"No Ascertainable Value" Struck Down in Kimberlin

IKimberlin & Steele, et al., 128 T.C. No. 13 (May 8, 2007) addresses the appropriate valuation of warrants.

On November 9, 1993 Ciena Corp. (Ciena) entered into a private placement agreement (1993 PPA) with Spencer Trask Ventures (Ventures), an investment banking firm, making Ventures the preferred-stock placement agent for Ciena. Ciena broke the agreement, and a dispute arose that was settled in 1995. As part of the settlement, Ciena issued Ventures warrants to purchase shares of Ciena preferred stock, which were exercised by Ventures in 1997.

The Commissioner of the Internal Revenue (Respondent) claimed that the income generated from the exercise should have been taxable in 1997. The Court held against the IRS and found that the warrants were taxable in 1995, the year granted, because they had an "ascertainable fair market value" at that time..

BACKGROUND

Ciena Corp., a telecommunications corporation formed in 1993, entered into a business relationship with Kevin Kimberlin (Mr. Kimberlin), an investment banker who owned 87 percent of Spencer Trask & Co., the parent company of Ventures. Ciena needed financing and planned several private stock offerings, as well as a subsequent IPO. Mr. Kimberlin, through his wholly owned investment company INNO Co., provided Ciena with $190,000 in seed capital and a $300,000 line of credit following a stock subscription agreement.

Ciena entered into an exclusive private placement agreement (PPA) with Ventures on November 9, 1993. The 1993 PPA stated that Ventures would try to raise $3 to $5 million on a "best efforts" basis in a private placement of Ciena stock. In exchange, Ventures would be paid a cash commission equal to 10 percent of capital raised. Ventures would also be issued warrants to purchase a certain number of shares based on the number of shares sold in the offering. The warrants were exercisable at $5 a share for a period of five years.

The 1993 PPA was amended on April 8, 1994, along with the 1994 PPA, to allow another investment firm to serve as the placement agent for Ciena’s Series A convertible preferred stock, while Ventures would serve as the agent for Ciena’s Series B offering. The amended agreement also stated that if Ciena did not proceed with the offering, it would issue Ventures a warrant to purchase up to 150,000 shares of Series A Preferred at a price of $1 a share, exercisable in three years or upon the occurrence of Ciena’s IPO, whichever came first.

Ciena later decided not to use Ventures as the placement agent for its Series B offering. Instead, Ciena successfully sold its stock through direct sales to institutional and individual investors, failing to adhere to the 1994 PPA and leaving Ventures unable to perform any of its agreed-upon services for Ciena. For its failure to use Ventures as placement agent, Ciena offered reparations equal to those determined by the "liquidated damages" clause in the 1994 PPA.

Ciena terminated the 1994 PPA on December 21, 1994 and granted Ventures a warrant for 150,000 shares of Series A convertible preferred stock. However, a dispute arose between the parties, with Ventures claiming that Ciena was liable for full compensatory damages, rather than just the "liquidated damages" due to the breach of the 1994 PPA. On February 10, 1995 the parties signed a settlement and release agreement (SRA) that allowed the issuance of warrants to Ventures exercisable for 300,000 shares of Series B convertible preferred stock at $2 per share. The exercise period would be the earliest of three events: (1) four years from the date of issue date, (2) the consummation of a public offering for Ciena stock, or (3) the sale of all or substantially all of the company’s assets. Ciena would also pay Ventures’ legal fees, and Ventures would acquit Ciena from any claims or causes of action.

At the execution of the SRA, Ventures designated the warrants to purchase 250,000 shares to Mr. Kimberlin, 45,000 shares to Spencer Trask and the remaining 5,000 shares to another interested party.

On June 25, 1996, at the request of Mr. Kimberlin, Ciena reissued his warrants to Kevin Kimberlin, Ltd., a TEFRA partnership in which Mr. Kimberlin is the general partner and the remaining interests are held by entities owned by Mr. Kimberlin.

Following a 5-for-1 split in February 1997, the existing warrants were converted to a warrant to purchase 1,500,000 shares at 40 cents each. The parties exercised all the warrants on February 5 – when Ciena was trading at an average of $29.30 – with a payment totaling $600,000 to Ciena.  When Ciena held its IPO on February 17, 1997, Ciena common sold for a mean price of $35.68, an enormous windfall for Mr. Kimberlin.

