplated by the foregoing resolutions would reduce

the Partnership's exposure to the risk of interest rate

fluctuations and recommended that the Partnership

reduce its position in the variable rate instruments

purchased to hedge against such exposure. He reported

that a reduction of approximately 30 percent in the
- 46 -

hedging provided by the Installment Purchase Agreements

executed by the Partnership on November 27, 1989 would

be economically advisable. He noted that this

reduction would not adversely affect Kannex because of

the adjustment of sharing of Yield Component effected

by the notice dated December 12, 1989, from Southampton

to the Partnership Committee.

It was decided that the BFCE Notes would be distributed to

Southampton as a partial return of capital. ACM assigned the

BFCE Notes to Southampton as of December 13. By Assignment

Agreements dated December 22, 1989, Southampton agreed to assign

the notes to Sparekassen for aggregate consideration of

$9,406,180. The discrepancy between the issue price at which the

Notes had been acquired ($9,831,661) and the price that

Southampton received on their sale ($9,406,180) was largely

attributable to a bid-ask spread of $390,000. The bid-ask spread

reflected the margins above and below mid-market value that

Merrill deemed necessary in order to originate and sell the

Notes. Estimating cash flows under the Notes from ask-side swap

rates and discounting at a spread below LIBOR in its valuation of

the Notes at issuance, Merrill was able to create an attractively

priced liability for BFCE. Estimating cash flows under the Notes

from bid-side swap rates and discounting at a spread above LIBOR

in its valuation of the Notes for purposes of the assignment

transaction, Merrill was able to create an attractively priced

asset for Sparekassen. The remaining portion of the discrepancy,

$35,481, was due to a decline in market interest rates over the
- 47 -

10 ACM computed the gain as follows:

 Payments received in FYE 11/30/89 $140,000,000

 Basis recovered in FYE 11/30/89

Citicorp Note basis plus 

 accrued interest 175,504,564

Portion allocable to

 FYE 11/30/89 (1/6) (29,250,761)

 Capital gain 110,749,239

3-week period since the issuance of the LIBOR Notes, which caused

them to lose value.

6. Tax and Financial Accounting for the Results

For Federal income tax purposes, ACM treated the sale of the

Citicorp Notes as a contingent payment sale, governed by section

15a.453-1(c)(3), Temporary Income Tax Regs., 46 Fed. Reg. 10714

(Feb. 4, 1981). As there was no stated maximum selling price and

all payments on the LIBOR Notes would be received over a fixed

period of 6 taxable years, ACM recovered its basis in the

Citicorp Notes ratably over 6 years. On Form 1065, U.S.

 Partnership Return of Income, for FYE 11/30/89, the

partnership reported capital gain of $110,749,239.10 The gain

was allocated among the partners in proportion to their capital

accounts as shown on the November 30, 1989, revaluation

worksheet: $91,516,689 to Kannex, $18,908,407 to Southampton,

and $324,144 to MLCS. The parties to this proceeding have agreed

that the partnership's tax basis in the LIBOR Notes immediately

after the sale was $146,253,803, an amount that exceeded the cost

of the Notes by the gain recognized on the sale.
- 48 -

11 Colgate computed the loss as follows:

 Cash proceeds $9,406,180

 Imputed interest on contingent 

 payments (48,693)

 Amount realized 9,357,487

 Citicorp Note basis plus

 accrued interest 50,144,161 

 Basis allocable to LIBOR

 Notes (5/6) 41,786,801

 Section 1274 interest accrued

by ACM 525

 Adjusted basis allocable to

LIBOR Notes 41,787,326

 Capital loss 32,429,839

Kannex paid neither U.S. nor foreign tax on its 82.63

percent distributive share of the partnership capital gain. On 

its consolidated Federal income tax return for 1989, Colgate

reported a net capital loss attributable to Southampton in the

amount of $13,521,432, representing the difference between

Southampton's distributive share of the partnership capital gain

($18,908,407) and the capital loss that Southampton recognized on

the sale of the BFCE Notes to Sparekassen ($32,429,839).11

During the years at issue, Colgate retained Arthur Andersen

& Co., as its accountants. In connection with the audit of

Colgate's consolidated financial statement for 1989, the audit

engagement team and Arthur Andersen's tax team discussed with 

Colgate's treasury, financial, and tax department personnel how

to report the partnership and its activities for financial

accounting purposes. Representatives of Merrill were also

present. An outline was presented of the planned sequence of
- 49 -

12 "Outside basis" refers to a partner's basis in its

partnership interest.

steps by which the partnership would borrow to redeem ABN's

interest in October 1991 and recognize the remainder of the total

$100 million capital loss. The auditors were concerned that

recognition of the large tax loss without a corresponding book

loss would leave Colgate with an outside basis considerably lower

than the value of the partnership assets.12 The deferred tax

liability associated with this built-in gain would have to be

recognized for financial accounting purposes, unless the company

could demonstrate an "exit tax strategy". With Merrill's

assistance, Colgate explained how the low outside basis and

deferred tax liability would be eliminated through a series of

contemplated tax-free asset and stock transfers among Colgate

affiliates some time after 1992. The auditors were of the

opinion that until it became clear that they would be

sustainable, for the most part the tax benefits of the

transaction should not be recognized for financial accounting

purposes. They understood from Colgate's account of the

partnership, however, that sizable transaction costs would be

incurred in connection with its activities. Colgate explained

that only a minor amount of these costs would be shared with the

other partners. Colgate would bear approximately $5 million,

including all of Merrill's advisory fee of $1.7 million as well

as approximately $2 million to originate and remarket the LIBOR
- 50 -

Notes. The auditors agreed with Colgate that tax benefits from

the partnership could be recognized to the extent of the

net-of-tax amount of these transaction costs.

 On the issue of consolidation, the auditors endorsed

Colgate's position. Consolidation would not be required until

ABN's retirement, chiefly because the Colgate debt was not

effectively retired to the extent that ABN was sharing changes in

its market value. In the meantime, since Colgate was using its

position in the partnership essentially as a hedge of its

liabilities, and would otherwise have used swaps or other

conventional hedging operations to accomplish the same purposes,

its investment in ACM should be treated in the same manner for

financial accounting purposes as a swap. This would entail the

recognition of mark-to-market changes in the value of its equity

interest on its financial statements.

The Curacao office of Arthur Andersen served as accountants

for ACM. In the course of their review of the results for FYE

11/30/89, the auditors noted two problems with the partnership's

financial statements. The first problem was that the $1,093,750

discount on the sale of the Citicorp Notes was not reflected in

the income statement. The second problem was that the

partnership had included this discount in the book value of the

LIBOR Notes, contrary to provisions of the Partnership Agreement

that required partnership assets to be restated at fair market

value on the last day of the fiscal year. Following
- 51 -

consultations with the New York office of Arthur Andersen and

with Colgate, in February 1990, the audit engagement manager

briefed his colleague on the status of the problem:

Colgate does not want the cost to sell of US

$1,093,750 * * * in the November 30, 1989

income statement of ACM. The reasons are

mainly tax driven, as inclusion might set the

IRS on top of the reasons why the partnership

was constructed in the first place and thus

the planned tax losses may be denied by the

IRS. We, in cooperation with Steve Rossi of

our New York office, were requested to think

with Colgate in order to keep the cost to

sell out of the balance sheet. [Emphasis

added.]

One proposal under consideration was as follows:

Leave the LIBOR notes on the balance sheet as

they are and reason that one third of the

notes will be distributed to Colgate by 1990

and that the remainder of the notes is

eventually for the account of Colgate too. 

This would require a side letter to the

partnership agreement stating that the LIBOR

notes are the one exception to the valuation

rules which now state valuation at market and

would state valuation at market and would

then state valuation at market increased by

the cost to sell the original Citicorp notes. 

The partnership followed this approach. Pursuant to the

"Summary of Financial Accounting Policies" (Accounting Policies),

adopted 2 weeks later at the fourth partnership meeting, the

LIBOR Notes would be:

carried on the books of the Partnership 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 liquidation of the Partnership.
- 52 -

Thus, the LIBOR Notes were initially booked at a cost that

included the $1,093,750 transaction costs incurred on their

origination. The cost would be amortized over the life of the

investment. This amortization would constitute a charge against

income, offset by accrued payments on the Notes. If any of the

LIBOR Notes were distributed or a partner was redeemed, the

amortized balance would be adjusted for changes in value due to

interest rate movements and increased by the previously amortized

portion of the origination cost. This convention had the effect

of ensuring that the origination cost would be borne solely by

the partner(s) that held an interest in the Notes, directly or

indirectly, at the time they matured or were sold.

The Accounting Policies do not specify the methodology to be

used in revaluing the LIBOR Notes to reflect changes in interest

rates. The methodology would differ depending on whether the

book value was meant to reflect the minimum price at which the

Notes could be purchased in the market (ask value), the maximum

price at which they could be sold in the market (bid value), or

the midpoint between the two (mid-market value). The

understanding among the partners on this issue is revealed by the

partnership's actual accounting practice. In pricing the LIBOR

Notes at issuance, Merrill used an ask-side valuation

methodology. The Notes were originally booked at a value based

on this price; the bid value of the Notes at that time, as

determined by Merrill, was about $1.3 million lower. Thereafter,
- 53 -

book value was consistently adjusted to reflect the current ask

price. This convention had the effect of ensuring that the

bid-ask spread would be borne solely by the partner(s) that held

an interest in the Notes, directly or indirectly, at the time

they matured or were sold.

Finally, unlike the policies governing the revaluation of

Colgate debt, there is no provision in any agreement for

adjusting the book value of the LIBOR Notes to reflect changes in

the credit quality of the issuers. As a result, any credit risk

would be borne only upon the sale of the Notes to a third party.

As a corollary to the Accounting Policies described above,

the partners agreed that in the event that any of the LIBOR Notes

were distributed to a partner before maturity, they would be

distributed at book value. As a result, the distributee

partner's capital accounts and outside basis would be reduced.

This reduction would result in the distributee in effect paying

the full origination cost and bid-ask spread attributable to the

distributed LIBOR Notes. In connection with the distribution of

the BFCE Notes to Southampton, as of December 13, the

partnership's assets were revalued. The book value of the BFCE

Notes was adjusted to $10,133,540. For financial and tax

accounting purposes, Southampton's capital account was reduced by

this amount, resulting in a decrease in its ownership percentage

from 16.89 percent to 12.60 percent.
- 54 -

7. Final Stage of Colgate's Partnership Strategy

ACM made additional purchases of Colgate debt from the

marketplace as follows:

Aggregate

 Issue Principal Purchase

 Acquired Date Amount Price 

 Euro Notes 6/1/90 $5,000,000 $5,154,861

 Long Bonds 9/6/90 4,000,000 3,864,622

 Euro Notes 9/11/90 1,750,000 1,859,132

 Long Bonds 9/12/90 6,000,000 5,852,290

 Euro Notes 10/23/90 2,000,000 2,159,389

There were also exchanges between ACM and Colgate of the

Met Note and approximately one-third of the Long Bonds. In

January 1990, ACM exchanged the Met Note for a new Colgate Note

with substantially identical terms. This new note was, in turn,

exchanged on July 26, 1990, for the purpose of rescheduling

certain payments. 

ACM made two exchanges of the Long Bonds, which totaled

$10 million. On December 13, 1989, ACM exchanged $4.7 million

principal amount of Long Bonds for $5 million principal amount of

Colgate 8.72-percent notes due June 13, 1993. On March 1, 1991,

the partnership exchanged $4.85 million principal amount of Long

Bonds for $5 million principal amount of Colgate Notes due in

1994. The exchanges of the Long Bonds had the effect of reducing

Colgate's original average debt maturity of 13 years by only

2 months (or 1 percent).
- 55 -

At the end of August 1990, Colgate's treasury concluded that

a significant change had occurred in the interest rate

environment. Inflationary expectations and the prospect of war

in the Persian Gulf were causing a rise in long-term interest

rates and a steepening of the yield curve. Under these

conditions, the value of Colgate debt held by the partnership

would fall. Reversing its policy over the past 10 months of

accepting substantially greater interest rate exposure than its

pro rata share, Colgate caused Southampton to reduce its share of

the Yield Component to 10 percent, effective September 6.

Thereafter, Southampton adjusted the Yield Component Sharing

ratio on two more occasions, maintaining its exposure between

10 and 20 percent.

Contrary to the expectations of Colgate's management,

long-term interest rates declined. By the spring of 1991

Colgate's treasury department identified a constellation of

factors favoring consolidation of the partnership and retirement

of its Colgate debt holdings in the near future. Not only were

general interest rates lower, but the credit spreads on Colgate

debt had narrowed appreciably, reflecting stronger prices for the

company's stock and diminished takeover risk. Moreover, efforts
- 56 -

to locate Colgate debt available for purchase were no longer successful.

By Partnership Interest Purchase Agreements dated June 25,

1991, Colgate acquired a 38.31-percent interest in ACM from

Kannex for $85,897,203, and Southampton acquired a 6.69-percent

interest in ACM from Kannex for $15 million. As a result of

these transactions, Kannex's ownership percentage declined to

43.04 percent. The shift in ownership was accompanied by a

revaluation of partnership assets. Changes in asset values were

allocated among the partners' respective capital accounts and the

purchase price was determined based upon the balance of Kannex's

account. In this process, the book value of the BOT LIBOR Notes

was adjusted to reflect their current market value increased by

$781,250, the full amount of the origination cost attributable to

the notes, and 88 percent of the adjustment was allocated to

Kannex's capital account. Although not specifically provided for

by the partnership's Accounting Policies, a revaluation of the

LIBOR Notes under these circumstances was evidently consistent

with the agreement among the partners that Kannex would bear none

of the origination cost.

By agreement dated November 27, 1991, ACM redeemed the

remainder of Kannex's partnership interest for $100,775,915. The

redemption was financed in part with cash and in part with the

proceeds of a loan from Citibank secured by the partnership's

holdings of Colgate debt. In accordance with the Accounting
- 57 -

Policies, partnership assets were revalued and unrealized income,

gains, and losses were allocated among the partners. For this

purpose, a value of $13,974,304 was assigned to the BOT LIBOR

Notes, reflecting their current market value increased by the

$781,250 origination cost attributable to them. The liquidating

distribution that Kannex received was equal to the resulting

balance in its capital account.

At the twelfth partnership meeting, held on December 5,

1991, it was observed that 

as Colgate and a subsidiary, Southampton, owned 99.4%

of the Partnership, the principal Partners' net

economic exposure to the risk of interest rate

fluctuations in the value of the Colgate debt was

effectively minimal, and the Partnership need not

maintain its position in the instruments purchased to

hedge against such exposure. 

