The Venerable Firms Behind SantaMonica Pictures

By Darryll K. Jones

The saddest and most frustrating aspect of SantaMonica Pictures LLC v. Commissioner is not that theopinion is 322 pages long with 227 footnotes.1 It is noteven that the opinion, despite its overwhelming verbos-ity, provides scant precedential guidance given the in-credible stupidity of some allegedly smart people. It isinstead that the opinion represents a painstakingly de-tailed record of moral and ethical breakdown amongleaders and well-heeled members of our tax profession.In fact, representatives of nearly every sector of the taxprofession have some responsibility for Santa MonicaPictures’ sordid story of arrogant greed and laughingirresponsibility. Those include Harvard Law School, theU.S. Tax Court, the IRS, accounting firm Grant Thornton,and, most especially, such ‘‘venerable’’ law firms asO’Melveny & Meyers; White & Case; Shearman & Ster-ling; Chamberlain, Hrdlicka, White, Williams & Martin;and Kaye, Scholer, Fierman, Hayes & Handler. Afterreading the opinion, the rest of us ought to resolve onceand for all that tax sheltering is theft, pure and simple,despite the white-collar professionals who perpetuate thepractice. Those who practice in tax shelters are involvedin a conspiracy to steal and Santa Monica Pictures repre-sents the worst kind of attempted grand theft. If you areone of those members of our profession who likes topontificate about ‘‘business purpose’’ and ‘‘step transac-tions’’ without naming the polite perpetrators who makesuch sophistry as ‘‘substance over form’’ worth talkingabout, you probably should not read this month’s col-umn.2 The Santa Monica perpetrators, named in the

opinion and in this column, were absolutely adept at thepractice of smoke and mirrors and at the same time soobviously and transparently corrupt. Even those praisedfor their ‘‘credibility’’ were complicit in the scheme.Sadly, those suspects may well represent living meta-phors for the entire profession.

Last week, by the way, I was riding a bus to work fromone of the Pittsburgh city suburbs when a young,disheveled-looking man boarded and actually asked thedriver for a free ride into the city. ‘‘You don’t go into astore and ask for free stuff, do you?’’ replied the busdriver rather indignantly. Santa Monica Pictures is differ-ent only in that it involves well-groomed ‘‘free-riders’’who didn’t even bother to ask. They just tried to takewhatever they wanted and to do so as if they werethoroughly entitled. The basic transaction was as fol-lows.3 Credit Lyonnais owned Metro-Goldwyn-Mayer(MGM) when MGM was losing money hand over fist.Credit Lyonnais obtained its MGM stock after MGMdefaulted on loans made by Credit Lyonnais. MGM stillowed Credit Lyonnais $1 billion. MGM’s fixed assetswere a bunch of really bad movies with a combined basisof $665 million. The movies had literally been rottingaway in an old warehouse and were later stuffed intoMGM to make it look like a going concern. Because theassets (the movies and MGM’s debt) were virtuallyworthless, given MGM’s near insolvency, Credit Lyon-nais essentially held a $1.6 billion tax deduction waitingto be recognized. Credit Lyonnais wanted to sell MGMand liquidate the $1 billion note for whatever it could get.An outright sale would have resulted in a nearly $1.6billion loss. Along comes Perry Lerner, a Harvard-trained‘‘tax lawyer,’’ according to the court. Lerner clerked forJudge Raum, worked in Treasury’s Office of InternationalTax Counsel, and headed up O’Melveny & Meyers’sLondon office in the late ’80s and early ’90s. After hearingwhat the court had to say about Lerner, one can onlywonder which of Lerner’s characteristics helped him getto those venerable institutions.

Lerner may have actually been looking for a legitimateinvestment for his client, Peter Ackerman, when heconducted a due diligence review of MGM. What hefound, though, was a memorandum from the venerablelaw firm of Kaye Scholer. The memorandum laid out instraightforward detail, as if describing a chili recipe, thesteps that should be taken, not to structure a sale in the

1T.C. Memo 2005-104, Doc 2005-10308, 2005 TNT 91-12 (May 11,2005). The decision is also posted on the Tax Court Web site athttp://www.ustaxcourt.gov/InOpHistoric/Santamonica.TCM.WPD.pdf.

2For a more polite discussion of Santa Monica Pictures, LLC v.Commissioner, one that doesn’t sufficiently name names in-volved in bad behavior, see Mark Leeds, ‘‘The Pendulum

Swings Back: IRS Successfully Challenges Loss Shifting in SantaMonica Pictures,’’ Tax Notes, June 27, 2005, p. 1669.

3As the Tax Court noted, changes made by the American JobsCreation Act of 2004, P.L. 108-357, destroy the tax shelter effectsought to be exploited in Santa Monica Pictures. See sections704(c)(1)(C), 743(a), (d)-(e) (2004).

