Free Memorandum in Opposition - District Court of California - California

Case 3:07-cv-04762-PJH

Document 116-3

Filed 09/08/2008

Page 1 of 8

Steven Soulios, Esq. Ruta & Soulios 1500 Broadway, 21st Floor New York, NY 10036
Telephone: (212) 997-4500

Facsimle: (212) 768-0649

Attorney for Debtor
Derivium Capital LLC

UNITED STATES DISTRICT COURT
FOR THE SOUTERN DISTRICT OF NEW YORK

In re DERIVIM CAPITAL LLC,
Debtor,
I

No. 05-37491 (CGM)
DECLARATION OF EDWARD O.C. ORD IN OPPOSITION TO THE TRUSTEE'S MOTION TO CONVRT THE CHAPTER I i PROCEEDING TO CHAPTER 7

1. I am Edward O.C. Ord, Esq. a lawyer duly admtted to the Distrct of

Columbia and th Californa State Bar.
2. Formerly, I spent may yea as a tr attrney in the Tax Division of

the U.S. Depent of Jusice in Washington, D.C. Dug those
year, I represented the Interal Revenue Serice ("IRS") in the Federal
Cours in varous par of

the United States and sometmes abroad.

Subsequently, I was an Assistat U.S. Attorney for civil tax litigation.
Attched is a paria

list of some of the cases I have hadled during my

career while with the U.S. Deparent of Justice or subseqently in
private practice.

3. I also have a Master Degr in Taxtion from New York University

law school in New York, New York.
i

Case 3:07-cv-04762-PJH

Document 116-3

Filed 09/08/2008

Page 2 of 8

I
2

4.

I have been reesenti the debtor prior to the Chapter 11 fiing in the

IRS investigation known as the Inter Revenue Code Section 6700
investigation.
5.
The investigation has mainly bee ru out of the Sacraento, California
offce of

3 4
5

the IRS. The investigation staed when the Frachise Tax

6 7
8

Board ("FTB") referd Debtor information and Debtor documents to

the IRS.
6.

The IRS took that information, includig customer lists and appears to

9
10

intend to assess and collect income taes from borrowers who
parcipate in borrwing under the 900.1 serice maked loan

II
12 13

traction.
7.

The 90% serce marked loan trion is very similar to a magin
loan and colla-loa tractions provide by brokerge fis, and the

14 15

related loan document is simla to collar-loan and margin-loan
agreeents used by the major brokerge houses on Wall Str.
Basically, unde such stadad stock loan agreements, the borrower puts

16 17
18 19

up publicly trde stock as securty. Then, the borrower borrows a

substatial amoun of money based on the value of the stok at a rate of
intest. Under the stadad brkerae fi loan arangement, the
brokerage house is free to loa, hypothecte, pledge, trfer, or sell the

10

ii
:z
13 24
15

publicly trade stock and to use the proceed from such trsactions for

its (the brokerage fi's) own benefit. The loan agreement require
tht when the loan term ends, afr any extensions, and upon repayment

of the loan balance, the brokerage house has to retu to the borrower
the collatera, which would be the sae number of shares of

the stock

26
17 28

tht were originaly pledged by the borrower adjusted for stock splits or

other distrbutions. Th would be the norm settement, uness the
2

Case 3:07-cv-04762-PJH

Document 116-3

Filed 09/08/2008

Page 3 of 8

i

borrower does not want the stock back and the loan is non-recoure to
the borrower. Then, if the fai market value of

i
3 4
5

the stock is less than the

loan balance, the borrower may elect to surnder his claim to the stock.
Since the loan are non-reoure, the liabilty of the borrower on his
debt is limted to the value of the securty. Durng the period of

the

6 7 8 9
10

loan, for book entr purses, the stock is still trated as being owned

by the borrower. Any dividends on the stock are treated as being owned
by the borrower and ar usually crete to his account in one way or

another and/or used to offet interest.
8.
The IRS for decades ha recogned any margin loa tranaction as a

_11
12
13 14

l)ona fide loan tracon ~d is not a sale in tle ye~the loanjs taen
out, despite the fact that the securd shaes may be sold or hypothecated
or otherse disposed of by the brokerage house dur the loan ter.

Instead, the tranaction is recogned for what it is, i.e., a loa
traction. At the end of

15 16 17
18

the loa term, when the stock is required to

be retued, if the stock has gone down in value below the amount of

the loan, then a default on th loan would be treate as a sale or an
exchange in tht last~.

19

9.