Moreover, the LIBOR Notes "were a highly volatile investment and

* * * without the need to hedge interest rate risk, it was unwise

for the Partnership to hold them." "[Short-term interest rates

had declined steadily in recent months, thereby reducing the

value of the instruments." It was resolved that the partnership

would sell the LIBOR Notes. The final substantive comment of the

meeting was delivered by Belasco, representing Colgate, who noted

that "the Partnership had achieved substantially all of its

objectives in connection with the acquisition of Colgate bonds

and related debt management."
- 58 -

13 This figure represents the aggregate face amount of

Colgate long-term debt held by the partnership ($136.6 million)

minus the decline that would have occurred in any case during

(continued...)

On December 17, 1991, shortly before the close of Colgate's

1991 taxable year, ACM sold the BOT LIBOR Notes to BFCE for

$10,961,581. The notes had fallen considerably in value owing to

the decline in market interest rates. Eight and one-half percent

at the time the first payment on the notes had been determined,

3-month LIBOR was below 5.7 percent when the last payment was

determined. The price at which the BOT LIBOR Notes were sold

also reflected a remarketing cost corresponding to the bid-ask

spread, equal to $440,000.

The economic loss incurred on the sale of the LIBOR Notes

was more than compensated for by the tax loss. On its Form 1065

for FYE 12/31/91, ACM reported a capital loss in the amount of

$84,997,111. Colgate claimed $84,537,479 as its own and

Southampton's combined distributive shares of this loss on its

consolidated corporation tax return for the 1991 taxable year. 

By amended return, Colgate carried this loss back to 1988. The

total net tax loss that Colgate achieved through the CINS

transaction exceeded $98 million.

As a result of the consolidation of ACM on Colgate's

financial statements for 1991, Colgate's reported outstanding

long-term indebtedness declined by $124.1 million,13
- 59 -

13(...continued)

1991 owing to a scheduled principal payment ($12.5 million).

approximately one-half of the overall decline in long-term debt

during this year. As of December 31, 1991, the value of

Southampton's and Colgate's capital accounts plus the proceeds

that had been received from sale of BFCE LIBOR Notes exceeded the

costs of their combined investment in the partnership by

approximately $5.42 million, representing a pre-tax internal rate

of return of 4.7 percent. More than 2 percentage points of this

return was attributable to the appreciation of the partnership's

Colgate debt caused by further declines in interest rates in the

month following Kannex's redemption.

8. Merrill's Collateral Swap Transactions

The origination and remarketing costs of nearly $2 million

that Colgate incurred through its partnership strategy

represented the costs of a highly complex structure of collateral

swaps arranged and executed by Merrill for the purpose of

accommodating the investment in and divestment of assets

qualifying for contingent payment sale treatment. This section

outlines the transactions that Merrill entered into with BOT,

BFCE, and Sparekassen between the issuance of the LIBOR Notes in

November 1989 and the partnership's sale of the BOT LIBOR Notes

in December 1991.
- 60 -

14 In financial terminology, a "structured transaction" is

one that combines two or more financial instruments or

derivatives. Most structured transactions, like those in this

case, include at least one derivative.

To secure the participation of BOT and BFCE in the

contingent payment sale desired by ACM, Merrill's Swap Group

offered each of the banks a "structured transaction."14 The

structured transaction consisted of two swaps to be executed in

conjunction with the contingent payment sale, a basis swap

related to the asset that the banks would be purchasing and a

hedge swap related to the liability that they would be issuing to

finance the purchase. The banks' counterparty in these swaps was

Merrill Capital. Both sets of swaps were entered into on

November 27, 1989.

Under the basis swaps, BOT and BFCE were obligated to make

monthly payments to Merrill Capital at the 1-month commercial

paper rate plus 15 basis points on notional amounts of $125

million and $50 million, respectively. These payments were

equivalent to the interest that the banks received on the

Citicorp Notes. In exchange, Merrill Capital was required to

make monthly payments to the banks at a rate of 1-month LIBOR

plus 25 basis points on identical notional amounts. After

3 months the spread over LIBOR that Merrill Capital was required

to pay increased to 40 basis points and in the case of BOT, to

50 basis points after another month, unless on any payment date
- 61 -

Merrill Capital elected to terminate the basis swaps and purchase

the Citicorp Notes from the banks at par.

The basis swaps served a risk management function for the

banks. The net cash flows resulting from the combination of the

Citicorp Notes with the basis swaps were tied to LIBOR, the index

in terms of which BOT and BFCE, like international banks

generally, conducted most of their business. The step-up

provisions were negotiated at the request of the banks and were

designed to give Merrill Capital a financial incentive to make

arrangements for resale of the notes as quickly as possible.

Merrill Capital would forgo the exercise of its call option only

in the event of a substantial decline in Citicorp's credit that

caused the value of the Citicorp Notes to fall by more than the

cost of paying the premium.

Under the hedge swaps, Merrill Capital was obligated to make

quarterly payments over 5 years equivalent to the LIBOR Note

payments that the banks were required to make to ACM. In return,

BOT agreed to pay the sum of $25 million in 20 equal quarterly

installments plus interest on the unpaid balance at a rate of

LIBOR minus 18.75 basis points. BFCE agreed to pay the sum of

$9,831,661 in 20 equal quarterly installments plus interest on

the unpaid balance at a rate of LIBOR minus 25 basis points. In

addition, there were two upfront payments: Merrill Capital paid

$35,000 to BOT, and BFCE paid $168,339 to Merrill Capital. Like
- 62 -

15 The banks did not actually pay Merrill Capital the full

amount of the interest coupons they received from Citicorp, nor

did Merrill Capital pay them the full amounts payable to ACM

under the LIBOR notes. On each payment date amounts owed by each

counterparty to a swap were offset, and only the net payments

were made. The netting of payments is standard practice in the

swap market and was provided for in all of the swap agreements

discussed hereafter.

the basis swaps, the hedge swaps served a risk management

function for the banks. They were designed to replicate the

portfolio effects of partly financing the purchase of the

Citicorp Notes with a conventional amortizing loan, whose value

would not be affected by changes in LIBOR, rather than with the

highly volatile LIBOR Notes.15

The structured transactions were designed to be remunerative

for the dealer, Merrill Capital. Under the basis and hedge

swaps, the present value of the banks' payment obligations

exceeded the present value of Merrill Capital's obligations. In

this way, the swaps were expected to result in the transfer from

the banks to Merrill Capital of the 5/8 discount incurred by ACM

on the contingent payment sale. To the extent that the basis

swap continued beyond 3 months, Merrill Capital would return some

or all of the discount to the banks through the stepped up LIBOR

payments.

BOT and BFCE would not have participated in the hedge swaps

if they did not also perceive an opportunity to profit. Internal

bank documents confirm that those who negotiated the structured
- 63 -

16 Beder is affiliated with the New York consulting firm of

Capital Market Risk Advisors, and serves on the faculty of the

Yale School of Management.

transactions with Merrill believed that they offered "very

attractive", "extremely favorable" terms. According to

calculations performed by petitioner's expert Tanya Beder

(Beder),16 the transactions effectively provided both banks with

funding at a cost 39 basis points lower than that available in

the direct interbank market. The 39 basis points in savings

represents each bank's net present value gain from the structured

transaction expressed in relation to the amount of the financing

involved. Beder's valuation analysis is useful for identifying

how the banks expected to gain overall while losing money on both

the basis and hedge swaps.

Valuation of the Positions of

BOT and BFCE as of 11/27/89

( $ millions = mm )

BOT BFCE

LIBOR Notes

Price rec'd from ACM $24.58 mm $9.83 mm

Mid-market value (24.05)mm (9.61)mm

Citicorp Notes

Price paid to ACM (124.58)mm (49.83)mm

PV of expected sale proceeds

 rec'd by banks 125.39 mm 50.15 mm

Hedge Swap

Liability leg (24.88)mm (9.77)mm

Asset leg 24.08 mm 9.62 mm

Basis Swap

Asset leg 18.77 mm 7.43 mm

Liability leg (18.22)mm (7.29)mm

Merrill's cancellation option (0.89)mm (0.29)mm
- 64 -

Up-front payment 0.04 mm (0.17)mm

Net Present Value 222,586 88,323

Implied Funding Spread

 Under LIBOR 

10.39% 10.39%

1 The approximate calculations are: $222,586 savings

divided by $25 million in principal, spread over 2.3 year

duration of principal payments; $88,323 savings divided by

$9,831,661 in principal, spread over 2.3 year duration of

principal payments.

This analysis indicates that the source of the banks' expected

gains was Merrill's pricing of the Citicorp Notes and LIBOR Notes

for purposes of the contingent payment sale. These prices

reflect sizeable bid-side and ask-side spreads. Transaction

spreads generally tend to be wider for structured transactions

than for direct market transactions because structured

transactions are customized to meet the needs of the end users

and often incorporate a premium to the dealer for innovations

that competitors are unable to replicate. The spreads implied in

Merrill's pricing of the Citicorp Notes and LIBOR Notes

represented the costs of the financial engineering that the

contingent payment sale required. Accordingly, the costs were

charged to ACM. The banks acquired the Citicorp Notes at the bid

price and issued the LIBOR Notes at the ask price. The spreads

on these two instruments could have been expected, at the time of

the contingent payment sale, to result in the transfer of a total

of about $1.8 to $1.9 million in value from ACM to the banks. 
- 65 -

17 As will be seen hereafter, Merrill Capital did not retain

all of the remaining $1.5 to $1.6 million of value extracted from

the partnership. Some of this value was transferred back to ABNs

and Kannex through a separate set of swaps relating to the LIBOR

notes.

The banks could have expected to retain approximately $300,000 of

this value. See diagram 1 infra p. 67.17

It was the understanding of BFCE that Merrill would arrange

for the resale of the Citicorp Notes after only 1 month, well in

advance of the date that the step-up in Merrill's payments took

effect. The written agreement contained no such provision, but

Merrill found a buyer, and BFCE sold its $50 million principal

amount of Citicorp Notes on December 22, 1989. At the same time,

the basis swap between Merrill Capital and BFCE was canceled. In

January 1990, the basis swap with BOT was terminated, and the

remaining $125 million principal amount of Citicorp Notes was

resold.

Merrill arranged another structured transaction to

facilitate Southampton's sale of the BFCE LIBOR Notes to

Sparekassen on December 22, 1989. Under the hedge swap between

Merrill Capital and Sparekassen, Sparekassen was obligated to

make quarterly payments equivalent to those it was entitled to

receive from BFCE under the LIBOR Notes. In return, Merrill

Capital was required to pay $9,406,180, an amount that

corresponded to the purchase price of the notes, in 20 equal
- 66 -

quarterly installments, together with interest on the unpaid

balance at a rate of LIBOR plus 35 basis points. The spread over

LIBOR increased to 85 basis points after March 1, 1990, if

Merrill did not first exercise its right to call the notes at a

price equal to the unpaid principal balance and terminate the

swap. From Sparekassen's perspective, the structured transaction

was similar to investing in an amortizing loan that paid a margin

over LIBOR, rather than in volatile LIBOR Notes. From Merrill

Capital's perspective, the transaction provided an asset whose

volatility matched and offset the volatility of its liability

under the hedge swap with BFCE or BOT. The step-up in Merrill

Capital's payment obligations provided it a financial incentive

to exercise its call right and cancel the swap. Petitioner's

expert, Beder, concluded that as of the time of its acquisition

of the BFCE Notes, Sparekassen could have expected a net present

value benefit of $7,208, equivalent to a return on its investment

of 41 basis points more than that available in the direct

interbank market.
- 67 -

Flow of Benefits in 11/17/89 Structured Transaction

Diagram 1

 

 Purchase Citicorp Notes at the Bid

 <

 ACM Expected benefit to Bank = $$ BoT/BFCE 

 

 Issue Contingent LIBOR Notes at the ask 

 = 

 Expected benefit to Bank = $

 Swaps

AMerrill Capital puts the bank (BoT or BFCE) into the Expected benefit

 Postion of a dealer to Merrill = $$$

ABank expects to benefit by executing transactions at

 Dealer prices (benefit shown as $ + $$) ?

AThrough swaps, most of the expected benefit of dealer

 Pricing is transferred back to Merrill (shown as $$$) Merrill

ABank is left with sub-LIBOR funding, but has taken Capital

 Incremental credit risk 

Flow of Benefits in 12/22/89 Structured Transaction

Diagram 2

 Purchase Contingent LIBOR Notes at the Bid 

 Southampton < Sparekassen

 Hamilton Benefit to Bank = $$

 Hedge Swap

AMerrill Capital puts the bank (Sparekassen)into the Benefit to 

 Position of a dealer Merrill = $

ABank benefits by executing transacation at a dealer's

 Price (benefit shown as $$)

AThrough Hedge Swap, most of the benefit of dealer ?

 Pricing is transferred back to Merrill (shown as $) Merrill 

ABank is left with above-market asset, but has taken Capital

 Incremental credit risk 
- 68 -

 

Flow of Benefits in 12/17/91 Structured Transaction

Diagram 3

 Purchase Contingent LIBOR Notes at the Bid

 ACM < BFCE

 

 Benefit to Bank = $$

AMerrrill Capital puts the bank (BFCE) into the Hedge Swap

 Position of a dealer Benefit to

ABank benefits by executing transaction at a dealer's Merrill = $

 Price (Benefit shown as $$) 

AThrough Hedge Swap, most of the benefit of dealer ?

 Pricing is transferred back to Merrill (shown as $)

ABank is left with above-market asset, but has taken Merrill

 Incremental credit risk Capital

Valuation of Sparekassen's 

Position on 12/22/89

 ( $ millions = mm )

LIBOR Notes

Price paid to Southampton (9.41)mm 

Mid-market value 9.63 mm

Hedge Swap

Asset leg 9.58 mm

Liability leg (9.63)mm

Merrill's cancellation option (0.17)mm

Net Present Value 7,208

Implied Return Over LIBOR 

10.41%

1 The approximate calculation is: $7,208 gain divided by

$9,406,180 invested, spread over 0.189 year duration of payments. 

The calculation assumes that Merrill Capital will cancel the swap
- 69 -

on March 1, 1990, when the opportunity to do so first arises: At

the inception of the swap, the prospect of a decline in BFCE's

credit sufficient to warrant retention of the option at the large

cost that this would impose was highly unlikely.

As in the structured transaction that Merrill designed for

the other two banks, Sparekassen could expect to lose money on

the swap; the source of its gain is the bid-side spread implied

in Merrill's pricing of the LIBOR Notes. The transaction pricing

resulted in the transfer from Southampton to the bank of more

than $200,000 in value, most of which would ultimately enure to

the benefit of Merrill Capital. See diagram 2 supra p. 67.

By agreements among BFCE, Sparekassen and Merrill Capital,

the BFCE LIBOR Notes and the two hedge swaps related to them were

terminated during 1990.

