Opinion ID: 769343
Heading Depth: 2
Heading Rank: 2

Heading: The Value of the Warrants

Text: 21 In a very similar factual situation, the Tenth Circuit in Monarch Cement valued the options at issue for OID purposes by considering the difference between the interest rate that would have been required without the options and the interest rate actually used. See 634 F.2d at 484-86. In this case, the Tax Court decline[d] to apply the approach of Monarch Cement, because it found that the evidence in the instant case does not establish that the $26 million loan was obtained at a below market interest rate. Custom Chrome I, 76 T.C.M. at 393. A necessary corollary of this finding is that the warrants were worthless at the time they were granted. See id. at 393-94. 22 It is an open question in this circuit what method should be used for valuing warrants for purposes of OID. The problem in valuing the warrants stems from the combination of the general speculative nature of options and the related difficulty of determining precisely what effect options granted for OID have on a core loan transaction. The Tenth Circuit in Monarch Cement applied one reasonable approach to this problem by looking at the difference between the interest rate actually used and the standard market rates that otherwise would have been applied in the absence of the equity kicker of granting options. See 634 F.2d at 484-85. 8 We hold that the approach of Monarch Cement may be suitable to value options granted for OID, but should not be the only method open to the courts 9 . In particular,the factfinder may adopt any well-established and reliable method for determining the value of the options, such that the factfinder can assess with reasonable accuracy the value of the options with respect to the evidence in the record 10 . 23 Under any well-established and reliable financial method, the options in this case clearly did not have zero value. Contrary to the Tax Court's findings, there is no evidence that reasonably supports the conclusion that the loans were not provided at below-market rates. First, even the Commissioner's own expert stated in a detailed valuation study that, under two different methods, 11 the value of the warrants was positive. 12 24 Second, no one contests that the terms of the warrants were hotly negotiated. In particular, Foy testified that the Bank and the shareholders of the new company viewed [the warrants] as quite valuable and that's why they were the subject of obviously a very heated negotiation over the amount. If the options were valueless at the time they were granted, none of the parties would have wasted so much time, effort, and money negotiating the terms of worthless securities. 25 Third, the Bank's documents indicated that the future value of the warrants after five years was approximately $5 million. Loan professionals at BancBoston based this valuation on the expected market value of the company if it went public, under the well-established method of taking a standard multiple of a company's expected earnings before interest, depreciation, amortization, and taxes (EBIDAT). Foy testified that the $5 million expected future value was what they were looking forward to in order to achieve[an] internal rate of return of 22 to 23 percent. Indeed, Foy stated that [t]he bank would not have made a $26 million loan without getting 12 percent warrants and without viewing those warrants as having value. 26 Under a similar method of valuation, Bank of America-from which Custom Chrome ultimately decided not to borrow -determined that the value of warrants for 12 percent of Custom Chrome, along with put and call provisions similar to those included with the warrants granted to FNBB, had a future value after five years of approximately $4.4 million. For instance, Michael Romanchak, Vice-President of Commercial Banking, 1989, Bank of America, testified that he would not have taken the loan to the relevant committee for evaluation without the warrants being included. Like FNBB, Bank of America was looking for an internal return of approximately 20 to 25 percent, which exceeded the interest rates of the bank's pure commercial loans. 27 The Tax Court's reasoning and the Commissioner's arguments proffered in favorof a zero valuation are unsupportable. First, the Tax Court places heavy emphasis on the warrants being at the money, that is, at a strike price equal to the price being offered to investors at the time of the buyout. Custom Chrome I, 76 T.C.M. at 393 (internal quotation marks omitted). Specifically, the Tax Court stated: 28 This constitutes strong evidence that the options had no premium value to be associated with them at the time of issuance. Thus, any value that might attach to the options would be speculative and would depend on the profits of petitioner and on apprecia tion in the value of the underlying stock in subsequent years. 29 Id. As a matter of finance, that an option is at the money does not render the option valueless. An option has two values: an intrinsic value and a time value. See, e.g., Charles J. Woelfel, Encyclopedia of Banking & Finance 874 (10th ed. 1994). The intrinsic value of an option is the difference between the actual value of a share and the exercise price of the option. See id. Thus, if ABC stock is trading at $50 a share, and the exercise price of the option is $40 per share, then the intrinsic value of the option is $10. See id. 30 The time value of an option refers to whatever value the option has in addition to its intrinsic value.  