Free Supplemental Brief - District Court of Federal Claims - federal

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IN THE UNITED STATES COURT OF FEDERAL CLAIMS ) ) ) ) ) ) ) ) ) ) ) ) ) )

MARRIOTT INTERNATIONAL RESORTS, L.P., MARRIOTT INTERNATIONAL JBS CORPORATION, Tax Matters Partner, Plaintiffs, v. THE UNITED STATES, Defendant.

Nos. 01-256T and 01-257T Judge Charles F. Lettow

PLAINTIFFS' SUPPLEMENTAL BRIEF REGARDING IMPLICATIONS OF REGULATION T

Harold J. Heltzer Robert L. Willmore Alex E. Sadler CROWELL & MORING LLP 1001 Pennsylvania Avenue, N.W. Washington, D.C. 20004 Tel: (202) 624-2915 Fax: (202) 628-5116

June 6, 2008

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TABLE OF CONTENTS PLAINTIFFS' SUPPLEMENTAL BRIEF REGARDING IMPLICATIONS OF REGULATION T.........................................................................................1 A. Defendant Argues That Regulation T Is Relevant To Whether The Obligation To Close A Short Sale Is A "Liability" Within The Meaning Of Section 752 Because Regulation T Requires That Collateral Be Maintained With The Broker-Dealer. For The Reasons Set Forth In Marriott's Reply, The Existence Of Collateral Has No Bearing On Whether The Obligation To Close A Short Sale Constitutes A "Liability" Under Section 752...........................................................................2 Regulation T Also Does Not Have Any Such Implications With Respect To The Existence Of A Section 752 "Liability" At The Time Of The Transfer Of The Obligation To The Partnership. ............................................4

B.

APPENDIX D 12 C.F.R. Part 220 (1994) (Regulation T).....................................................D-1

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TABLE OF AUTHORITIES CASES Kornman & Assocs., Inc. v. United States, No. 06-11422, slip op. (5th Cir. May 12, 2008).................................................................................. 5 Klamath Strategic Investment Fund, LLC v. United States, 440 F. Supp. 2d 608 (E.D. Tex. 2006)......................................................... 3-4 Klamath Strategic Investment Fund, LLC v. United States, 472 F. Supp. 885 (E.D. Tex. 2007), appeal pending, Nos. 07-40861 & 07-40915 (5th Cir.) ........................................................... 4 La Rue v. Commissioner, 90 T.C. 465 (1988) ..................................................... 4 STATUTES, REGULATIONS AND OTHER MATERIALS 15 U.S.C. § 78c .................................................................................................... 2 26 U.S.C. § 752 ...........................................................................................passim 26 U.S.C. § 1233 ............................................................................................... 5-6 Treas. Reg. § 1.1233-1(a)(1) ................................................................................ 4 12 C.F.R. Part 220 (Regulation T) ............................................................passim Rev. Rul. 95-26, 1995-1 C.B. 131........................................................................ 5 Rev. Rul. 95-45, 1995-1 C.B. 53................................................................... 5-6, 8 New York Stock Exchange Rule 431 .................................................................. 3 Charles F. Rechlin, Securities Credit Regulation (2d ed. 2007) (vol. 22 of West's Securities Law Series) .................................................... 2-3 Steven Lofchie, Lofchie's Guide to Broker-Dealer Regulation (2005) ............... 3

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IN THE UNITED STATES COURT OF FEDERAL CLAIMS ) ) ) ) ) ) ) ) ) ) ) ) ) )

MARRIOTT INTERNATIONAL RESORTS, L.P., MARRIOTT INTERNATIONAL JBS CORPORATION, Tax Matters Partner, Plaintiffs, v. THE UNITED STATES, Defendant.

Nos. 01-256T and 01-257T Judge Charles F. Lettow

PLAINTIFFS' SUPPLEMENTAL BRIEF REGARDING IMPLICATIONS OF REGULATION T Pursuant to this Court's Order of May 19, 2008, Plaintiffs Marriott International Resorts, L.P., Marriott International JBS Corp., Tax Matters Partner ("Marriott"), respectfully submit this supplemental brief regarding the implications of Regulation T (12 C.F.R. Part 220 (1994)).1 Specifically, the Court asked the parties to address the question of "whether Regulation T as it stood in 1994 has implications for the applicability of Section 752 to the transfer of the obligation to close the short sales pertinent to these cases." For the reasons set forth below, Marriott does not believe that Regulation T has any such implications.