The IRS ha issued Revenue Ruling 57-451, 1957-2 C.B. 295, which
recognze that the trsfer of stock to a broker, giving the broker the

20

ii

abilty to lend or engage in other tractions with the stock, does not
constitute a disposition of

ii
23 24 25 26

the stock by the tapayer. The Revenue

Ruling concludes tht even though all incidents of ownership (and not
merely legal title) were trferrd, as long as the broker satisfies the
obligation to replace such certficates, ultimately restoring the

stockholde to the sae economic position he/she would have been in if the tranaction had not taen place, a disposition wil not have taken
3

27
28

Case 3:07-cv-04762-PJH

Document 116-3

Filed 09/08/2008

Page 4 of 8

1

plac period. The trsation is withn the scope of Internal Revenue

2

Code § 1036, which bar a sale. The IRS is estopped from tag
positions contrar to positions in published revenue rulings. See for

3

4 5 6 7

intace Brooke v. U.S., 292 F.Supp. 571, (D.Mont. 1968), amended

300 F.Supp. 465, affrmed 468 F.2d 1155 (9th Cir. 1972). The above

Revenue Ruling has be in place and opertive for almost fift year,
and is relied upon by the brokerage industr.
10. Attched is a tre and corrct copy of one of

8
9 10

the serice marked loan

trsaction loan documents.
II. The IRS is now tag the position, including in the U.S. Tax Cour

---ll
ii
13
14

_ _ _l~int lJorrQwer tht, under ths agreement or similar forms of ths -_._-~------------_.the yea tht the stock is required to be reted tht ths is just an

-

agrent, in the year tht the loan is taen out there is a sale. Then, in

option for the borrower to reacquire the shas ifhe chooses. Besides
bein appaently inconsistent with the above stated Revenue Ruling, the
IRS is really attptig to rewrte a bona fide loan agreement. This is

15

16 17
18

going to prove diffcult for the IRS to maintain in Federal Cour. See
for intace, Stern v. Comm'r, 747 F.2d 555,558 (rjh Cir. 1984)(wrtten

19

anuity contract caot be rewrtten by the IRS and must be recognzed

20
21

as such). Moreover, as indicated above, the IRS for decades has agree

that these tyes of stock loan agrements are not a sale in the year that
the loan is taen out.

22 23
14

12. In my opinon, I do not believe it wil be likely that the IRS wil prevail

in the declaratory relief civil action that the Debtor is going to file under
U.S.C. Section 505 to detee tht th is a bona fide loan tranaction
and is not a sale traction in the yea of the loan with a right to

25

26
27 28

reacquie the stock at the end of the loan term.
4

Case 3:07-cv-04762-PJH

Document 116-3

Filed 09/08/2008

Page 5 of 8

1 13. As the cour can see, ths is not a complicate tranaction but a very

2 straightforward sitution tht should be promptly determed.

3 14. Morever, I believe tht the IRS wil have great diffculty in prevailng
4 under their asserton tht ths tye of tranacton is even covered by
5 Section 6700 at all. Ths is verified in par by the evidence provided

6 below in paragraphs 20-26.
7 i 5. The undersigned asks the cour to tae judicial notice of a pettion that

8 has been filed in the U.S. Distrct Cour for the Souther Distrct of

9 New York seeking to enforce an admstrative suons. agait the

10 Debtor.
i 6,- _ Ths petition and declartion se out the theories tht the ia~ __ _ _ _
12 plang to advance in the Section 505

litigation. We believe that such

13 theories are incorrct. The petition also discloses tht these efforts
14 would interfere with the Chapter i 1 proceedig, including the effort to

15 seek an injuncton to tete the operations ofDervium Capita,

16 LLC.
17 i 7. Accordingly, I believe the cour should not convert ths matter to a

18 Chapter 7 proeeg and allow the litigation to procd and give the 19 debtor an opportty to demonstrate that th is a bona fide loan 10 tranaction, which is exempt frm Secon 6700. 21 18. Moreover, the fiing and seice of ths Seon 505 action trsfer ths

12 matt frm the jursdiction of the IRS, which is par of the Treasur
23 Deparent to the U.S. Deparent of Justice, Tax Division, which wil 24 then have the indepdent sttutory authority to resolve ths matter. I 25 have a reasonable belief that thre may be a way we can reolve ths 26 mattr without litigation. I believe tht a sophisticated independent
17
18
i A Notice of

Relat Ca i-i to lsilD di matt to th Ba Qi ha be filed. Unti th ungn is hire
5

by the Cour th LLC lw no counl who ca rend to th shw ca ord or ip at th beii so it ap tht other

due pr an constu rip of th Detor ii to be in je witht a st beni p1te.