Merrill arranged another hedge swap for BFCE in conjunction

with the bank's purchase of the BOT LIBOR Notes from ACM for

$10,961,581 on December 17, 1991. The structure and function of

this swap were for the most part identical with those of the

hedge swap between Merrill Capital and Sparekassen. BFCE agreed

to pay Merrill Capital amounts equal to the flows it was entitled

to receive under the BOT Notes. Merrill Capital agreed to make

12 equal quarterly payments aggregating $10,961,581, together

with interest on the unpaid balance at LIBOR plus 35 basis

points. The interest rate was stepped up after the first year

unless Merrill elected to terminate the swap and acquire the
- 70 -

notes at a price equal to the unpaid principal balance remaining

on the amortizing leg. For BFCE, the hedge swap effectively

created a synthetic asset paying an attractive margin over LIBOR,

and, for Merrill Capital, a hedge for its payment obligations

under the outstanding swap with BOT.

According to Beder's calculations, the midmarket value of

the BOT LIBOR Notes at the time of their sale to BFCE was $11.18

million. The bid-side spread of $220,000 implicit in the

purchase price that BFCE paid ACM for the notes financed the

gains shared by Merrill and the bank from the transaction. See

diagram 3 supra p. 68. Ultimately, the cost of engineering this

structured transaction, like the two before it, was borne almost

entirely by Colgate.

9. ABN's Investment Management

In conformity with the requirements for approval of Kannex's

loan, den Baas and his colleagues at ABN New York took steps to

protect the bank from the risks of Kannex's participation in ACM

and to ensure the bank an adequate return. ABN New York had the

authority to implement a comprehensive financial management

program for Kannex by virtue of ABN New York's financial services

agreement. First, Kannex's exposure to the intrinsic interest

rate risk of partnership assets would be "fully hedged". Den

Baas never considered relying on the partnership's LIBOR Notes

for this purpose. He made no attempt to evaluate their hedging
- 71 -

effect within the partnership portfolio. It was clear to him 

that effect would not be adequate, and hedging instruments of

greater precision and reliability were available. Accordingly,

ABN New York arranged to neutralize the effect of the LIBOR Notes

on Kannex's interest. The structure that it employed for this

purpose consisted of back-to-back swap transactions with Kannex

on the one hand and Merrill Capital on the other. ABN New York

assumed the role of intermediary on the assumption that neither

Merrill Capital nor any other third party would accept Kannex's

credit risk.

By swap confirmations effective November 27, 1989, the issue

date of the LIBOR Notes, ABN New York entered into a hedge swap

agreement with Merrill Capital. Under the swap, ABN New York was

required to make to Merrill Capital quarterly payments of 3-month

LIBOR over 5 years equivalent to Kannex's 82.63 percent pro rata

share of the payments owed to ACM under the LIBOR Notes. Merrill

Capital was required to pay to ABN New York the sum of

$28,433,655 in 20 equal quarterly installments together with

interest on the unpaid balance at a rate of LIBOR minus 25 basis

points. This amortizing principal amount was equal to 82.63

percent of $34,410,814, Kannex's pro rata share of the issue

price of the LIBOR Notes. ABN New York entered into a matching

hedge swap with Kannex under which Kannex's rights and

obligations vis-a-vis ABN New York corresponded to those of ABN
- 72 -

New York vis-a-vis Merrill Capital. When Kannex's indirect

interest in the LIBOR Notes held by the partnership changed

significantly as a result of the distribution of the BFCE Notes

to Southampton on December 13, 1989, the partial purchase of

Kannex's partnership interest on June 27, 1991, and the

redemption of its remaining interest on November 27, 1991, both

legs of the hedge swaps were adjusted proportionately. At these

times, the portion of the swap that was to be terminated would be

marked to market, and the counterparty that would otherwise have

benefitted from the change in market interest rates would receive

a compensatory termination payment. The back-to-back hedge swaps

satisfied complementary needs. Kannex was able to stabilize its

return on $28 million of its partnership investment. Likewise,

Merrill Capital was able partly to offset the interest rate

exposure that it incurred in connection with its hedge swaps with

BOT and BFCE.

The back-to-back hedge swaps relating to the LIBOR Notes

also served an additional function that can be understood only by

reference to the terms of the structured transactions in which

the LIBOR Notes were issued. According to the analysis of

petitioner's expert, the transaction spreads implied in Merrill's

pricing of the Citicorp Notes and LIBOR Notes for purposes of the

contingent payment sale could be expected to result in the

transfer of between $1.8 and $1.9 million of value from ACM to
- 73 -

the foreign banks. The banks could have expected to retain only

about $300,000 of this value, because their basis and hedge swaps

with Merrill Capital were structured in such a way that the

present value of the swap payments they were entitled to receive

from Merrill Capital was less than the present value of the swap

payments they were obligated to pay to Merrill Capital. Thus,

the value of BFCE's right to quarterly payments of 3-month LIBOR

Notes over 5 years on a notional principal amount of $27.91

million was $9.62 million, while the value of its obligation to

pay $9,831,661 in equal quarterly installments over 5 years

together with interest on the unpaid balance at LIBOR minus

25 basis points was $9.77 million. As a result of the

discrepancy in the value of these two legs of the hedge swap,

Merrill Capital could have expected to realize a net gain, and

BFCE a net loss, of $150,000.

The hedge swap between Merrill Capital and ABN was

structured in a manner similar to the hedge swap between BFCE and

Merrill Capital. The ABN swap differed from the BFCE swap in

only two respects. First, the payment obligations on both sides

of the ABN swap were proportionately larger. In the BFCE swap,

the notional principal amount of the fixed notional leg was set

at an amount ($27.91 million) equal to 50/175, or 28.5 percent,

of the combined total notional principal amount of the BOT and

BFCE Notes ($97.76 million); in the ABN swap, it was set at an
- 74 -

amount ($80,779,000), equal to Kannex's 82.63 percent share of

the combined total notional principal amount of the BOT and BFCE

Notes. Likewise, in the BFCE swap, the principal amount of the

amortizing leg ($9,831,661) was equal to 50/175, or 28.5 percent

of the combined total issue price of the BOT and BFCE Notes

($34,410,814); in the ABN swap, the principal amount of the

corresponding leg was $28,433,655, an amount approximately equal

to Kannex's 82.63 percent share of the combined total issue price

of the BOT and BFCE Notes. If, as Beder concluded, the

amortizing leg was worth more than then fixed notional leg in the

BFCE swap, that asymmetry in value would necessarily have been

magnified in the larger, but structurally identical, ABN swap. 

The second respect in which the swaps differed was that Merrill

Capital occupied the position of the net creditor in the BFCE

hedge swap but that of the net debtor in the ABN swap. The hedge

swap between ABN and Kannex was in all respects identical to the

hedge swap between Merrill Capital and ABN, except that ABN now

assumed the position of net debtor.

The effect of the back-to-back hedge swaps would have been

to transfer from Merrill Capital to ABN and from ABN to Kannex a

portion of the value extracted from the partnership through the

transaction spreads it was charged in the contingent payment

sale. This transfer partly indemnified Kannex for its share of

the partnership's economic loss.
- 75 -

By separate swap confirmations effective November 27, 1989,

Merrill Capital agreed to pay ABN, and ABN agreed to pay Kannex,

interest at the rate of LIBOR minus 25 basis points on a notional

principal of $903,765, an amount that corresponded to Kannex's

share of the 5/8 discount incurred by the partnership in the sale

of the Citicorp Notes and origination of the LIBOR Notes. 

Following the distribution of the BFCE Notes to Southampton, the

notional principal was reduced to $680,156. This revised amount

represents the product of Kannex's then current percentage

interest as reflected on a preliminary draft revaluation

worksheet (87.06 percent) multiplied by the portion of the

discount attributable to the BOT Notes retained by the

partnership ($781,250). The documentation characterized these

agreements as "swaps". This is a misnomer, however, because the

payment obligations were unilateral. The parties'

characterization reflects the fact that these "one-sided swaps"

were negotiated in conjunction with the back-to-back hedge swaps

and were intended to complement them. Like the hedge swaps, the

one-sided swaps had the effect of compensating Kannex for a loss

that it would otherwise have borne in connection with the

contingent payment sale.

We have previously discussed how the partnership chose to

account for the 5/8 discount incurred in the contingent payment

sale for financial and tax accounting purposes. Rather than
- 76 -

recognizing this transaction cost, the partnership included it in

the carrying cost of the LIBOR Notes. Although this method of

accounting was calculated to result eventually in the allocation

of all of the transaction cost to Kannex's partners, as long as

recognition of the cost was deferred, the capital accounts of

Kannex's partners were overstated, and Kannex's share of

partnership income was understated. According to the revaluation

worksheets, the partners' capital account balances as of the end

of FYE 11/30/89, were restated at fair market value as follows:

Kannex MLCS Southampton Total

 $170,617,686 $603,976 $35,145,281 $206,366,943

 (82.68%) (0.29%) (17.03%) (100%)

Had the $1,093,750 discount been recognized and allocated, say,

entirely to Southampton at this time, Kannex's pro rata interest

in partnership assets and share of partnership income would have

been .4402742 percentage points higher and Southampton's .4402742

percentage points lower:

Kannex MLCS Southampton Total

 $170,617,686 $603,976 $34,051,531 $205,273,193

 (83.12%) (0.29%) (16.59%) (100%)

This .4402742 percentage point discrepancy corresponds to

Kannex's allocable share of the discount:

$205,273,193 x .4402742% = $903,765 = $1,093,750 x

82.63%.
- 77 -

Under the one-sided swaps, ABN received from Merrill Capital and

Kannex received from ABN a return on this .4402742 percentage

point discrepancy in the capital accounts. When the transaction

cost was subsequently recognized in part and charged to

Southampton's capital account upon the distribution of the BFCE

Notes, the understatement of Kannex's capital account was partly

corrected and the notional principal amount on which the

one-sided swap payment obligations were based was accordingly

reduced. This compensatory arrangement appears to be critical to

an understanding of why ABN agreed to an accounting policy that

caused the partners' capital accounts to misrepresent the agreed

allocation of costs to Kannex's detriment.

An unexecuted version of the one-sided swap between Merrill

and ABN ran for a 5-year period coterminous with the hedge swap.

In the executed agreements, the termination date was December 1,

1990. At the expiration of this term, the one-sided swap between

ABN and Kannex was extended for a second year. There is no

record of any similar extension of the corresponding one-sided

swap between ABN and Merrill.

Through another series of swaps arranged by ABN New York,

Kannex effectively eliminated its risk of loss and opportunity to

gain from allocations of the Yield Component of the Colgate debt. 

The counterparty in these swaps was ABN Cayman Islands, but it

was den Baas and others at ABN New York who executed the
- 78 -

transactions on behalf of both counter parties. With respect to

each issue of fixed-rate Colgate debt acquired by the

partnership, Kannex entered into a fixed-for-floating interest

rate swap on a notional principal amount corresponding to the

dollar amount of Kannex's exposure to interest rate risk on the

debt. Whenever Southampton elected to adjust the Yield Component

sharing ratio or Kannex's partnership interest changed, the

notional principal amounts of Kannex's swaps were adjusted to

cover the amount of its exposure. The net effect for Kannex

resembled an investment in a portfolio of LIBOR-based assets

whose value would not vary in relation to the value of its

LIBOR-based liability under the Revolving Credit Agreement.

The swaps with ABN Cayman Islands effectively offset

Kannex's losses and gains from the intrinsic treasury risk of the

Colgate debt held by the partnership. The swaps also offered

Kannex the opportunity to profit from the spread risk of the

Colgate debt. Kannex was required to pay interbank swap rates on

its swaps. The fixed interbank swap rates were determined by

adding a spread to the prevailing yields on comparable Treasury

securities. For every piece of Colgate debt purchased, there was

a referenced Treasury rate. To the extent that the yields on the

partnership's Colgate debt exceeded these rates, Kannex kept the

difference. ABN profited from the spreads that it earned in

hedging its swap positions through coordinated trading of
- 79 -

18 Details of the syndication of the loan to Kannex and

details of Kannex's ultimate liquidation, which are related

hereafter, shed light on the character of the relationship

between Kannex and ABN. 

Treasury securities or futures, or through matching swaps with

third parties.

In order for the hedging of Kannex's risks to be both

effective and lucrative, the selection of Treasury securities

used in the construction of hedge positions had to be consistent

with the selection of Treasury securities used in the revaluation

of the Colgate debt within the partnership. Aware of these

hedging operations, Merrill accommodated them by consulting with

ABN on the valuation of ACM's Colgate debt whenever changes in

value were likely to affect Kannex's capital accounts. Thus, one

Merrill internal memorandum described the procedures for an

upcoming revaluation:

Since Kannex must actually trade Treasuries

based upon the Base Treasury yields, Kannex

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.

Under its Revolving Credit Agreement with Kannex, ABN

reserved the right to sell participations, provided that it would

remain solely responsible for performance of the obligations owed

to Kannex under the Agreement.18 Beginning in the fall of 1989,

ABN offered a number of banks the opportunity to participate in
- 80 -

its loans to Kannex as well as to other special purpose

corporations that ABN Trust had organized for section 453

partnerships. The participations ABN proposed were short-term

and renewable. ABN would guarantee an interest rate of LIBOR

plus 35 basis points or 50 basis points. ABN would possess the

exclusive right to enforce the loan.

ABN's relationship to Kannex was a source of some confusion. 

An internal memorandum of Banco di Roma outlining the syndication

proposal described ABN as a "shareholder in Kannex together with

another major U.S. Corporation". In the attempt to reassure

prospective investors that their principal would be secure, den

Baas went further than the terms of the formal Participation

Agreement in defining ABN's position in the arrangements: "Since

there is neither a scheduled interest payment on the notes held

in the portfolio nor a principal repayment you would look even

more to ABN to take you out at the maturity date of the loan". 

Within Banco di Roma, the participation was recommended for

approval with the following explanatory gloss: "The repayment

source of our advance is the committed facility provided by ABN

through its Curacao or Grand Cayman Branch." The memorandum

concludes: "Taking into consideration: The de facto guarantee

of ABN, * * * we recommend your authorization to participate". 

An internal credit proposal of Banco Espirito Santo E Comercial

De Lisboa (Banco Espirito Santo) reflects a similar
- 81 -

understanding. Beside the heading "Guarantor", the following

explanation appears: "Subsidiary of ABN will borrow against a

firm takeout at maturity". Considering its reliance on the

repeated participation of a small group of banks to sustain its

involvement in numerous section 453 partnerships, it is not

surprising that ABN would wish to imply, and that the investors

would be prepared to infer, that they could look to ABN for

repayment.