1

In accordance with the Court's Order, all references to Regulation T are to the 1994 version of Regulation T, as published in the 1994 Code of Federal Regulations (1-1-94 Edition). For the Court's convenience, a copy of that version of Regulation T is attached at Appendix D.

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A.

Defendant Argues That Regulation T Is Relevant To Whether The Obligation To Close A Short Sale Is A "Liability" Within The Meaning Of Section 752 Because Regulation T Requires That Collateral Be Maintained With The Broker-Dealer. For The Reasons Set Forth In Marriott's Reply, The Existence Of Collateral Has No Bearing On Whether The Obligation To Close A Short Sale Constitutes A "Liability" Under Section 752. Defendant argued in its reply brief that Regulation T is relevant to the issue

before the Court on the ground that Regulation T requires that collateral be maintained with the broker-dealer while the short sale is outstanding. See Defendant's Reply, at 2, 4-5 & 17-18. Typically, this initial collateral includes the proceeds from the sale of the shorted securities plus an additional margin amount (the entire amount of the required collateral is referred to as the "margin requirement").2 With respect to short sales of nonexempted securities, the margin requirement is 150 percent of the current value of the security. 12 C.F.R. § 220.18(c). With respect to short sales of exempted securities ­ which includes securities issued by the Federal government (such as Treasury notes)3 ­ the margin requirement is 100 percent of the current value of the security plus an additional margin required by the broker-dealer in good faith. 12 C.F.R. § 220.18(d).

2

See generally Appendix B attached to Plaintiffs' Reply (Investopedia® article, "What are the minimum margin requirements for a short sale account?"). Regulation T (at 12 C.F.R. § 220.2(r)) refers back to the definition of "exempted security" found in section 3(a)(12) of the Securities Exchange Act of 1934 (15 U.S.C. § 78c(a)(12)). That definition includes "government securities," as defined in section 3(a)(42), which includes securities that are direct obligations of the United States. See generally Charles F. Rechlin, Securities Credit Regulation §§ 3:2 & 3:3 (2d ed. 2007) (vol. 22 of West's Securities Law Series).

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As discussed in Marriott's Reply (at 5-7), the margin requirement is not "fixed" (contrary to Defendant's contention), but fluctuates with the value of the shorted security subject to a "maintenance margin." This maintenance margin is not specifically addressed in Regulation T, but is established by the applicable Exchange rule, typically New York Stock Exchange Rule 431 ("NYSE Rule 431"). See generally Rechlin, Securities Credit Regulation §§ 3:32 & 3:33; Steven Lofchie, Lofchie's Guide to Broker-Dealer Regulation 564-65, 569, 589, 596 (2005).4 Accordingly, Defendant's contention that the amount of collateral that the broker-dealer holds pursuant to Regulation T is "fixed" is wrong. But even if Defendant were correct in this regard, the existence of collateral ­ in whatever amount ­ is ultimately irrelevant to whether the amount of the obligation is contingent. The amount of the pertinent obligation ­ that is, what it actually costs the short seller to fulfill the obligation to return the borrowed securities ­ simply cannot be determined until the short seller purchases the securities he must deliver to the broker-dealer in order to close the short sale. Until that event happens, the cost of closing the short sale by definition is contingent and undetermined, and the obligation thus cannot constitute a "liability" for purposes of Section 752. As also noted in Marriott's Reply, this is not the first time the Government has made this "collateral" argument in the context of what constitutes a "liability" under Section 752. The Government made a similar argument in Klamath

4

The actual operation of the maintenance margin can be complex. For illustrative examples, see Rechlin, Securities Credit Regulation § 3:38.