Darryll K. Jones is associate dean and associateprofessor of law at the University of Pittsburgh Schoolof Law. K Rations is a monthly column devoted topartnership tax issues.

edited by Robert J. Wells

(Footnote continued in next column.)

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most efficient manner (buyer gives money to seller, sellergives property to buyer), but to hide the true nature ofMGM’s fire sale so the buyer could claim $1.6 billion inunwarranted losses. Money for nothing, that’s what KayeScholer offered. Instead of a straight sale, Credit Lyonnaisshould ‘‘contribute’’ the MGM stock and the $1 billionnote to a partnership. Under section 721, Credit Lyonnaiswould take a high, substituted outside basis for a part-nership interest that was worth nearly nothing. Thepartnership, too, would have a high inside basis fornearly worthless assets, meaning that the loss realized byCredit Lyonnais on the later ‘‘coincidental’’ sale of itspartnership interest could be cloned for use by the buyer.That is, of course, in the absence of a section 754 election.Credit Lyonnais would then sell its partnership interestto a loss-hungry investor who, quite coincidentally mindyou, would not insist on a section 754 election. On thepartnership’s later sale of the assets, the cloned losswould flow through to the investor.

Kaye Scholer proposed that plan apparently withoutreference to Lerner’s client, Peter Ackerman. Lerner,though, informed Ackerman of the plan and set abouttaking advantage of the opportunity to get money fornothing. Credit Lyonnais, desperate to dump the lousymovies and bad loan, played along quite willingly. CreditLyonnais was advised by Sean Geary, a partner in thevenerable law firm of White & Case. The Tax Court’spraise of Geary, despite his complicity in the scheme,reminded me of the statement concerning honor amongthieves, particularly as that honor compares to virtueamong workers in the world’s oldest profession. In anyevent, the transaction closed just as described: CreditLyonnais contributed the built-in loss assets to SantaMonica Pictures, LLC (SMP) and then sold its interest toAckerman for $10 million; Credit Lyonnais realized the$1.6 billion loss. Ackerman ended up with an interest ina partnership that, in turn, had $1.6 billion in clonedlosses waiting to be allocated to Ackerman. Ackerman, ofcourse, still had $1.6 billion, minus $10 million andwhatever handsome fee he paid to Lerner. He wascertainly not $1.6 billion poorer.

‘‘But these losses were not enough’’ for Lerner.4 Hewas also a board member of Imperial Inc., a firm thatexpected sizable capital gains and desperately wanted toshirk its own civic duty. So Lerner offered Imperial thesame money-for-nothing scheme. In a strange dance ofconflicting interests, Lerner advised Imperial to invest$14.5 million in Corona, another loss partnership inwhich Lerner held an interest, and thereby obtain theapproximate $80 million loss it needed to shelter theexpected gain. Imperial agreed. Thus, SMP ‘‘contributed’’some of the built-in loss assets to Corona and thenpromptly sold its high-basis, low-value partnership in-terest in Corona to Imperial for $14.5 million. SMPrecognized and passed its ‘‘loss’’ from the sale to Acker-man. Corona did not have a section 754 election in effect.SMP’s recognized loss duplicated the loss actually sus-tained by Credit Lyonnais when it sold its SMP partner-ship interest. Corona promptly sold the built-in loss

assets to a friend of Lerner’s — someone who never reallypaid the sale price, by the way5 — and recognized thesame loss a third time. This was no ordinary case ofdouble dipping, this was triple dipping. Pigs turn intohogs and hogs get slaughtered!

The IRS issued a notice of deficiency disallowing thecloned losses. Lerner must have been thoroughly indig-nant as he explained with straight face to the IRS and theTax Court that the transaction was legitimate, that Ack-erman and Credit Lyonnais really wanted to be in themovie business together, and that Imperial thought buy-ing worthless paper for $14.5 million was a wise businessmove. After all, Lerner had memoranda from GeraldRokoff and Alvin Knott, both of the venerable law firm ofShearman & Sterling. Those two former partners of thevenerable accounting firm of KPMG6 flat-out concludedthat the purported contribution, double- and triple-dipping would be respected, and that the transactionwould not be recharacterized as a straight sale. The courtnoted rather charitably that the memoranda were not somuch an objective analysis but instead an advocacy forLerner’s scheme. Rokoff and Knott knew the particularsof the transaction and yet their memoranda, according tothe court, were based on ‘‘faulty’’ and ‘‘dubious’’ factsand assumptions. In any event, the memoranda toldLerner exactly what he wanted to hear. HowardLevinton, of the venerable accounting firm Grant Thorn-ton, likewise came to the same conclusion as Rokoff andKnott. In fact, Levinton’s memorandum relied in part onRokoff and Knott’s memoranda. Levinton concluded thatdespite the facts that Credit Lyonnais sold its partnershipinterest just days after becoming a partner, that Acker-man purchased Credit Lyonnais’s interest using funds setaside and fully secured for that purpose before SMP’sformation, and that Geary insisted that the purchaseprice be set aside and fully secured before SMP’s forma-tion, no court would conclude or even imagine thatCredit Lyonnais never intended to be Ackerman’s part-ner. The venerable law firm of Chamberlain Hrdlickagave Lerner further reason for confidence. Its 19-pageopinion letter contained 11 pages of historical facts, 6pages of disclaimers, 42 factual assumptions, and finallythe all-important conclusion that the double- and triple-dipping was all hunky-dory. Lerner need only have readthe last page to find the language he hoped for and thenpay Chamberlain Hrdlicka a handsome fee. It would nothave mattered had he not done so, because the opinionletter contained no legal analysis and not a single citationto a subchapter K provision.