Generale Bank, Banco Espirito Santo, and Banco di Roma

acquired participations in Kannex's loan in amounts between

$25 million and $75 million. All participations were repaid by

July 1991. The loan from ABN Cayman Islands was ultimately

repaid out of the liquidating distribution that Kannex received

at the end of November 1991. Owing to the preferred return that

Kannex received from Southampton and appreciation of Colgate debt

as a result of the decline in interest rates, there was a

sizeable surplus remaining after repayment of the loan, as shown

on Kannex's balance sheet for the period ended November 30, 1991. 

Kannex did not retain this surplus. Kannex also did not

distribute this surplus to its nominal shareholders when Kannex

was liquidated shortly thereafter.

Following the redemption, Kannex's swaps with ABN were

terminated. The benefit that Kannex had enjoyed from a fall in

interest rates for purposes of the valuation of its partnership
- 82 -

interest was offset by the appreciation of the fixed-rate cash

flows that it was obligated to pay relative to the floating rate

cash flows it was entitled to receive under the Colgate debt

swaps. Kannex owed ABN Cayman Islands $3,180,453. For reasons

that the record does not disclose, the amount Kannex paid was

higher by $1,655,000, and this excess was credited to den Baas'

Financial Engineering Group. The back-to-back hedge swaps

between Kannex and ABN New York and ABN New York and Merrill

Capital were also terminated at the same time. Although the

terms of the swaps were identical, for reasons not disclosed in

the record, the termination payment that ABN New York made to

Kannex was $500,000 less than the termination payment that was

received from Merrill Capital. Kannex's balance sheet for the

period ended January 27, 1992, shows remaining stockholder's

equity of $17,278. Of this amount, $6,000 was attributable to

the loans that Kannex had originally made to the foundations to

finance their contributions and the rest may have been

attributable to a capitalized loan from ABN. All the proceeds of

Kannex's participation in ACM were, in one way or another,

remitted to ABN. Liquidation procedures commenced in the

following month.

OPINION

ACM structured its sale of the Citicorp Notes to fall within

the contingent payment sale provisions of section 15a.453-1(c),
- 83 -

Temporary Income Tax Regs., 46 Fed. Reg. 10711 (Feb. 4, 1981). 

On November 3, 1989, ACM purchased $205 million of Citicorp

Notes, and, 3 weeks later, it sold $175 million of the notes to

BOT and BFCE for $140 million in cash and eight LIBOR Notes with

a present value of $35 million. The LIBOR Notes did not provide

for the payment of a stated principal amount. For FYE 11/30/89,

ACM applied the ratable basis recovery rules of section

15a.453-1(c), Temporary Income Tax Regs., supra, recovering only

$29,250,761 of its basis in the notes and recognizing

$110,749,239 of capital gain. ACM allocated $91,516,689 of the

gain to Kannex, an entity that was not subject to U.S. tax. 

In FYE 12/31/91, after ACM redeemed Kannex's partnership

interest, ACM sold the BOT LIBOR Notes to BFCE for $10,961,581,

and, under section 15a.453-1(c), Temporary Income Tax Regs.,

supra, recognized a capital loss of $84,997,111. ACM allocated

$84,537,479 of this loss to Colgate and Southampton.

We must decide whether ACM's planned sequence of investments

and dispositions should be respected for tax purposes. We

sometimes refer to ACM's planned sequence of investments and

dispositions calculated to create the capital losses that were

the objective of the CINS transaction as the "section 453

investment strategy".

1. Mechanics of a Contingent Payment Sale
- 84 -

Section 15a.453-1(c), Temporary Income Tax Regs., supra,

provides installment sale treatment for "contingent payment

sales". A "contingent payment sale" is "a sale or other

disposition of property in which the aggregate selling price

cannot be determined by the close of the taxable year in which

such sale or other disposition occurs." Id. Where the sales

agreement provides for no maximum aggregate selling price but

fixes the period over which payments may be received, the

temporary regulations generally require the seller to allocate an

equal portion of its basis in the sale property to each of the

taxable years in which payments may be received. Sec.

15a.453-1(c)(3), Temporary Income Tax Regs., 46 Fed. Reg. 10714

(Feb. 4, 1981). The seller computes its income for each year in

respect of a contingent payment sale as the excess of the

payments received in that year over the portion of the basis

allocated to that year. Id.

The temporary regulations anticipate that application of the

general rule for basis recovery will create distortions of income

in some cases, and they provide certain remedies. The

Commissioner may require an alternate method of basis recovery if

the Commissioner finds that the general rule will "substantially

and inappropriately accelerate recovery of basis." Sec. 15a.453-

1(c)(7)(iii), Temporary Income Tax Regs., 46 Fed. Reg. 10716. 

Conversely, if application of the general rule "will
- 85 -

substantially and inappropriately defer recovery of basis," the

taxpayer may request an alternate method, but the Commissioner is

not granted explicit authority by the temporary regulations to

require the use of an alternate method in that situation. 

Sec. 15a.453-1(c)(7)(ii), Temporary Income Tax Regs., 46 Fed.

Reg. 10716. The Commissioner may prescribe an alternate method

if she determines that the taxpayer's method of accounting with

respect to the sale does not "clearly reflect income". Sec.

446(b). In general, the Commissioner has broad discretion to

determine whether an accounting method clearly reflects income. 

See Thor Power Tool Co. v. Commissioner, 439 U.S. 522, 532-533

(1979); Commissioner v. Hansen, 360 U.S. 446, 467 (1959); Ferrill

v. Commissioner, 684 F.2d. 261, 264 (3d Cir. 1982), affg. T.C.

Memo. 1979-501; Hudson v. Commissioner, T.C. Memo. 1996-106. A

taxpayer's method of accounting does not clearly reflect income

when it does not represent "economic reality". See Prabel v.

Commissioner, 882 F.2d 820, 826-827 (3d Cir. 1989), affg. 91 T.C.

1101 (1988). In this case, the Commissioner has not exercised

her discretion by raising the clear reflection of income issue in

her pleadings or in her brief.

2. Economic Substance

a. Introduction

In his opening statement, petitioner's counsel aptly

characterized the role of economic substance in this case: 
- 86 -

"[B]oth parties agree that the question of substance is critical

to the outcome. At the most fundamental level, this case is

about very different views of commercial reality and very

different views of the tax law's concept of substance."

ACM sold the $175 million aggregate principal amount of

Citicorp Notes for $140 million in cash and eight LIBOR Notes,

and, in connection therewith, reported a capital gain for

FYE 11/30/89 and a corresponding capital loss for FYE 12/31/91. 

Respondent eliminated this gain and disallowed the loss. 

Respondent determined that the underlying transactions should not

be given effect for Federal income tax purposes because it was

tax-driven and devoid of economic substance. Respondent argues

that the formation of the partnership and its activities during

the relevant years were merely prearranged steps in a contrived,

tax-motivated transaction that was carried out in accordance with

Merrill's pursuit of approximately $100 million in taxable losses

for Colgate. Respondent states that the liability management

functions ascribed to ACM in documentation prepared by Merrill

and Colgate were spurious. Respondent alleges that the

structured transactions in which the LIBOR Notes were created and

sold formed a "tax shelter market" that was controlled by

Merrill, and that was operated in accordance with unwritten

understandings. Respondent asserts that this "market" was

supported by subsidizing the participating banks, as well as by
- 87 -

circular payment flows and premature terminations that insulated

the banks from a material risk with respect to the LIBOR Notes. 

Respondent alleges that structured transactions involving

substantially the same patterns, timetables, and many of the same

banks were involved in the issuance and sale of LIBOR Notes for

each of the other section 453 partnerships.

Petitioner's account of the CINS transaction bears little

resemblance to respondent's view. Petitioner argues that ACM was

rationally designed to address genuine liability management

needs. Petitioner alleges that all partnership transactions were

negotiated at arm's length, priced at fair market value,

conducted in accordance with standard commercial practices, and

had practical effects wholly apart from their tax consequences. 

Petitioner asserts that the partnership and each of its partners

had reasonable prospects for profit and risk of loss. Petitioner

contends that, in arranging the structured transactions, Merrill

acted in the customary role of a market maker, bringing

counterparties together on terms that suited their respective

needs. Petitioner argues that the swaps are irrelevant to the

legal analysis because ACM was not a party to any of the swaps.

Following our review of the record, with due regard to our

view and perception of the witnesses, we do not find any economic
- 88 -

19 We need not, and do not, delve into the appropriateness

of reporting the transaction on the installment method. We are

compelled to note, however, that the installment method reports

income, sec. 453(a), and the partnership sold the Citicorp Notes

for consideration equal to the notes' purchase price.

substance in the section 453 investment strategy.19 We are

convinced that tax avoidance was the reason for the partnership's

purchase and sale of the Citicorp Notes. We do not suggest that

a taxpayer refrain from using the tax laws to the taxpayer's

advantage. In this case, however, the taxpayer desired to take

advantage of a loss that was not economically inherent in the

object of the sale, but which the taxpayer created artificially

through the manipulation and abuse of the tax laws. A taxpayer

is not entitled to recognize a phantom loss from a transaction

that lacks economic substance.

In analyzing whether the CINS transaction had economic

substance, we have been mindful that for some businesses there is

little, if any, meaningful difference between an improvement in

financial performance achieved by cutting operating expenses and

one that results from reducing taxes. Both reductions improve

the financial statement. The tax law, however, requires that the

intended transactions have economic substance separate and

distinct from economic benefit achieved solely by tax reduction. 

The doctrine of economic substance becomes applicable, and a

judicial remedy is warranted, where a taxpayer seeks to claim tax
- 89 -

benefits, unintended by Congress, by means of transactions that

serve no economic purpose other than tax savings. Yosha v.

Commissioner, 861 F.2d 494, 498-499 (7th Cir. 1988), affg.

Glass v. Commissioner, 87 T.C. 1087 (1986); see also Estate of

Thomas v. Commissioner, 84 T.C. 412, 432-433 (1985), and the

cases cited therein.

Our conclusion is supported by well-settled judicial

jurisprudence. In the seminal case of Gregory v. Helvering,

293 U.S. 465, 469 (1935), the Court recognized an individual's

right to decrease her taxes in any way permitted by law. As held

by the Court, however, this right is not absolute. The Court

held that a reorganization that met the literal requirements of

the Code would not be respected for Federal income tax purposes

because "what was done, apart from the tax motive, was [not] the

thing which the statute intended". The Court stressed that the

transaction had "no business or corporate purpose", but was "a

mere device which put on the form of a corporate reorganization

as a disguise for concealing its real character". Id.

In the 60 years since the U.S. Supreme Court first expounded

this doctrine of "business purpose", the doctrine's application

has proved a perennial challenge to the courts to set boundaries

between acceptable tax planning and abuse, while taking into

account the importance of maintaining public confidence in the

integrity of the tax system. In Knetsch v. United States,
- 90 -

364 U.S. 361 (1960), for example, the Court applied the

Gregory v. Helvering case to disallow an interest deduction. In

so doing, the Court stated that "there was nothing of substance

to be realized * * * from this transaction beyond a tax

deduction." Knetsch v. United States, supra at 366. Similarly,

in Frank Lyon Co. v. United States, 435 U.S. 561 (1978), the

Court stated that economic substance is a necessary requirement

of any transaction. In Frank Lyon, the Court looked to "the

objective economic realities of a transaction rather than to the

particular form the parties employed", id. at 573, and stated

that the Government should honor the allocation of rights and

duties effectuated by the parties "where, as here, there is a

genuine multiple-party transaction with economic substance which

is compelled or encouraged by business or regulatory realities,

is imbued with tax-independent considerations, and is not shaped

solely by tax-avoidance features that have meaningless labels

attached", id. at 583-584. 

The Court of Appeals for the Second Circuit applied an

economic substance analysis in Goldstein v. Commissioner, 

364 F.2d 734 (2d Cir. 1966), affg. 44 T.C. 284 (1965). In that

case, Mrs. Goldstein won the Irish Sweepstakes. In an attempt to

shelter her winnings from tax, she borrowed from two banks and

invested the loan proceeds in Treasury notes. The loans required

her to pay interest at 4 percent, while some Treasury notes
- 91 -

20 In United States v. Wexler, 31 F.3d 117, 123 (3d Cir.

1994), the Court of Appeals for the Third Circuit described

Goldstein as "[t]he seminal sham transaction case".

21 We believe the CINS transaction also was real and not

(continued...)

yielded one-half percent and others yielded 1-1/2 percent. Her

financial advisers estimated that these transactions would

produce a pretax loss of $18,500 but a substantial after-tax

gain. This Court sustained the Commissioner's disallowance of

the interest deductions. In affirming the decision of this

Court, the Second Circuit stressed that this Court had found that

Mrs. Goldstein's purpose in entering into the loan transactions

"'was not to derive economic gain or to improve here [sic]

beneficial interest; but was solely an attempt to obtain an

interest deduction as an offset to her sweepstakes winnings.'" 

Id. at 738 (quoting Goldstein v. Commissioner, 44 T.C. at 295). 

The Second Circuit stated further that the loan arrangements did

not "have purpose, substance, or utility apart from their

anticipated tax consequences", and that the transactions had no

"realistic expectation of economic profit". Id. at 740.

The Goldstein case marks an important step in the

development of the economic substance doctrine.20 Unlike many

purported tax shelters, the tax-motivated transactions in that

case were not fictitious. Goldstein v. Commissioner, supra at

737-738. They were real and conducted at arm's length.21 Mrs.
- 92 -

21(...continued)

fictitious. In Rice's Toyota World, Inc. v. Commissioner,

752 F.2d 89 (4th Cir. 1985), affg. in part and revg. in part

81 T.C. 184 (1983), the Court of Appeals for the Fourth Circuit

concluded that a transaction was a sham because it lacked

business purpose and economic substance. In Lerman v.

Commissioner, 939 F.2d 44, 53-54 (3d Cir. 1991), affg. Fox v.

Commissioner, T.C. Memo. 1988-570, the Court of Appeals for the

Third Circuit adopted the Second Circuit's definition of a sham

transaction as "a transaction that 'is fictitious or * * * has no

business purpose or economic effect other than the creation of

tax deductions.'" (quoting DeMartino v. Commissioner, 862 F.2d

400, 406 (2d Cir. 1988), affg. 88 T.C. 583 (1987)). The CINS

transaction was not a sham in the sense that it was fictitious

but it was a sham in the sense that the sec. 453 investment

strategy lacked economic substance.

Goldstein's indebtedness was enforceable with full recourse and

her investments were exposed to market risk. Yet, the strategy

was not consistent with rational economic behavior in the absence

of the expected tax benefits. Other courts have applied the

teaching of Goldstein in varied settings. In Sheldon v.