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Strategic Investment Fund, LLC v. United States, 440 F. Supp. 2d 608 (E.D. Tex. 2006), which the District Court there expressly rejected.5 Id. at 618 (noting that the reserve account in La Rue v. Commissioner, 90 T.C. 465 (1988), was the "functional equivalent" of collateral, and that the Tax Court nonetheless held that the obligation to correct the "back office" trading failures was too contingent to constitute a Section 752 liability). Accordingly, to the extent Defendant is arguing that Regulation T is relevant to the legal issue before the Court because the Regulation establishes a requirement that the broker-dealer maintain collateral while the short sale is outstanding, that requirement has no implications regarding whether or not the short seller's contractual obligation to close the short sale constitutes a "liability" for purposes of Section 752. B. Regulation T Also Does Not Have Any Such Implications With Respect To The Existence Of A Section 752 "Liability" At The Time Of The Transfer Of The Obligation To The Partnership. In its May 19, 2008, Order, the Court asks the parties to address whether Regulation T has any "implications for the applicability of Section 752 to the transfer of the obligation to close the short sales." As Marriott understands the question being posed, the Court is asking whether the requirement of Regulation T that the broker-dealer maintain collateral while the short sale is outstanding has
5

A description of the collateral in Klamath can be found in the District Court's 2007 Memorandum Opinion and Order after the trial of the economic substance issues. See Klamath Strategic Investment Fund, LLC v. United States, 472 F. Supp. 2d 885, 896-98 (E.D. Tex. 2007), appeal pending, Nos. 07-40861 & 07-40915 (5th Cir.).

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implications for the nature of the obligation to close the short sale at the time of the transfer of that obligation by the partner, Marriott Ownership Resorts, Inc. ("MORI"), to the partnership, Marriott International Resorts, L.P. ("MIR").6 Marriott does not believe that Regulation T has any implications with respect to Section 752 in that regard. As the Court is aware, since 1995, the Internal Revenue Service ("IRS") has taken the position in its revenue rulings that, not only is the obligation to close a short sale a "liability" within the meaning of Section 752, but that the amount of that "liability" is determined at the time of the short sale of the borrowed securities; that is, the Section 752 "liability" equals the amount of proceeds obtained by the short seller from selling the borrowed securities. While this latter position is implicit in Rev. Rul. 95-26,7 the IRS expressly stated this position in Rev. Rul. 9545. See Rev. Rul. 95-45, 1995-1 C.B. 53 (dealing with short sale obligation assumed by a corporation); Kornman & Assocs., Inc. v. United States, No. 06-11422, slip op. at 23-24 & 26 n.17 (5th Cir. May 12, 2008) (applying holding of Rev. Rul. 95-45 to determine amount of short sale "liability" assumed by partnership).8 Thus, for

6

Technically, this transfer occurred in the form of an assumption of the obligation by MIR. As noted at the May 19, 2008, hearing, there is no reference to Regulation T in Rev. Rul. 95-26, 1995-1 C.B. 131. However, in order to comply with Code section 1233 and Treas. Reg. § 1.12331(a)(1), which provide that recognition of gain or loss from a short sale transaction is determined at the time the short sale is closed, some basis adjustment is then presumably made at the time the short sale is closed under which the amount of the Section 752 "liability" established under Rev. (continued...) 5

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purposes of determining the amount of the purported Section 752 "liability," Defendant looks to the time of the short sale of the borrowed securities rather than to the time of any subsequent transfer of the obligation to close that short sale. With respect to the time of MORI's transfer to MIR of the obligation to close the Treasury Note short sales, Regulation T does not have any implications for the Section 752 analysis that are pertinent to this case. Regulation T merely requires that the broker-dealer (here CS First Boston) maintain adequate collateral in a margin account to protect itself in the event of a default by the investor. For that purpose, the broker-dealer receives a security interest in the collateral being maintained in the margin account.9 There is no indication whatsoever that this security interest was affected by MORI's contribution of the short sales proceeds to (continued) Rul. 95-45 apparently becomes irrelevant. This adjustment, however, is not explained by the IRS and directly contravenes Section 1233, which provides that recognition of gain or loss from a short sale transaction is determined at the time the short sale is closed.
9

This security interest is described in the "Terms of Agreement" on the backs of the CS First Boston trading confirmation statements. For example, see page MAR-008546 in Defendant's Exhibit 13 appended to the Second Declaration of G. Robson Stewart, dated April 18, 2008. Paragraph 7 of the "Terms of Agreement" provides in pertinent part: Customer hereby grants to each FBC party a security interest in all securities, moneys or other property, and all proceeds of any of the foregoing, now or hereafter held or carried by any FBC Party in Customer's account(s) with any FBC Party or otherwise as collateral security for the payment of any and all obligations and liabilities of Customer and its subsidiaries to any FBC Party now existing or arising hereafter. "FBC" refers to The First Boston Corporation, which was subsequently renamed CS First Boston Corporation.