Chamberlain Hrdlicka not only wrote the opinionletter, it also represented Lerner as he testified that hisclient really and truly sought to acquire the movie rights,not just the built-in losses, and really and truly sought tobe a partner with Credit Lyonnais. Lerner testified that hewas surprised that Credit Lyonnais sold its partnershipinterest so soon after the deal closed, leaving Lerner and

4The court’s words, not mine.

5The ‘‘purchase price’’ was paid and then funneled back toLerner’s friend through another phony sale. Sheeesh!

6Never mind.

COMMENTARY / K RATIONS

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his client holding $1.6 billion in deductible losses. Cham-berlain Hrdlicka must have surely winced when it readthe court’s characterization of its client’s testimony as‘‘self-serving,’’ ‘‘contrived,’’ ‘‘ultimately not credible,’’‘‘implausible,’’ and ‘‘absurd.’’ The court had good reasonfor using words that come so close to ‘‘liar.’’ For reasonsknown best to litigators whose witnesses have somethingto hide, Chamberlain Hrdlicka called none of the opinionletter authors to the stand. That left Lerner’s ‘‘self-serving, contrived, incredible, implausible, and absurd’’testimony subject to easy impeachment. Geary did justthat. He testified that Credit Lyonnais had no intention ofever being a partner. Credit Lyonnais wanted only to sellits interest in MGM and the $1 billion note for whateverfew pennies on the dollar it could. Strangely, the TaxCourt appeared to go out of its way to praise Geary,calling his testimony ‘‘exceptionally credible, thoroughand persuasive.’’ One really has to wonder. If Geary, aformer Air Force captain, had kindly cooperated with atwo-bit burglar seeking an open window through whichto burglarize a house, would he have been praised if helater testified candidly and persuasively that the defen-dant was the person he helped climb through the openwindow?

Our profession is in a pretty sad statewhen we start praising those whodon’t stink as badly as the peoplenext to whom they are standing.

What is to be learned from this sad and sordid affair?Obviously the Harvard-trained, well-traveled, and well-credentialed Lerner comes out smelling like anything buta rose. Geary, Rokoff, Knott, and Levinton might evensmell more like roses standing next to Lerner, given ourgreatly degraded olfactory-ethical senses. I checked eachof the venerable firms’ Web sites and they all talk aboutthe big cases and the dedicated service they provide onbehalf of their clients. None of them mention SantaMonica Pictures. Perhaps their Webmasters have just notgotten around to updating the Web sites yet. We couldpose a question about a tax adviser’s ethical obligation torefrain from knowingly assisting a client’s deliberatemisrepresentations to the tax collector, or the court forthat matter. That seems too easy and besides, 42 factualassumptions provide plenty of sand in which to stickone’s big head. A really interesting question would bewhether a seller’s counsel has an obligation to refrainfrom assisting a buyer’s counsel in a deliberate effort tostructure a disguised sale. Geary, you will recall, waspraised even though he must have surely known whatLerner was up to and willingly played along. MaybeGeary’s participation in the disguised sale was the onlyway to help his client sell the worthless assets. Shouldthat excuse his complicity and warrant the court’s praise?Our profession is in a pretty sad state when we startpraising those who don’t stink as badly as the peoplenext to whom they are standing.

In any event, I consulted all the ethical rules, includingCircular 230 and the Model Rules of Professional Con-duct, to see if there were any answers. I talked with

Donald Tobin, a law professor at Ohio State Universitywho is writing a book on tax ethics. He found thequestion, particularly concerning Geary’s actions, in-triguing enough that he intends to include it — withoutnaming the venerable players, I imagine — in his book.Not surprisingly, there is enough gray matter in ourethics provisions to allow even those whose opinionletters were so obviously wrong to defend and justifytheir behavior. The only saving grace about all of this isthat the tax provisions sought to be exploited in SantaMonica Pictures are so obscure, and the opinion so pain-fully long, that ordinary and even learned people willnever know just how low our standards have become. Weand our venerable firms and institutions should bethankful for that.

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