Opinion ID: 330160
Heading Depth: 1
Heading Rank: 3

Heading: appropriate measure of debt discount

Text: 47 Having held that Cities incurred an additional cost for the use of capital by its exchange of preferred stock for debentures, we turn now to the issue of the appropriate measure of that cost. 14 48 The Court in National Alfalfa stated the economic basis for debt discount: 49 The economics underlying discount is that it is an adjustment of the difference between the interest prescribed in the instrument issued and the prevailing market rate for money, and it arises because the prescribed rate is too low to sell the obligations at par in that market. 417 U.S. at 150. 50 Where bonds are issued for cash in the open market, the marketplace determines this adjustment. But where the transaction is insulated from the market, as in National Alfalfa, there are no market forces to perform the evaluation process. 51 In National Alfalfa, the Court was disturbed chiefly by two related facts: first, the claimed fair market value of $33 per share for the preferred was the product of an extremely thin market and, second, there was no guarantee that this price for the preferred bore any relation to the fair market value of the bonds which had been issued. Since the transaction had been insulated from the market, the taxpayer in effect was asking the Court to speculate about the market price and value to the corporation of the debentures in question had they been sold upon the open market. 417 U.S. at 148. There was no proof that the discount claimed by the taxpayer had been fixed by anything other than an arbitrary determination by the corporate directors: 52 (T)here is no evidence of what the fair market value of the bonds was at the time of their issuance. Other factors that would have to be considered would include (the taxpayer's) financial condition at the time of the exchange, including both its credit position and its profits prospects, and the availability and cost of capital in the general market as well as from its preferred shareholders. Normally, the market itself performs this evaluative process. Aside from the fact that the transaction was insulated from the market processes, there has been no attempt here to show that the discount rate was determined with a view toward accounting for these several factors rather than simply having been predicated on the par value of the preferred. 417 U.S. at 151. 53 In the instant case, Cities argues that its exchange was quite different from that in National Alfalfa. Here the exchange was not insulated from the market since the preferred shares were widely held and actively traded on the Boston Stock Exchange and the New York Curb Exchange. Moreover, the instant exchange took place only after hearings and scrutiny by the SEC and after bargaining with the preferred shareholders. Cities points out that the aggregate fair market value of the preferred at the time of the exchange, $86,313,600--as arrived at by its expert and accepted by the court below, 362 F.Supp. at 835-38 (Tenney, J.)--is the product of an evaluation of those factors outlined by the Court in National Alfalfa. 417 U.S. at 151. 54 Assuming this to be so, the critical deficiency in the record before us is the absence of any finding as to the market value of the debentures at the time of their issuance. This is indispensable to measuring the debt discount. The sole issue determined on the third round in the district court below was the value to Cities of the preferred and preference stock received on the exchange. 362 F.Supp. at 835-38 (Tenney, J.). This was the sole issue ordered for trial on the first round in the district court. 316 F.Supp. at 74 (Mansfield, J.). Since National Alfalfa was decided by the Supreme Court subsequent to the district court decisions below, we have the benefit of hindsight in holding that the appropriate question for the district court to answer, in order to measure debt discount, is what was the market value of the debentures at the time of the exchange, rather than the value to Cities of the preferred it received. 55 In National Alfalfa, the Court made clear that the relevant inquiry in determining bond discount is the market value of the debentures when issued. True, an equivalence in value of the debentures and preferred shares might be assumed if the debentures were issued for cash and/or property in the marketplace. But it should be noted that the opinion in National Alfalfa dealt separately with the fair market value of the preferred and the fair market value of the debentures involved in that exchange. 417 U.S. at 149-50. Any assumption of an equivalence of the debentures and the preferred is unjustified where the transaction is insulated from the marketplace since the market forces which normally would bring about an equivalence of the two are absent. Here there is no proof that the two were equal. The Court's observation in National Alfalfa is applicable here. (T)here has been no demonstration that the difference between the (fair market value of the preferred) . . . and the face amount of the debentures is attributable to debt discount. 417 U.S. at 151. 56 The amount of debt discount must be determined by reference to a market evaluation and not a private transaction. The issue for determination by the district court here is that indicated by the Court in National Alfalfa: 57 (T)he market price and value to the corporation of the debentures in question had they been sold upon the open market. 417 U.S. at 148. 58 Accordingly, we reverse and remand to the district court for determination of this issue. 15 59 For the guidance of the district court, we wish briefly to comment on certain evidence in the instant record relevant to the issue to be determined on remand. Unlike the situation in National Alfalfa, the issue to be determined here is not a matter of speculation. 16 Here both the preferred and debentures were being traded at the time of the exchange. On May 27, 1947, the day prior to the exchange, the aggregate closing market price of the preferred was $104,827,450. Contrary to the implication of the district court that this market price is irrelevant because it was dependent on the value of the consideration to be received in exchange for the stock, 362 F.Supp. at 837, we suggest that for this very reason it is relevant to the determination of the market value of the debentures at issuance. The closing price of the debentures on the date of their issuance was 91 7/8, 17 or an aggregate market price of $105,883,135. We suggest that both of these figures may be relevant to the determination of the market value of the debentures at the time of their issuance. Which of these two measures (or what combination of them) is more appropriate presumably will depend in part on which market was less thin. That determination, among others, is for the district court. 60 On this appeal it is not for us simply to choose one or the other. Rather, it is for the district court to determine what is the best available market assessment of the value of the debentures at issuance. As indicated in National Alfalfa, where there is no available market evaluation, the district court's inquiry might include consideration of the taxpayer's financial condition at the time of the exchange, including both its credit position and its profits prospects, and the availability and cost of capital in the general market as well as from its preferred shareholders. 417 U.S. at 151. No such inquiry would appear to be required here since a market assessment of these factors is available. 18