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MIR or by MIR's assumption of the obligation to close the short sales. To the contrary, during this entire time period (both before and after the contribution and assumption), CS First Boston continued to reinvest those proceeds in 30-day Repos. See Plaintiffs' Response to Defendant's Proposed Findings of Uncontroverted Facts, at 6 (no. 12), dated March 27, 2008. These Repos were ultimately used to purchase the replacement Treasury Notes that were returned to CS First Boston to close the short sales. See id. at 8-9 (no. 23). In addition, CS First Boston clearly was aware of and approved MORI's transfer of the obligation to close the short sales to MIR. See Defendant's Exhibit 5 appended to Declaration of G. Robson Stewart, dated February 1, 2008.10 At the May 19, 2008, hearing, the Court raised the issue of whether Regulation T required the short sales proceeds to be transferred by MORI to MIR when MIR assumed the obligation to close the short sales. While Marriott believes that it was entirely logical to transfer the short sales proceeds to MIR in conjunction with MIR's assumption of the obligation to close the short sales,11 there does not

10

Defendant's Exhibit 5 is a countersigned June 24, 1994, letter agreement between CS First Boston and Marriott. The first paragraph of the letter agreement states in pertinent part as follows: "The Company [MORI] has hedged approximately $65 million of MORI Notes in 1994 (the `Transaction'). We [CS First Boston] understand that subsequent to entering into the hedge the Company assigned its interest in the Transaction to an affiliated partnership (the `Partnership')." The referenced partnership is MIR. As noted by Marriott's counsel at the hearing, the proceeds were part of the interest rate hedge. That is, by transferring the proceeds to MIR (along with the mortgages and the obligation to close the short sales), the entire hedge as a unit was transferred from MORI to MIR. As an economic matter, Marriott (continued...) 7

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appear to be anything in Regulation T that specifically requires that result.12 As long as the collateral remains in the margin account (which it did), and the brokerdealer is protected through its security interest in the collateral (which it was), the requirements of Regulation T are satisfied.13 In sum, while Regulation T required CS First Boston to maintain collateral with respect to the Marriott short sale transactions, that requirement had no implications with respect to the Court's analysis of whether the obligation to return the borrowed Treasury Notes to CS First Boston was a "liability" within the meaning of Section 752. For the reasons set forth in Marriott's opening and reply briefs, because that obligation was contingent in amount, it could not be considered a "liability" under that provision.

(continued) believes that it made a great deal of sense, and was certainly reasonable, to transfer the hedge in its entirety rather than keep part of the hedge in one entity and the rest of the hedge in another entity.
12

The IRS appears to have a similar view, based on Rev. Rul. 95-45. In that ruling, the IRS dealt with the transfer of short sale proceeds (from a short sale of "XYZ securities") and the obligation to close the short sale by a parent corporation ("P") to a wholly owned subsidiary corporation ("S"). Although P had deposited additional cash as further collateral with the broker-dealer (presumably in compliance with the 150 percent margin requirement in Regulation T), it did not transfer this additional cash to S when it transferred the short sale proceeds and the obligation to close the short sale to S. While the collateral thus was split between P and S, the IRS did not see this as presenting an issue in Rev. Rul. 95-45. In that regard, Marriott assumes that CS First Boston, as a large and sophisticated broker-dealer, fully understood its margin obligations under Regulation T and complied with those obligations.

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Respectfully submitted, June 6, 2008 s/Harold J. Heltzer Harold J. Heltzer (Attorney of Record) Robert L. Willmore Alex E. Sadler CROWELL & MORING LLP 1001 Pennsylvania Avenue, N.W. Washington, D.C. 20004 Tel: (202) 624-2915 Fax: (202) 628-5116 Counsel for Plaintiffs

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Appendix D

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