Commissioner, 94 T.C. 738 (1990), for example, this Court

analyzed the financial transactions in issue there in a manner

similar to that employed in Goldstein. The Court first

determined that the transactions at issue were real, rather than

fictitious. The Court then evaluated economic substance, stating

that "the principle of * * * [Goldstein] would not, as

petitioners suggest, permit deductions merely because a taxpayer

had or experienced some de minimis gain." Id. at 767. The Court

held that a transaction resulting in gain that was

"infinitesimally nominal and vastly insignificant when considered
- 93 -

22 The Court of Appeals for the Third Circuit commented that

"Sheldon actually expanded the sham transaction doctrine because

it barred interest deductions from arrangements motivated by tax

benefits even if the transactions could have generated a profit." 

United States v. Wexler, 31 F.3d 117, 124 n.9 (3d Cir. 1994).

in comparison with the claimed deductions" had no economic

substance.22 Id. at 768. The Court noted that "[i]f the

transactions had been fully offset, straddled, or hedged to

obviate the possibility of any loss or gain, the form of the

transaction could have been more readily attacked by respondent." 

Id. Accord Merryman v. Commissioner, 873 F.2d 879, 881 (5th

Cir. 1989), affg. T.C. Memo. 1988-72; Levin v. Commissioner, 87

T.C. 698, 699, 728 (1986), affd. 832 F.2d 403 (7th Cir. 1987);

Julien v. Commissioner, 82 T.C. 492, 509 (1984). 

In Lerman v. Commissioner, 939 F.2d 44 (3d Cir. 1991), affg.

Fox v. Commissioner, T.C. Memo. 1988-570, the Court of Appeals

for the Third Circuit analyzed the economic substance doctrine. 

In Lerman, the taxpayers claimed to be commodities dealers and

sought to deduct losses resulting from their option-straddle

transactions. Id. at 45. The Third Circuit held that the

transactions were "shams, devoid of economic substance, and thus

any losses generated thereby cannot be the basis for deductions." 

Id. at 56. The court noted that "Per Gregory v. Helvering * * *

it is settled federal tax law that for transactions to be
- 94 -

recognized for tax purposes they must have economic substance." 

Id. at 52. 

More recently, the Third Circuit reiterated that "[t]he

general rule on sham transactions in this circuit is wellestablished: 'If a transaction is devoid of economic substance

* * * it simply is not recognized for federal taxation purposes,

for better or for worse. This denial of recognition means that a

sham transaction, devoid of economic substance, cannot be the

basis for a deductible loss.'" United States v. Wexler, 31 F.3d

117, 122 (3d Cir. 1994) (quoting Lerman v. Commissioner, supra at

45). In Wexler, the taxpayer claimed deductions resulting from

financial arrangements known as "repo to maturity" transactions. 

Id. at 118. The taxpayer argued that the economic substance

doctrine did not apply to the deduction of interest payments

pursuant to section 163 if the taxpayer's obligation to pay the

interest is binding and enforceable. Id. at 122. The Third

Circuit analyzed a series of related cases and noted that the key

requirement that permeated each of those cases was that the

financial transaction be "economically substantive". Id. at 127

(emphasis omitted). The Third Circuit stated that "transactions

with no economic significance apart from tax benefits lack

economic substance." Id. at 124. 

The "principle laid down in the Gregory case is not limited

to corporate reorganizations, but rather applies to the federal
- 95 -

taxing statutes generally." Weller v. Commissioner, 270 F.2d

294, 297 (3d Cir. 1959), affg. Emmons v. Commissioner, 31 T.C. 26

(1958) and Weller v. Commissioner, 31 T.C. 33 (1958); see also

Knetsch v. United States, 364 U.S. 361 (1960)(interest

deduction); Higgins v. Smith, 308 U.S. 473 (1940) (loss deduction

on sale to wholly owned corporation); Weyl-Zuckerman & Co. v.

Commissioner, 232 F.2d 214 (9th Cir. 1956), affg. 23 T.C. 841

(1955)(mineral rights transferred to a wholly owned subsidiary); 

Braddock Land Co. v. Commissioner, 75 T.C. 324 (1980)

(shareholders-employees' forgiveness of accrued salaries,

bonuses, and interest owed by corporation in complete

liquidation); David's Specialty Shops v. Johnson, 131 F. Supp.

458 (S.D.N.Y. 1955)(affiliated corporations). The tax statutes

apply only "to transactions entered upon for commercial purposes

and 'not to * * * transactions entered upon for no other motive

but to escape taxation.'" Weller v. Commissioner, 270 F.2d supra

at 297 (quoting Commissioner v. Transport Trading & Terminal

Corp., 176 F.2d 570, 572 (2d Cir. 1949), revg. 9 T.C. 247

(1947)). Thus, transactions will only be recognized for tax

purposes if there is some "tax-independent purpose" for the

entire transaction. See Sheldon v. Commissioner, supra at 759. 

Only after we conclude that a transaction has economic substance

will we consider the transaction's tax consequences under the

Code. See Rice's Toyota World, Inc. v. Commissioner, 752 F.2d
- 96 -

89, 95 (4th Cir. 1985), revg. on a different issue 81 T.C. 184

(1983). 

Whether a transaction has economic substance is a factual

determination. United States v. Cumberland Pub. Serv. Co.,

338 U.S. 451, 456 (1950). Key to this determination is that the

transaction must be rationally related to a useful nontax purpose

that is plausible in light of the taxpayer's conduct and useful

in light of the taxpayer's economic situation and intentions. 

Both the utility of the stated purpose and the rationality of the

means chosen to effectuate it must be evaluated in accordance

with commercial practices in the relevant industry. Cherin v.

Commissioner, 89 T.C. 986, 993-994 (1987). A rational

relationship between purpose and means ordinarily will not be

found unless there was a reasonable expectation that the nontax

benefits would be at least commensurate with the transaction

costs. See Yosha v. Commissioner, 861 F.2d 494, 498 (7th Cir.

1988), affg. Glass v. Commissioner, 87 T.C. 1087

(1986)(explaining the teaching of Goldstein); cf. Seykota v.

Commissioner, T.C. Memo. 1991-234, amended T.C. Memo. 1991-541. 

"[D]eliberately to incur an expense greater than the expected

gain--to pay 4 percent for the chance to make 2 percent--is the

antithesis of profit-motivated behavior; such a transaction lacks

economic substance." Yosha v. Commissioner, supra at 498.
- 97 -

Since the overall transaction must have economic substance

for the Federal tax statutes to apply, we first consider whether

the section 453 investment strategy had economic substance. 

Petitioner concedes that the section 453 investment strategy was

tax motivated, but argues that tax-independent considerations

informed and justified each step of the strategy. Petitioner

explains ACM's investment in the Citicorp Notes as follows: 

"[T]he ACM partners believed the Citicorp Notes offered a

reasonable return on ACM's investment until such time as ACM

might require cash for the purchase of Colgate debt". The

Citicorp Notes were sold after 24 days to enable the partnership

to invest in Colgate debt and LIBOR Notes. Petitioner argues

that the investment in LIBOR Notes had two purposes. First,

unlike an interest rate swap, which ACM could have used as an

alternative hedging instrument, the LIBOR Notes provided the

partners with an investment return. According to petitioner,

"there was a realistic prospect that ACM would have made a profit

on the LIBOR Notes." Petitioner contends that ACM disposed of

the BFCE Notes and the BOT Notes when the hedging protection was

no longer needed. Second, ACM invested in LIBOR Notes because it

was "within the four corners of the partnership to operate as a

hedge". 

In light of each of these stated purposes, we examine the

economic substance of the section 453 investment strategy.
- 98 -

b. Profit

The following colloquy at trial sheds some light on how

Colgate's management arrived at the conclusion that the section

453 investment strategy promised a reasonable return and

realistic prospect for profit. Pohlschroeder was the witness.

Q: In determining whether you should cast a vote

or recommend that the partnership purchased

(sic) the Citicorp Notes, did you take into

account the transaction cost that would be

incurred upon the sale of those notes?

A: It was known that there were transaction

costs.

* * * * * * * *

I really didn't know at that time what that

exact amount was going to be, and basically,

the initial part was just to get a reasonable

return on the Citicorp Notes and make sure

that the cash that we had received as a

contribution was invested as quickly as

possible. 

Q: So, in determining whether you were going to

earn a reasonable return, did you take into

account the transaction costs that might be

incurred upon the sale?

A: Not at that point. It was just basically an

investment decision.

Q: So you did not compare those transaction

costs that might have to be incurred upon the

sale of the Citicorp note to the transaction

cost on other instruments?

A: That is right, yes.
- 99 -

When the Partnership Committee formally authorized the

purchase of the Citicorp Notes, Merrill informed Colgate that the

section 453 investment strategy would result in transaction costs

of between $2.3 and $3.1 million on a pretax present value basis,

of which $1.3 to $2.0 million would be incurred in the contingent

payment sale. The cash contributions that had to be "invested as

quickly as possible" in Citicorp Notes yielding 8.78 percent in

order for the partners to earn a reasonable return were already

earning 8.75 percent in an ABN deposit account before the notes

were acquired. 

That Colgate's treasury department did not attach importance

to the relative costs of the section 453 investment strategy is

particularly significant because Colgate would bear both the

transaction and remarketing costs. Pepe testified concerning the

mutual understanding with respect to the five-eighths discount

incurred in connection with the contingent payment sale:

The transaction was performed and put

together, organized, on behalf of

Colgate-Palmolive; therefore, the partners

understood that the cost related to setting

the transaction up should be borne by

Colgate-Palmolive, whether that's through the

partnership or through one of its partners.

The allocation of these costs to Colgate was accomplished by

including them in the value at which the LIBOR Notes were carried

on the partnership books and in the partners' capital accounts. 

When the BFCE Notes were distributed to Southampton, the other
- 100 -

partners' allocable shares of these costs were charged to

Southampton's capital account. When Southampton, Colgate and, to

a nominal extent, MLCS acquired Kannex's partnership interest,

they effectively purchased Kannex's share of the BOT Notes at a

price that included Kannex's allocable share of these costs. 

Because the LIBOR Notes were acquired for Colgate's benefit, the

partners provided that the remarketing costs would be borne

almost entirely by Colgate as well. This was accomplished by

selling the LIBOR Notes only after Colgate, Southampton and, to

nominal extent, MLCS, had acquired all of Kannex's interest in

them.

Kannex's interest in the BOT Notes could be acquired by

Colgate alone or together with MLCS. If only Colgate purchased

Kannex's interest, Colgate would bear all origination and

remarketing costs allocable to that interest. If Colgate and

MLCS purchased or redeemed Kannex's interest pro rata, each would

bear a pro rata share of these costs. Acquisition of Kannex's

interest by a combination of these methods would result in the

sharing of these costs in some intermediate ratio. This was the

approach that the parties actually adopted, but the evidence

suggests that this decision may not yet have been made in

November 1989. Nevertheless, it is unlikely that Colgate would

have acquired any less than a pro rata share of Kannex's

interest, since the opportunity cost of foregoing valuable tax
- 101 -

23 The BOT Notes had a tax basis of $104.467 million. Even

if we assume that interest rates rose by 500 basis points,

causing an increase in the cost to acquire Kannex's interest in

the notes from $20.955 million ($25.361 million x .8263) to

$29.283 million ($35.439 million x .8263) and a decrease in the

taxable loss recognizable on the sale of Kannex's interest in the

notes from $66.842 million (($104.467 million - $23.574 million)

x .8263) to $58.622 million (($104.467 million - $33.521 million)

x .8263), each $1 that Colgate paid to acquire Kannex's interest

would still produce more than $2 of taxable losses.

benefits would have been too great.23 The nontax benefits of

holding and selling Kannex's share of the notes would be shared

in the same ratio as the costs associated with that share, but,

in all events, these benefits would necessarily be less than the

costs.

If the section 453 investment strategy was economically

justifiable in part on the basis of expected pretax returns, and

the partners understood that Colgate, as the beneficiary of the

strategy, would bear virtually all transaction costs, then the

strategy must have provided Colgate a realistic possibility of

recovering these costs for the section 453 investment strategy to

be deemed profitable. We examined the proposition that Colgate

could reasonably have expected to recover the transaction costs

of the strategy through cash flows from the LIBOR Notes, and we

now set forth our analysis with respect thereto.

Colgate's return was a function of two variables. First,

the credit quality of the issuers of the LIBOR Notes could have

affected Colgate's returns. The possibility of benefitting from
- 102 -

a credit improvement, however, was negligible. BFCE's rating was

AAA and could not have improved. BOT was rated AA. If an

improvement in BOT's credit could have increased the sale price

of the notes, then one would expect that the difference between

the banks' respective ratings would have affected the pricing of

the notes at issuance. It had no effect.

The second and more important factor was interest rates. 

Based on its assumption that future interest rates would equal

the levels predicted by the yield curve used to price the LIBOR

Notes at their issuance, Merrill estimated that the issue price 

for the notes exceeded by approximately $1.3 million the bid

price at which the notes could be sold to a third party. Hence,

the partnership, and ultimately Colgate, would almost certainly

lose money. 

One must wonder what were the nontax benefits that the

partnership hoped to achieve through its acquisition of the notes

at that price level. Interest rates would have had to rise by at

least 400-500 basis points, to a level of 13 percent or more,

soon after the partnership acquired the LIBOR Notes and be

expected to remain at that level throughout the 5-year life of

the notes in order for Colgate to earn a sufficient return from

the notes to cover the transaction costs of the section 453

investment strategy. Had the partners' economic arrangement

contemplated a pro rata allocation of these costs, Colgate still
- 103 -

could not have earned a profit on a net present value basis

unless interest rates exceeded their expected levels, but a much

smaller increase would have been sufficient to break even.

We reviewed historical data to assess the likelihood that

3-month LIBOR would have risen by the requisite amount for

Colgate to break even. The record includes published records of

market interest rates extending back to January 1984. There are

71 observations of 3-month LIBOR as of the first day of each

month between January 1984 and November 1989. Not one of the

71 monthly quotations is 300 basis points or more above the

quotations for the 1 to 6 previous months. Only three of the

quotations represent a level 200 basis points or more above any

quotations during the previous 6 months. There is no month for

which 3-month LIBOR was above 12.13 percent. It reached or

exceeded 11 percent in 6 months, all in mid-1984. In 30 months,

it fell within the range of 8 to 9.99 percent, and it fluctuated

between 10.31 and 8.56 percent during the first 11 months of

1989. The longest that 3-month LIBOR remained at or above

10 percent was 9 consecutive months in 1984. Thereafter, the

longest period was 2 consecutive months in early 1989. In the

late summer and early autumn of 1989, Colgate's treasury

department confidently expected that interest rates would follow

a downward trend for the foreseeable future.
- 104 -

Colgate could not have achieved a non-negative net present

value under any reasonable forecast of future interest rates. A

major war, an oil crisis, a resurgence of double digit inflation

or other economic catastrophe might have been capable of inducing

a sudden rise in interest rates by 400-500 basis points and might

perhaps have sustained such levels for a period of months or

years. But nothing in the record suggests that anyone involved

in planning the section 453 investment strategy anticipated, or

had any reason to anticipate, the extraordinary economic

conditions which would have been necessary in order to make

Colgate's investment in the LIBOR Notes profitable.