The Tax Return

On its original 1995 return, Spencer Trask did not report income from the receipt of the warrants.  No income from the exercise of the warrants was reported on the 1997 return either. However, in March 1998, Spencer Trask filed an amended return for 1995 and reported $13,500 in income resulting from receipt of the warrants. On February 16, 2005, the Respondent mailed a notice of deficiency to Spencer Trask, claiming that, pursuant to Sections 83 & 61, the warrants received by Spencer Trask resulted in $43,950,000 of taxable income for 1997, the year the warrants were exercised. The Respondent also issued a deficiency notice adding $36,625,000 to Mr. Kimberlin’s personal income.

On December 27, 2004, Mr. & Mrs. Kimberlin filed a petition with the Court seeking review of the 2004 notice of deficiency. The same day, Kevin Kimberlin, tax matters partner for Kimberlin Partners, filed a petition seeking review of the respondent’s notice of final partnership administrative adjustment (FPAA). On May 13, 2005, Spencer Trask filed a petition with the Court for the review of the 2005 notice of deficiency. The Court agreed on September 23, 2005 to consolidate these cases.

DECISION

Several questions were left to the Court’s discretion:

• Were the warrants issued to Ventures in accordance with the settlement and release agreement transferred "in connection with the performance of services" issued to constitute taxable income pursuant to Section 83?
• What year did the warrants have a readily ascertainable fair market value; in 1995, on the date of grant, or in 1997, the year of exercise?
• Did the payment to Mr. Kimberlin via the warrants transferred to him by Spencer Trask constitute a constructive dividend, return of capital or capital gain?

The Court found that Ventures was prevented, by virtue of Ciena’s breach, from performing its services and that the warrants were issued to Ventures following the SRA, making Section 83 inapplicable because there was no connection between issuing the warrants and performing any services. In addition, the Court found that any liquidated damages clauses in the PPA were severed by the SRA, which superseded the PPAs. Because Section 83 is not applicable, the Court found that the transferred warrants are taxable in the year of the grant if they had an ascertainable market value at that time.

The Respondent’s expert testified that the warrants for Ciena stock had no ascertainable fair market value on the date granted because he could not determine an "intrinsic value" for the warrants. The IRS’ expert inexplicably insisted that the 7,354,092 shares of Series B stock Ciena sold in 1994 and 1995 for $1.50 were not pertinent in determining fair market value. The Court held that the Respondent’s expert’s testimony was "inconsistent, confusing, and unconvincing." The expert inaccurately stated his credentials, repeatedly contradicted himself and insisted that errors in his report were the fault of his "editor." His testimony relied on two textbooks, both of which were out of print.

The Court agreed with the taxpayers’ expert, who determined a fair market value for the warrants. Unlike the IRS expert, his analysis considered the 7,354,092 shares of Series B stock Ciena sold in 1994 and 1995 for $1.50 a share. The expert concluded, after applying acceptable valuation techniques, that the warrants had a fair market value   of 90 cents a share when granted. He came to this conclusion by applying venture capital benchmark rates of return, which the Court found "prudent." Given the ascertainable fair market value for the warrants on the date of grant, their value was taxable in 1995, and the Respondent erred in determining a deficiency when the warrants were exercised in 1997.

Finally, pursuant to Section 61(a) (7), gross income includes dividends. As defined in Section 316(a), a "dividend" is a "distribution of property by a corporation to its shareholders out of its earnings and profits." Finding that Mr. Kimberlin received the warrants as a distribution from Spencer Trask, the Court ruled with the petitioners because it was determined that the warrants had an ascertainable fair market value at the time of distribution, making them taxable income to Mr. Kimberlin upon receipt in 1995.

PLURIS COMMENTARY

This case is a reminder that quality valuation advice can make a difference, even when the argument is not solely over the multiples applied or the magnitude of a discount. Nevertheless, the decision in Kimberlin seems to be logical enough to raise the question why the Service even bothered to make its argument. It is well established that illiquid securities have ascertainable values – and the IRS argues very large values for illiquid shares every day of the year!  The Service’s argument in Kimberlin comes off as a desperate attempt to extract more taxes from the plaintiff than were owed.