Case 3:07-cv-04762-PJH

Document 116-3

Filed 09/08/2008

Page 6 of 8

i

i
3 4 5 6
7 8

review by the Justice Dearent may result in the Depent of Justice agreein that ths is a bona fide loan traction. With repect to
the maketing of th transaction, we would look forward to working

with the Depent of Justice to arve at an amcable wrtten
arangement so tht the debtor could sta up a new loan operation with
the support of a new lender with some reassurce tht as long as the
debtor stays with the pareters of an agreement that the opration

could proceed. Ths would also give more comfort to the lender. I
believe th is a curtly viable option.

9
10

19.

Since the Debtor is the taget of ths investigation and is in Chapter 1 1,

it is only the Debtor that has stadig to get prompt decl~~ry rel~!
12 13
14

conceng the loan traction.
20.
There ar other indications made by the IRS tht indicate the curent

position is not valid. 21.
On or about November 27, 2001, the IRS intiate a very detaled
examination of the activities of the Debtor's via ofan audit of

15 16 17
18 19

the 1998

Fonn i 065 informtiona retu filed by the Debtor with the IRS.
22.

The IRS requeste and received copies of the Form i 065 for the Debtor

for the yea 199 and 2000. These ret and activities in the year
1999 and 200 were also reviewed.
23.

20
21

As par of the audit tea, an IRS Finacial Products Examiner
Speialist was assigned to the audit. This Speialist spet at least 67
hours on ths examtion. The Fincial Products Examiner Specialist

11

23 24
25

expended these 67 hour by examg the loan trsaction(s), the
marketing of

the loan tracton(s) and the Loan adstrtion as well

16 27 28

as the other ficial services of

the Debtor. Ths specialist is a highly

trned agent with expertise in conductig Section 6700 ta shelter

6

Case 3:07-cv-04762-PJH

Document 116-3

Filed 09/08/2008

Page 7 of 8

i
2 3

infrctions and an ability to spot abusive ta tractions and challenge
them. The speialist did not intigate a 6700 investigation or challenge

the transactions as other than bona fide loas.

4 24. After ths extenive review, the IRS issued a fial agency action stating

5 that no chages were reuire. Ths fial agency acton was made under
6 the Admstrative Procedur Act, 5 U.S.C. §55 I (13), which includes

7 tag a no-chage action. The fil agency action was based in par on

8 an accptace and fi admstrative determnation that the marketing
9 of the loan tranaction was not an abusive trsaction, that the loan

10 transaction was a bona fide loan tranaction, and that the Debtor was not
_ 11 _ _ --ketin an abusive ta shelter under 26 U.S.C. §6700_~r in violation

ii of Secon 6700. Ths fi agency action2 occured on or about June

13 16,2003.
14 25. Since the trined speialist spent 67 hour going over the loan

15 transactions, the maretg of th tranaction and the IRS closed the
16 investigation with a no-chage fil agency action, ths is a strong 17 indication tht the IRS wil not prvaiL. The yea coverig the fina1

18 agency action ar the same yea the IRS is now investigating under 19 Section 6700.
20 26. A fuer indicia of th questionableness of

the loan being a sale of

21 stock in the year the loan is taen out is the sumar judgment and 12 related decision entere agait the Californa Deparent of
23 Coiporations by the Superior Cour in the State Capital of Sacraento.

14 The Californa Deparent of Cororations sued the Debtor on the basis 25 that the Debtor was engaging in securties trsactions without a license

26 from the State of Californa. A tre and corrt copy of the sumar
17
2 Ea ta or caCD yea is i se CI of aaon. See Ca 'r v. Si, 333 u.s. 591,598 (1948). Th sae year

28

ar involved in th cur ne seon 1670 inveptiD IS se oiit in th IRS Sumns so¡lt to be entb 7

Case 3:07-cv-04762-PJH

Document 116-3

Filed 09/08/2008

Page 8 of 8

1

judgment decision is attched as Exhbit A. It has been my experience

2 3

that Superior Cour Judges give grat deference to State agencies in

cour proeedigs. Even so, the Superor Cour rejected the sale
arents. The Supenor Cour also sanctioned the Californa
Deparent of Corprations. A tre and corrt copy of

4
5

the sanction

6
7 8 9 10

decision is attched as Exhbit B.
27. I believe the above are importt facts and fators as to why ths Cour

should not conver and allow the Debtor to litigate these mattrs

promptly.

-- - - .- - -

1

I declare un pelty ofpeiur under the U.S. Code tht the foregoing is

ii
13

based on persona knowledge and is tre and corr.

14
15

Execute ths 2nd day of

November, 2005, at San Fracisco, California.
/s/ Edward O.C. Ord

16 17 18 19
T:\icnts\6932\eap\D1 Or Ops lD ConvercI

Edward O.C. Ord

20
21

n
:z
24

25 26
27

:i
8