Appreciation of the LIBOR Notes was not the only source of

potential profit from the section 453 investment strategy. 

Petitioner and its experts contend that some or all of the

transaction costs of the strategy could have been recovered out

of returns from the Citicorp Notes. They identify three sources

of potential profit: (1) Gain on the sale of the Citicorp Notes

attributable to an improvement in Citicorp's credit, (2) gain

attributable to an increase in the commercial paper rate to which

the coupon on the notes was linked, and (3) accumulation of

interest income over the period the partnership held the notes.

With respect to petitioner's first claim that an improvement

in Citicorp's credit could produce a profit, petitioner states

that "ACM's exposure to Citicorp's credit was real, not
- 105 -

theoretical": There was a significant risk that Citicorp's

credit could deteriorate, but a significant possibility of

improvement as well. The Citicorp Notes were rated AA by

Standard & Poors and A1 by Moody's, which implies that there was

some room for improvement in the issuer's credit quality. Data

for the 5-year period ending in December 1991 confirm many

instances in which the credit spread on publicly traded Citicorp

debt declined by large amounts over short periods of time. To

conclude from this that there was a reasonable possibility that

ACM could have sold the Citicorp Notes at a price above par would

not be warranted, considering the terms of the structured

transaction in which they were sold.

Under the terms of the basis swap between Merrill and the

purchasing banks, Merrill had a right to call the Citicorp Notes

at a strike price equal to their par value. This option was

exercisable on any payment date and the step-up in the amount of

Merrill's payment obligations under the basis swap after 3 months

effectively guaranteed that Merrill would exercise the option

unless Citicorp's credit quality had substantially declined. 

Internal documents of BOT and BFCE indicate that both banks

expected Merrill to purchase the notes from them within 1 to 3

months under this arrangement. Even if Citicorp's credit quality

had improved over the period that ACM held the notes, it is

unlikely that the banks would have been willing to pay any more
- 106 -

than par for them, since all the increase in the value of the

notes would only be appropriated by Merrill. It appears from the

BOT and BFCE documents that the terms for Merrill's call option

had already been worked out, along with most of the other details

of the transaction structure, within 1 week of ACM's acquisition

of the Citicorp Notes. Thus, Merrill designed the Citicorp Note

transactions in a manner that effectively left no opportunity for

ACM, or Colgate, to benefit from an improvement in Citicorp's

credit. We reject petitioner's first contention.

Turning to petitioner's second claim that the Citicorp

Notes, as floating rate notes (FRN's), could increase in value by

way of an increase in the related commercial paper rate, we note

that the value of a FRN is generally invariant to changes in

market interest rates. Indeed, this is the source of its appeal

to investors. Because the coupon payable on the Citicorp Notes

was reset each month at the current commercial paper rate, the

value of the notes should not have deviated significantly from

par. This appears to have been the understanding of those who

planned and approved the Citicorp Note investment. A memorandum

of ACM's accountants recites that "[a]s per explanation of

Mr. Hans Pohlschroeder * * * the Citicorp Notes were floating

rate notes * * * and can thus by definition not fluctuate in

value because of changes in interest rates as the interest on the

notes follows these changes". Under the partnership's Accounting
- 107 -

Policies, the Citicorp Notes were treated as a cash equivalent

for this reason.

According to petitioner, this understanding is subject to

significant qualifications. Petitioner relies on the

observations of one of its experts, Joseph Grundfest (Grundfest)

of Stanford University. Grundfest notes that the decision to

purchase a FRN locks in a return tied to a specified floating

rate index. There are several indices, LIBOR, treasury bill,

Federal funds rates, etc., and their relationship is not stable

over time. Payments on FRN's can vary substantially depending on

the choice of the underlying index. Grundfest goes on to cite

actual examples of significant discrepancies between certain

floating rate indices that occurred during and around the years

at issue.

We cannot quarrel with these observations. How much

significance we should attach to the potential for such market

discrepancies as a basis for a reasonable expectation of profit

is another matter. FRN's are commonly used by investors as a

substitute for short term money market instruments such as

certificates of deposit (CD's). Historical interest rate data

introduced in evidence confirm that changes in the 1-month

commercial paper rate and CD rate are not perfectly correlated. 

Over the 71 months from January 1984 to November 1989, the two

rates fluctuated, but generally remained within 15 basis points
- 108 -

of one another. In only 4 months did the difference between them

equal or exceed 40 basis points. During the period that ACM

planned to hold the Citicorp Notes, the coupon would be reset

only once. The historical data provide no basis for concluding

that there was any significant likelihood that an appreciable

change in the historical relationship between the 1-month

commercial paper rate and other money market indices would have

arisen on this single occasion. Accordingly, we are not

persuaded by petitioner's claim that it expected the Citicorp

Notes to increase in value by way of an increase in the related

commercial paper.

We now consider petitioner's third and final claim that it

had a high probability of recovering its transaction costs

through accumulation of interest income on the Citicorp Notes

over the period that petitioner held the notes. Petitioner and

its experts take the position that a substantial portion of the

transaction costs of the section 453 investment strategy were

likely to be recovered dollar-for-dollar through the accumulation

of interest income from the Citicorp Notes: The longer ACM held

the notes, the greater the amount of interest it received from

Citicorp, and, all other things being equal, the greater the

likelihood of earning a profit. ACM could reasonably have

expected to receive, and did receive, about $1.2 million in

interest on the Citicorp Notes over the 24 days that it held
- 109 -

them. Colgate's share of this income (through Southampton) was

about 17 percent (approximately $204,840), significantly less

than the transaction costs incurred in the CINS transaction. 

The initial coupon on the Citicorp Notes offered a three

basis point advantage over the yield that the partners'

contributions were currently earning in an ABN deposit account. 

Had the Citicorp Notes retained that yield advantage for the

duration of the 24-day holding period, they would have provided

ACM with $3,500 more income, of which Colgate's share would be

about $600. Another alternative investment for the partnership

cash was a portfolio of short-term money market instruments like

those which it acquired with the $140 million cash proceeds of

the contingent payment sale and which matured 1 week later on the

settlement date for the purchase of the Colgate debt. These

commercial paper issues provided yields ranging from 8.15 to 8.20

percent, 45-50 basis points less than the 8.65-percent coupon

payable on the remaining $30 million Citicorp Notes for the

second reset period. This yield differential was likely to have

been attributable in part to a declining trend in short-term

interest rates throughout the fall of 1989, which the coupon rate

on the Citicorp Notes reflected only after a lag. Assuming,

however, that at the time ACM acquired the Citicorp Notes they

would have provided the same 50 basis point advantage over

alternative commercial paper investments over the 24-day holding
- 110 -

period, this advantage would have resulted in $58,000 more income

for the partnership and less than $10,000 more income for

Colgate. In short, any yield advantage that the Citicorp Notes

may have offered over less costly alternatives would not

significantly have improved Colgate's prospects for recovering

the $2-3 million present value of transaction costs that it

expected to incur in connection with the section 453 investment

strategy. Accordingly, we reject petitioner's third contention.

We conclude that the partnership did not undertake the

section 453 investment strategy with a reasonable expectation

that it would be profitable, on a pretax basis, for Colgate. We

also conclude that the strategy was not pursued with a realistic

expectation of realizing an economic profit for ABN. 

Petitioner's expert, Beder, concedes that the expected rate of

return in an environment with a 50-percent probability on a

rising rate and a 50-percent probability on a falling rate would

only equal 2.3 percent. Moreover, as the excerpt from Pepe's

testimony quoted above confirmed, the agreed allocation of

transaction costs reflected the fact that ABN did not expect to

derive any significant profit from the strategy. To the extent

that interest on the Citicorp Notes may have exceeded the

interest that could be earned on money market instruments, Kannex

would have shared in this premium pro rata, but given the short

holding period, the accumulation would not have been significant. 
- 111 -

Through the back-to-back hedge swaps that ABN arranged with

Kannex and Merrill with respect to the LIBOR Notes, ABN

relinquished the opportunity to gain from Kannex's interest in

the LIBOR Notes. 

Petitioner's experts correctly point out that it has become

common in the capital markets to enter into one transaction only

for the purpose of using it as the basis for a profitable swap

opportunity. The fact that the swap effectively forecloses the

possibility of gain from the underlying transaction does not mean

that the transaction serves no profit objective. On the

contrary, the underlying transaction is an indispensable

component of the arbitrage scheme. Arbitrage, however, is not a

plausible explanation for ABN's behavior in this instance. Based

upon testimony of Merrill witnesses, petitioner emphatically

maintains that ABN did not approach Merrill with the proposal for

the LIBOR Note hedge swap until shortly before the contingent

payment sale. This was after the decision had been made, with

Kannex's approval, to authorize the sale. If the partnership had

authorized the section 453 investment strategy with the

expectation that it would provide ABN with an arbitrage

opportunity, presumably there would be evidence that ABN had

planned, and attempted to arrange, its swap with Merrill

beforehand.
- 112 -

More importantly, the terms of the back-to-back hedge swaps

with respect to the LIBOR Notes are inconsistent with the

arbitrage interpretation. In our Findings of Fact, we discussed

at length the structural correspondence between these swaps and

the hedge swaps between Merrill Capital, BFCE, and BOT, and we

discussed the functional implications of that correspondence. 

Thus, although it appears that ABN could reasonably have expected

to derive gain from these swaps, this gain represented value

transferred, through the network of structured transactions

growing out of the contingent payment sale, from the partnership

to the banks, to Merrill Capital, and back to ABN and Kannex. 

The section 453 investment strategy was not designed to provide

ABN with an opportunity for profitable LIBOR Note swaps. On the

contrary, the swaps were calculated to compensate ABN in part for

Kannex's share of the economic loss sustained by the partnership

through the section 453 investment strategy.

Considering the high costs of the financial engineering it

required and ABN's unwillingness to have Kannex share any of

these costs or be exposed to any of the entrepreneurial risks it

entailed, the section 453 investment strategy would not have been

consistent with rational profit-motivated behavior in the absence

of the expected tax benefits.
- 113 -

c. Hedging within the four Corners of the partnership

The theory of the LIBOR Note hedge was carefully developed

in contemporaneous documents and argued in these proceedings. It

forms the linchpin of petitioner's economic substance argument. 

It is, however, false. It is false even if we assume arguendo

that there was as high a negative correlation between the

interest rate sensitivity of the LIBOR Notes and that of the

Colgate debt as petitioner asserts, a proposition that respondent

and her experts vigorously contest. To recognize why the theory

is false it is necessary to grasp this central insight: Neither

ABN nor Colgate needed a hedge inside the partnership for the

Colgate debt because both were effectively fully hedged outside

the partnership - ABN through swaps and Colgate by virtue of

being the issuer of the debt. Employing an additional hedging

instrument within the partnership was not only redundant, but

also flatly inconsistent with the manner in which both principals

were otherwise managing their interests in the partnership.

In his opening argument at trial, petitioner's counsel began

his analysis of the case as follows:

ACM, the partnership, is before the Court,

and the tax treatment of its transactions is

at the heart of the dispute. In many

respects, however, the real party in interest

is the Colgate-Palmolive Company and the

impact of ACM's transactions from Colgate's

vantage point is critical to understanding

the substance of this case.
- 114 -

In justifying the partnership, petitioner argues that it was

designed to perform functions integral and useful to Colgate's

liability management strategy. On the other hand, petitioner

argues that to evaluate whether the LIBOR Notes served a useful

hedging function it is the effects "within the four corners of

the partnership" that are relevant. The implication is that we

should treat the position that Colgate held within the

partnership through the instrumentality of Southampton as

functionally unrelated to Colgate's liability management

strategy: The utility of the LIBOR Notes is to be judged without

regard to the primary purposes for which the partnership was

created. It should be borne in mind that we are inquiring not

whether a partnership should be treated as an entity or an

aggregate for tax purposes or whether Southampton and ACM are

entitled to be respected as separate legal entities, but whether

there is any coherence to petitioner's economic explanation for

the existence of the partnership and Southampton's role in it. 

The shift in focus that petitioner proposes is simply a

sophistical sleight of hand. With a little analysis, the

absurdity of the implications of this proposition can be

appreciated. In any event, we emphasize that while we make this

analysis we nevertheless decline to unbundle the transaction in

order to isolate one element that might have economic substance. 
- 115 -

Rather, we view the transaction as bundled and judge it in its

entirety.

Colgate's position within the partnership was functionally

analogous to an interest rate swap. This is the way

contemporaneous documents of its treasury department analyzed

Colgate's overall interest rate exposure, the way Colgate's

accountants recommended that the investment in ACM be treated for

financial reporting purposes, and the way Pohlschroeder described

Colgate's intentions in designing ACM. The swap analogy is apt

and useful for purposes of our economic substance analysis. 

Suppose that Colgate issues fixed-rate debt and, in order to

reduce its exposure to interest rate movements, enters into a

"plain vanilla" interest rate swap in which it receives fixed and

pays floating interest. As a result, Colgate is hedged. Now

suppose that Colgate modifies the swap agreement such that

whenever interest rates fall or rise the fixed rate that it is

entitled to receive on the asset leg of the swap will be lowered

or raised by some specified proportion of the notional principal

amount. The reason offered for this modification is that Colgate

wants to limit its exposure to interest rates "within the four

corners of the swap", by ensuring that both its rights and

obligations under the swap will move in tandem. There is a major

fallacy in this proposition. The only effect of modifying the
- 116 -

swap in this way is to defeat its very purpose as a hedge against

Colgate's exposure to the underlying debt issuance.

From Colgate's perspective, the partnership's investment in

the LIBOR Notes had the same effect as the modification of the

swap in this hypothetical. To the extent that changes in their

value were inversely correlated with changes in the value of the

Colgate debt, the LIBOR Notes counteracted the hedging effect

that Colgate was trying to achieve through its position in the

partnership and thereby increased Colgate's exposure to interest

rate risk.