Id. The time value reflects the expectation that, prior to expiration, the price of . . . [the] stock will increase by an amount that would enable an investor to sell or exercise the option at profit. Id. As we noted in United States v. Smith, 155 F.3d 1051 (9th Cir. 1998): 31 An `out-of-the-money' call option allows a person purchasing the option to buy stock during a limited period in the future at a fixed price (the `strike price'). That [future] price is higher than the current market price. Thus, the option holder essentially is betting that the market price will rise over the strike price within the limited time period. The time period limitations make such investments extremely speculative. 32 Id. at 1069 n.26 (internal quotation marks and citations omitted). 33 Here, because the strike price of the warrants was the same as the nominal trading price at the time of the buyout, the warrants had no nominal intrinsic value. On the other hand, based on the voluminous evidence in the record, the warrants had a substantial time value -that is, the Bank and everyone else expected the stock price to increase significantly so that eventually it would be profitable to exercise the warrants. 13 Indeed, the exercising of the warrants eventually netted more than $3 million. 34 Thus, while the value that might attach to the options [may have been] speculative, Custom Chrome I, 76 T.C.M. at 393, the warrants nevertheless had some positive value. The Commissioner has cited no authority for the proposition that the lack of a well-defined present market value and the uncertainty in the future value of a financial instrument imply that the instrument has no value for tax purposes. Unlike Treas. Reg. S 83, which mandates that options without a readily ascertainable value be valued at the time of exercise, the applicable OID regulations require valuation at the time of grant under all circumstances. Indeed, the Commissioner argues as much. Yet, the Commissioner's argument that the warrants had zero value at the time of grant because they had no readily ascertainable market value and, in view of their being nominally at the money, a purely speculative future value, took an impermissible extra step. 35 For instance, in Monarch Cement, the Tenth Circuit upheld the district court's finding that the options were worth almost $650,000, even though the options traded at more than the current trading price of the stock. See 634 F.2d at 485. The court reasoned:The general unavailability of the stock [at the time of issuance] could make warrants representing the future right to purchase ten percent of the company worth more than the per share amount at which the very few traded stocks were being sold at the time. Favorable expectations, especially in light of the per ceived additional value that would be generated by the substantial loan being contemplated, could have led the lender to believe that warrants to purchase a substantial block of otherwise unavailable stock were worth $13.40 per share. 36 Id. at 485-86. The same reasoning is applicable to this case. While the nominal value of Custom Chrome's stock (i.e., the value paid by insiders) was $500,000, Jordan paid a little over $26 million to acquire Custom Chrome. This is strong, if not irrefutable, evidence that the insiders were receiving a price per share that no outsider could enjoy. 14 Thus, given the unavailability of equity at the $500,000 price, the fact that the warrants were nominally at the money has little, if any, bearing on their overall market value. 37 Second, the Tax Court relied heavily on the Bank's listing of the value of the warrants as $1,000 on its books. Similarly, the Commissioner pointed to the Bank's failure to claim the warrants as ordinary income. There is neither evidence in the record nor any legal basis for the proposition that Custom Chrome's and the Bank's financial or tax treatment of the warrants was or should be contractually or otherwise dependent. 15 Thus, the Bank's actions should not bind Custom Chrome. 38 Third, both the Tax Court and Commissioner emphasized that Custom Chrome failed to take any deductions for OID during the tax years in question. Neither the Tax Court nor the Commissioner, however, cited any authority for the proposition that failure to take proper deductions on submitted tax forms precludes a taxpayer from later utilizing those deductions through a petition for a redetermination of tax liabilities. See Mamula v. Commissioner, 346 F.2d 1016 (9th Cir. 1965) (holding that, where taxpayer in good faith elects incorrect method of computing tax, the taxpayer is not precluded from recalculating tax liabilities under correct method). Thus, Custom Chrome's mistake in overstating its tax should not be used against it to determine the value of the warrants. 39 In sum, under any well-established financial method that can determine with reasonable accuracy the value of the warrants in the instant case, a rational factfinder could find only that the warrants were not valueless at the time of issuance. The Tax Court clearly erred in finding otherwise. 40