Pohlschroeder's October 3, 1989, memorandum contains

quantitative projections that show this clearly. Pohlschroeder

analyzes the effects of a 200 basis point parallel shift in the

Treasury yield curve on Colgate's financial position. The table

presents his results.
- 117 -

Colgate's Financial Exposure to Partnership Portfolio

(Based on Pohlschroeder's Projections)

( $ millions )

Base Level 200 Basis Pt. Change 

 Decline 

Long Bonds (42.00) (51.45) (9.45) 

Met Note (98.00 (104.66) (6.66)

 Total liabilities (140.00) (156.11) (16.11)

Partnership interest(15%) 21.00 23.42 2.42 

 Net liabilities (119.00) (132.69) (13.69)

LIBOR Notes 60.00 48.99 (11.01)

Partnership interest(15%) 9.00 7.35 (1.65)

 Net position (110.00) (125.34) (15.34)

 200 Basis Pt. Change

 Rise 

Long Bonds (34.88) 7.12

Met Note (92.18) 5.82 

 Total liabilities (127.06) 12.94

Partnership interest (15%) 19.06 (1.94)

 Net liabilities (108.00) 11.00

LIBOR Notes 69.90 9.90

Partnership interest (15%) 10.48 1.48 

 Net position (97.52) 12.48

The parentheses in the table reflect that the Long Bonds and Met

Note are liabilities for Colgate. Changes in the value of these

liabilities are offset in part by changes in the value of

Colgate's 15-percent interest in the partnership portfolio

comprising these bonds and LIBOR Notes. When interest rates

fall, Colgate's bonds appreciate, resulting in a $16.11 million

decrease in the market value of Colgate's net worth. This loss

represents the opportunity cost to Colgate of being locked into a

fixed rate liability that now exceeds the prevailing cost of

capital in the market. By virtue of its proposed 15-percent

ownership share in the partnership portfolio, Colgate realizes a

gain that offsets this loss in part: The net effect on Colgate
- 118 -

is a $13.69 million loss. But the partnership also holds LIBOR

Notes, which decrease in value when interest rates fall. The

effect of holding a 15-percent share of the LIBOR Notes through

the partnership is to magnify the net effect of a fall in

interest rates: If the partnership did not hold LIBOR Notes the

market value of Colgate's net worth would decline by $13.69

million; the LIBOR Notes increase this loss to $15.34 million.

Now consider the effects of an increase in interest rates on

Colgate's net worth. The Colgate bonds decrease in value by

$12.94 million. The benefit to Colgate of having lower financing

costs than the prevailing market rates is partially offset by

Colgate's 15-percent share of the capital loss experienced by the

partnership. But the net effect for Colgate is a gain. Colgate

also benefits from the appreciation of the LIBOR Notes: If the

partnership did not hold LIBOR Notes, the market value of

Colgate's net worth would increase by $11 million; the LIBOR

Notes increase Colgate's gain to $12.48 million. Thus, once

again, the effect of the LIBOR Notes is to magnify Colgate's

exposure to interest rates. From the perspective of Colgate's

overall financial position, the LIBOR Notes do not function as a

hedge at all.

There is a curious inconsistency in Pohlschroeder's

memorandum between his discussion of how the partnership will

serve Colgate's liability management objectives and his
- 119 -

discussion of the function that the LIBOR Notes will perform. In

the section entitled "Risk Management Within the Partnership", he

calls attention to the importance of the partners' exposure to

the interest rate volatility of the Colgate debt in the

partnership portfolio, and states that the partnership will

acquire LIBOR Notes "[t]o minimize the exposure to ABN and

Colgate". "Based on the process of negotiation, a hedge ratio is

going to be negotiated with ABN which may not be a perfect

hedge." This might be taken to imply that a perfect hedge would

be desirable, if possible.

But Colgate would not really have wanted a perfect hedge. 

Indeed, in Pohlschroeder's view, for the foreseeable future,

Colgate did not want to reduce its interest rate exposure within

the partnership at all. On the contrary, consistent with his

forecast of falling interest rates over the next 3 to 9 months,

in a different section of the memorandum Pohlschroeder states

that Colgate will use the flexibility of the partnership

structure to increase its exposure within the partnership

substantially above its pro rata share:

One of the most important aspects of the

partnership structure relates to the risk

management of the interest rate risk as

negotiated between Colgate and ABN. Colgate

will attempt to negotiate a close to 50/50

sharing of the treasury risk.
- 120 -

To demonstrate how this arrangement would benefit the company, he

examines how a 200 basis point decline in interest rates would

affect the principals under different sharing ratios. He

concludes: 

The more treasury risk is assumed by Colgate,

i.e. 85/15 to 51/49, the better off Colgate

is. The value of Colgate's share in the

partnership is roughly $30 MM using the 85/15

example and increases to $36 MM if we were to

assume 49% of the treasury risk and interest

rates dropped by 200 b.p.

At some point in the future, Colgate might wish to reduce its

exposure: "As an example, if we started with a 50/50 sharing

ratio and see interest rates bottom out, in the future we could

switch at the bottom of the interest rate cycle to a 100%/0%

ratio."

The difficulty of reconciling the LIBOR Note hedge with

Colgate's liability management strategy becomes more apparent in

the light of events that unfolded over the next 11 months. In

his memorandum, Pohlschroeder assumed that the partnership would

"establish a hedged capital structure with approximately $140 MM

of Colgate debt and $60 MM of LIBOR Note hedge." The ratio of

$140 million Colgate debt to $60 million LIBOR Notes originated

in Merrill's first effort to integrate the CINS transaction into

a liability management framework, the Partnership Transaction

Summary dated July 28, 1989. Thereafter, all of Merrill's

revisions of this document, its cash-flow projections and flip
- 121 -

24 The change did not materially affect the size of the

anticipated tax loss.

chart presentations to Colgate management through late October

assumed that $200 million private placement notes would be sold

for $140 million cash and $60 million LIBOR Notes. Around the

time of the formation of ACM, however, it was decided that the

partners could afford to do without a substantial amount of this

internal hedge: $175 million private placement notes would be

sold for $140 million cash and $35 million LIBOR Notes. No

explanation was provided at trial, and none is to be found in the

documentary evidence, of the reasons for the decision. But the

effect was a reduction by 42 percent in the planned level of

interest rate hedging protection and the retention of assets

whose value would not vary with interest rates in a manner that

undercut the effectiveness of Colgate's liability management

strategy.24

At the time the LIBOR Notes were acquired, Colgate had no

intention of using them to reduce Southampton's interest rate

exposure. Its management of Southampton belies any such claim. 

Over the first 6 weeks after formation of ACM, Colgate increased

Southampton's share of the Yield Component to 39.7 percent, more

than double its original pro rata share and more than triple its

pro rata share after the distribution of the BFCE Notes. In

conformity with the original plan for a falling interest rate
- 122 -

environment outlined by Pohlschroeder in his memorandum, it held

Southampton's exposure at this level until September 1990.

One might suppose that if the LIBOR Notes were acquired for

their utility to Colgate as a hedge within the partnership it was

because, even if Colgate might have desired leveraged exposure to

treasury risk at the outset, at some point in the future when a

rise in interest rates appeared imminent it would wish to

minimize its exposure. Yet, before the LIBOR Notes were

acquired, Colgate and Merrill had planned for the immediate

disposal of 30 percent of them. The timing of the acquisition

and disposition of the LIBOR Notes bore no relationship to

Colgate's interest rate expectations.

If Colgate had intended to use the LIBOR Notes for

protection against rising interest rates, they would not have

been a cost-effective instrument for this purpose. Colgate

appears to have had no reason to believe otherwise. In an

undated document entitled "Risk Allocation Analysis" that seems

to have been prepared for Colgate in late October or November,

before the LIBOR Notes were acquired, Merrill estimated that a

200 basis point increase in interest rates would cause $35

million market value of LIBOR Notes to appreciate to $40.31

million. This appreciation of just over 15 percent would offset

less than half of the devaluation of the Colgate bonds.

Southampton's original 17.07 percent pro rata share of the gain
- 123 -

on the LIBOR Notes would offset approximately $906,000 ($5.31

million x .1707) of its share of the loss. After distribution of

the BFCE Notes, a 200 basis point increase in interest rates

would have generated a $3.79 million offsetting gain on the

remaining LIBOR Notes, of which Southampton would have been

entitled to only $478,000, in proportion to its 12.6 percent

post-distribution partnership interest. When Colgate would have

reviewed the results of Merrill's analysis and planned with

Merrill the distribution and sale of the BFCE Notes, it would

have understood that the discounted present value of the

transaction costs that it would bear in connection with the

acquisition and sale of the LIBOR Notes would be in the vicinity

of $2-3 million. The potential hedging benefits would properly

be discounted for uncertainty. Let us assume, for example, that

there was a weighted average probability of 50 percent that

interest rates would rise by an average of 200 basis points

during the foreseeable future. A 50-percent probability is still

clearly an overstatement, given the declining interest rate

environment predicted in the implied forward rates that Beder

estimated, in the market swap rates that Merrill used to price

the LIBOR Notes, and in the Colgate treasury department's own

forecasts. Nevertheless, even under this extreme assumption, the

maximum hedging benefit that could be expected during the
- 124 -

25 The hedging benefit is maximal if it is realized

immediately. The longer it takes for interest rates to rise, the

lower the present value of this benefit.

foreseeable future would have been less than 1/10 the expected

cost (.5 x $478,000 ÷ $2.5 million).25

In December 1991, after the redemption of Kannex's interest,

the partnership concluded that it no longer needed the BOT Notes. 

The explanation recited in the minutes of the twelfth partnership

meeting is that since Colgate and Southampton now owned over

99 percent of the partnership, "the principal Partners' net

economic exposure to the risk of interest rate fluctuations in

the value of the Colgate debt was effectively minimal," and with

their usefulness exhausted, so volatile an investment could not

be justified. Heidtke's explanation at trial was as follows: 

"[A]t that point in time, the need for the - originally for the

LIBOR notes as a hedge of the debt had basically gone away

because now we owned all of the debt basically, so it was no

longer outstanding, it was effectively retired".

It was reasonable for Colgate to be indifferent about

exposure to the volatility of its own debt in the partnership

portfolio at this time. Yet, it had always been the case that to

the extent Colgate held its own debt through the partnership that

debt was economically retired and there was no exposure to hedge. 

This was among the principal advantages of the liability
- 125 -

management partnership identified in the Executive Summary dated

October 9, 1989:

The Partnership also allows Colgate to

effectively retire its debt, while leaving

the debt outstanding for accounting purposes,

* * * As Colgate bears a relatively greater

share of the Treasury risk * * * with respect

to its debt, it has economically retired an

increasing percentage of such debt * * * 

Petitioner's expert, Kenneth Singleton of Stanford University,

makes the same point:

[E]xposure to Colgate debt through

Southampton would have fully hedged an equal

amount of liabilities on Colgate's balance

sheet * * * From this particular perspective,

Colgate's investment in Southampton had an

impact similar to the consolidation of the

bonds owned by ACM onto Colgate's balance

sheet * * *

If the LIBOR Notes were not necessary as a hedge for Colgate in

December 1991, they had never been necessary.

It is true that the hedging effect of Colgate's investment

in its own debt did not appear on Colgate's consolidated

financial statements until ACM was actually consolidated for

financial reporting purposes. All the same, the Colgate bonds

were stated on the balance sheet at their historic cost and were

not revalued to reflect changes in the market cost of capital. 

Yet, Colgate's investment in the partnership would be marked to

market, in accordance with the convention for reporting swaps or

other hedging activities. This asymmetrical accounting treatment
- 126 -

could have been expected to add an insignificant volatility to

the consolidated financial performance of the Colgate group. The

question arises whether this undesirable accounting byproduct of

Colgate's liability management strategy would have provided

reasonable grounds for hedging within the partnership.

We do not think so. If the standard financial accounting

treatment of hedging activities was a cause for concern

warranting countervailing positions designed to eliminate the

effects from the financial statements of the business, businesses

would routinely offset their own hedges and receive little or no

net economic benefit from them. In July 1989, Colgate had

entered into $300 million notional principal amount of interest

rate swaps for liability management reasons similar to those that

actuated its investment in ACM. That these swaps were also

marked to market for financial reporting purposes evidently did

not trouble Colgate, for it took no action to counteract their

economic effects. Thus, a desire to stabilize the value of the

ACM investment on its financial statements could not have

provided a rational basis for the decision to hedge inside the

partnership.

ABN never had any intention of using the LIBOR Notes as a

hedge for Kannex's interest in the partnership. Instead, it

hedged Kannex's exposure to the Colgate debt by means of swaps

outside the partnership and, by separate swaps, eliminated the
- 127 -

superfluous and deleterious effects of the volatile LIBOR Notes. 

However, that is not what the minutes of the third partnership

meeting on December 12, 1989, suggest. According to the minutes,

Taylor recommended that the partnership dispose of 20 percent of

the LIBOR Notes because the planned exchange of some of the Long

Bonds for new Colgate debt of shorter maturity would reduce the

partners' interest rate exposure. "He further noted that such

reduction would not adversely affect Kannex because of the

Adjustment of sharing of Yield Component effected by the notice

dated December 12, 1989, from Southampton-Hamilton Company",

which lowered Kannex's share of the Yield Component. One would

not gather from Taylor's explanation that, 2 weeks before the

meeting, Kannex, ABN, and Merrill entered into the back-to-back

hedge swaps that rendered the LIBOR Notes utterly ineffectual as

a risk management instrument for Kannex, or that Kannex and ABN

were also hedging Kannex's exposure to the Colgate debt so that

Kannex would not be affected by Southampton's adjustments of the

Yield Component.

The explanation for the decision to dispose of the BOT Notes

provided in the minutes of the twelfth partnership meeting in

December 1991 is likewise misleading. Pepe is reported to have

said:

[A]s Colgate and a subsidiary Southampton, owned 99.4%

of the Partnership, the principal Partners' net

economic exposure to the risk of interest rate
- 128 -

fluctuations in the value of the Colgate debt was

effectively minimal, and the Partnership need not

maintain its position in the instruments purchased to

hedge against such exposure. 

Although there is no explicit assertion here that the partnership

believed the LIBOR Notes to be necessary so long as Kannex was

one of the principal partners, that is the implication.

Petitioner contends that Merrill and the Partnership

Committee could honestly and reasonably have represented that the

LIBOR Notes actually served as a hedge for Kannex's benefit. 

Petitioner denies that Merrill and Colgate knew of Kannex's swaps

with ABN.

[E]ven though Merrill entered into swaps with ABN

relating to Kannex's share of the LIBOR notes owned by

ACM, Merrill was not specifically informed of the

Kannex/ABN swaps relating to the LIBOR notes. [Emphasis

added.]

Although Merrill may have suspected that Kannex and ABN

had entered into similar swaps, there is no evidence

that Merrill knew, in fact, that such a transaction had

taken place. Consequently, there is nothing about

Taylor's representation at the third Partnership

meeting that is inaccurate or misleading.

It is true that there is no evidence in the record that ABN

specifically apprised Merrill of its swaps with Kannex. But this

misses the point. Petitioner seems to think that Merrill's

understanding as to the utility of the LIBOR Notes would be

significantly affected by specific information or lack thereof

that ABN was engaging in a swap with Kannex that mirrored the

swap between ABN and Merrill. There was no doubt why ABN entered
- 129 -

into its hedge swap with Merrill. The purpose and effect of that

swap were to neutralize the impact of the LIBOR Notes on ABN's

investment in the partnership. Nor was there any illusion that

Kannex could pursue its own risk management strategy independent

of the purposes of ABN. That knowledge alone would have been

sufficient to enable Merrill to conclude that, in managing

Kannex's participation, ABN had no use for a hedge within the

partnership. There is also unequivocal evidence that Merrill was

in fact aware of the activities ABN was conducting outside the

partnership to hedge exposure to the Colgate debt on Kannex's

behalf. Merrill consulted with ABN on revaluations of the

Colgate debt, as an internal memorandum of the Merrill Swap Group

explains, "[s]ince Kannex must actually trade Treasuries based

upon the Base Treasury Yields".

 The misleading explanations we find in the minutes were

prepared long before the events they describe, during the

planning of the section 453 investment strategy. Therefore, they

raise the more fundamental issue of whether Merrill and Colgate

could honestly and reasonably have planned to have ACM acquire

the LIBOR Notes for ABN's use in managing the risks of Kannex's

participation. The evidence is overwhelming that from the early

stages in the planning of the liability management partnership at

least Merrill, if not Colgate as well, expected that, as a matter
- 130 -

of course, ABN would take steps to manage these risks

independently.

To secure a partner for Colgate that would bear most of the

interest rate risks of the liability management partnership's

investments, Taylor approached the Financial Engineering Group of

a major foreign commercial bank. As a rule, financial

institutions like ABN do not expose themselves to interest rate

risk; it is a common practice of such institutions to hedge their

positions as promptly and fully as practicable. Taylor and his

Swap Group knew this well enough to offer structured transactions

that eliminated interest rate risks to BOT, BFCE, and

Sparekassen, as well as to all the banks that issued or purchased

LIBOR Notes in connection with each of the section 453

partnerships that Merrill promoted. Taylor's Swap Group would

not need to offer similar services to ABN. That would be the

responsibility of den Baas and his Financial Engineering Group,

whose regular business was to devise sophisticated structures for

hedging interest rate and currency risks. As Kannex's financial

adviser, den Baas's Group performed the function for which they

had been recruited.

As a witness, Taylor was asked about his expectations

concerning the manner in which ABN would handle the risks of

Kannex's participation:
- 131 -

Q: * * * Mr. Taylor, based on your experience

with complicated transactions, why did you

not expect or believe that ABN was hedging

its risks with respect to ACM partnership?

A: I didn't-did I say I didn't-I never said they

wouldn't hedge.

* * * * * * *

Q: Okay. Did you believe that ABN would hedge

its risks?

A: Did I believe that they would hedge their

risks? Yes, in some way, sure.

Q: And hedge their risk with respect to their

investment in ACM partnership?

A: However they saw fit.

The expectation that ABN would manage the risks of Kannex's

participation "however they saw fit" does not square with the

notion that a hedge within the partnership was designed for the

principals' mutual benefit. That expectation, however, was a

cornerstone in Merrill's design for the liability management

partnership. The concept of creating a mechanism to separate

treasury risk from credit risk and "allocating to each partner

the risks that it is best able to bear" presupposed that the

foreign partner would make use of the risk management

capabilities in which it possessed a comparative advantage; it

would have made no sense if the foreign partner were expected to

rely upon risk management conducted at the partnership level. 

There was no attempt to make the LIBOR Note hedge into the kind
- 132 -

of flexible and precise hedging instrument that Kannex would have

required in order to provide Southampton with the Yield Component

option it desired at an affordable cost. Taylor knew that this

was unnecessary because ABN would not be relying on the LIBOR

Notes in any case. Yordan testified that before the formation of

ACM he asked Taylor why ABN would be willing for Kannex to bear

the burden of the flexible interest rate risk allocation

mechanism that Merrill contemplated. "[H]is answer was that they

intended to - to enter into some hedge transactions to neutralize

that risk". As Taylor expected, Southampton was able to

negotiate for the Yield Component option at little or no cost. 

The partnership was successful because ABN exploited its

comparative advantage in a manner consistent with rational

economic behavior, and did not behave in the manner implied by

the theory of the LIBOR Note hedge.

The LIBOR Notes served no useful risk management function

for the partnership. Nor was there any genuine expectation on

anyone's part that they would. The theory of the LIBOR Notes as

a hedge "within the four corners of the partnership" was nothing

other than an elaborate tax avoidance scheme that had no economic

substance.
- 133 -

d. Interim use for idle cash

Petitioner explains the investment in the Citicorp Notes on

November 3, 1989, in part by the need for an interim use for the

partners' cash contributions during the indefinite period during

which efforts were made to identify and acquire Colgate debt. 

This is supported by the account that Taylor gave of the sequence

of events in his trial testimony:

The partnership was funded on November 2nd. 

From that date forward, Colgate or

Southampton-Hamilton was - was negotiating

for the repurchase of a prior [sic-private]

placement note from Met. 

Merrill Lynch was trying to identify, locate,

and purchase Colgate long bonds, and ABN Bank

was charged with identifying, locating, and

purchasing Euro notes * * * so, * * * the

cash needed to be invested and it was

invested in these notes. [Emphasis added.] 

The weight of the evidence indicates that the search for

Colgate debt had begun long before the partnership was funded,

and that by the beginning of November the timing of the

partnership's purchase of the debt was largely within its

control. Between December 4 and 8, 1989, ACM acquired the Met

Note, Euro Notes, and Long Bonds in an aggregate principal amount

of $135.9 million. Prior to ACM's formation, Merrill prepared a

series of cash-flow projections with respect to the investment

activities of a liability management partnership under various

assumptions. In the six projections between August 8 and
- 134 -

September 7, 1989, the amount of Colgate debt in the partnership

portfolio is arbitrarily assumed to be $50 million. The actual

target contemplated since July was $140 million. In the

October 24, 1989, projection, the amount of Colgate debt is

assumed to be $138.95 million. In the October 27, 1989,

projection, it is assumed to be $134.96 million. The later

numbers are not arbitrarily selected for purposes of

illustration. They clearly purport to be estimates. Both the

precision and the accuracy of the estimates suggest strongly that

by the time of the formation, at least several days before the

Citicorp Notes were acquired, not only had Colgate debt been

identified, but Merrill already had a very clear expectation of

the prices.

In our Findings of Fact, we described in detail the pattern

of studied hesitation and postponement calculated to hold up

progress in consummating the purchases of Colgate debt. A brief

summary will suffice. Weeks before his negotiations with Met

Life on November 17, 1989, Pohlschroeder was ready, but

unwilling, to negotiate. His reluctance to enter into discussion

of specific terms before the appointed date was attributable at

least in part to concern that the partnership's activities be

conducted entirely offshore. Yet, the Partnership Committee

authorized ABN Trust to proceed with the negotiations in an

offshore location for that very reason, and evidently it made no
- 135 -

efforts to do so. Final arrangements for the purchase of Long

Bonds and Euro Notes in the marketplace were similarly delayed. 

In late October 1989, Pohlschroeder drafted standing orders

which, on their face, purport to instruct Merrill not to make any

purchases until the partnership had acquired the Citicorp Notes. 

Within 1 week after acquisition of the Citicorp Notes, the amount

of cash that would be needed for purchases of the Colgate debt

and the time it would be needed were definite enough that Merrill

could press BOT and BFCE to conclude arrangements concerning the

sale of the Citicorp Notes. The investment in the Citicorp Notes

was not made to accommodate the timing of the acquisition of

Colgate debt; rather, it was the reverse: The acquisition of the

Colgate debt was timed so as to accommodate the requirements of

the section 453 investment strategy.

If the timing of ACM's acquisition of Colgate debt was

largely within the principals' control, and they were confident

that negotiations could be concluded and sales closed within a

short time, what the partnership needed for its temporary cash

balances was a portfolio of short-term highly liquid investments. 

That need was not served by the decision to acquire an

undiversified portfolio consisting of Citicorp's unregistered

5-year notes. Nor can that need explain the decision to

liquidate the portfolio by means of a complex structured
- 136 -

transaction in which a substantial amount of the principal would

be consumed by dealer fees.

ACM's conduct subsequent to the Citicorp Note purchase

belies the claim that the use of the Citicorp Notes as a

temporary store for partnership cash was economically sound. The

Citicorp Note investment would not have met the criteria for

management of temporary cash balances set forth in the

partnership's Investment Guidelines, had they been in effect at

the time. But the adoption of the Investment Guidelines 2 weeks

later, like so many partnership decisions, appears to have been

scheduled to accommodate the section 453 investment strategy. 

Once the Citicorp Notes had been sold, the partnership was at

liberty to follow sound investment principles. The $140 million

cash generated in the sale was invested in a diversified

portfolio of commercial paper instruments maturing after 7 days. 

No liquidation costs were incurred to obtain the cash needed for

settlement of the Colgate debt purchases. But financial assets

that could be converted into cash without a sale and registered

financial assets that could be traded on an exchange at

relatively little transaction cost would not have satisfied

Colgate's tax needs.

Petitioner argues that the choice of private placement notes

allowed ACM to negotiate for a put option, "a valuable option it

could not otherwise have obtained". The logic appears to be
- 137 -

backwards. The partnership did not choose the Citicorp Notes

because they offered a put. If ACM had invested in short-term

money market instruments or otherwise in accordance with the

criteria in its belated Investment Guidelines, it would not have

needed a put option. The option was valuable because the

partnership chose to invest all of its cash in 5-year notes of a

single issuer that were not tradeable on an exchange.

e. The pattern of ostensibly market-driven decisions

Petitioner sums up the manner in which the partnership

executed the section 453 investment strategy as follows:

Although the evidence clearly indicates that

the transactions ACM entered into were

contemplated from the outset, it is equally

plain from the record evidence that none of

the ACM transactions was "pre-wired" or

certain to occur. Moreover, it is clear that

none of the parties was ever under any

obligation to undertake any of the

transactions: Ultimately market events and

conditions dictated whether the transactions

went forward and the terms on which they went

forward.

The pattern of market-driven decisions that petitioner describes

cannot be found in the record. On the contrary, the record

reveals only a series of inconsistencies between the steps

actually taken and the decisions that tax-independent

considerations would have implied. There is no evidence that the

occurrence or timing of any of these steps was a function of

anything other than tax planning.
- 138 -

The documents that were drafted to explain the liability

management partnership proposal for purposes of Colgate's

internal review exhibit a scrupulous regard for the need to

justify the proposal by reference to the relative costs of

alternative structures. Petitioner presented expert opinion to

the effect that ACM was a cost-effective vehicle for

accomplishing Colgate's liability management objectives. By

contrast, Pohlschroeder's account of how the decision was made to

invest in the Citicorp Notes reveals a striking indifference to

cost considerations. Petitioner points out, in support of its

position that the consequences of ACM's transactions were not

predetermined, that the partners' exposure to Citicorp's credit

was "real, not theoretical". If the purchase of the Citicorp

Notes confirms that market forces could have affected the

economic outcomes for the partners, it also illustrates how

little market considerations actually affected partnership

decisions. Investing all $205 million of the partners' capital

in Citicorp Notes, most of which would be sold at market price

rather than held until they could be put back to the issuer at

par, did subject the partnership to risk. The Investment

Guidelines reflect the judgment that such risk normally would not

be justifiable. In order to explain the acquisition of the

Citicorp Notes as an interim use for idle cash, preparations to

acquire the Colgate debt were suspended. Over the short period
- 139 -

that the partnership planned to hold the notes, any premium yield

it may have earned from them could not have covered an

appreciable amount of the costs that the partnership expected to

incur upon their sale. 

The acquisition of the LIBOR Notes, ostensibly to minimize

the partners' exposure to a rise in interest rates, was planned

and carried out at a time when Colgate expected interest rates

would fall over the next several months, and accordingly desired

leveraged exposure to interest rate risk within the partnership. 

Instead of initially setting Southampton's share of the Yield

Component at the target level of approximately triple its pro

rata share, Colgate caused Southampton to increase its share in

two steps over a period of 6 weeks to provide part of the

rationale for why the partnership no longer needed the hedging

effect of the BFCE Notes, in accordance with scenarios developed

several weeks beforehand. The acquisition of the LIBOR Notes was

planned with the expectation that Kannex would not in fact have

any net exposure to hedge, and the acquisition proceeded as

planned even after ABN and Merrill had entered into an agreement

that would offset their effect on ABN's interest altogether.

Each of the steps in the section 453 investment strategy was

planned and arrangements commenced considerably in advance of
- 140 -

26 Respondent's expert, Irving H. Plotkin, concluded that:

In judging the economic rationality of the

Partnership, it must be remembered that the complex

financial transactions and the profits realized by the

parties did not occur as a reaction to or consequence

of random economic factors. Likewise, the very low

pretax rate of return suffered by Colgate was not the

result of poorly chosen investments or of any

unexpected adverse market conditions. Rather the

transactions and the returns were the result of a

carefully crafted and faithfully executed sequence of

sophisticated and costly financial maneuvers that left

little to chance or market opportunities. The score

for the Partnership's actions was very detailed and the

libretto even included the writing of the minutes of

the Partnership meetings weeks before those meetings

occurred. The actual Partnership transactions

conformed to each of the seven steps choreographed in

Merrill Lynch's September 1989 presentation to Colgate.

execution.26 Before the negotiations to form ACM, Merrill had

already begun negotiations to purchase the Citicorp Notes. 

Before their purchase, Merrill was negotiating for their

disposition. By the time ACM acquired the LIBOR Notes, Merrill

was arranging with Sparekassen the terms on which some of them

would be sold. The contingent payment sale was scheduled to take

place before the end of ACM's first taxable year in order to

permit the partnership to spread its tax basis in the Citicorp

Notes over 6 years instead of 5. The distribution and sale of

the BFCE Notes was scheduled to occur before the end of Colgate's

1989 taxable year in order to offset Southampton's share of the

contingent payment sale gain on Colgate's consolidated return. 

It was the understanding of the principals that Kannex would
- 141 -

retire from the partnership by the fall of 1991 so that the LIBOR

Notes could be sold in time for Colgate to carry back the taxable

loss to its 1988 taxable year. No supervening market forces or

other nontax considerations disrupted the scheduled execution of

these steps. "'If we stood at the top of the world and looked

down on this transaction', we would see events unfolding during

the year[s] * * * about as they were contemplated when the plan 

was adopted." Braddock Land Co. v. Commissioner, 75 T.C. 324,

331-332 (1980)(quoting Mathews v. Commissioner, 520 F.2d 323, 325

(5th Cir. 1975)). 

But for the $100 million of tax losses it generated for

Colgate, the section 453 investment strategy would not have been

consistent with rational economic behavior. The section 453

investment strategy lacked economic substance. It served no

useful nontax purpose. Accordingly, the pertinent adjustments

made by respondent to ACM's reported items of income and loss are

sustained. 

To reflect the foregoing,

Decision will be entered

under Rule 155.