                       T.C. Memo. 2005-104



                     UNITED STATES TAX COURT



 SANTA MONICA PICTURES, LLC, PERRY LERNER, TAX MATTERS PARTNER,
   Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent

CORONA FILM FINANCE FUND, LLC, PERRY LERNER, TAX MATTERS PARTNER,
   Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent


     Docket Nos. 6163-03, 6164-03.*     Filed May 11, 2005.


     George W. Connelly, Jr., Linda S. Paine, and Phyllis Ann

Guillory, for petitioner.

     James P. Thurston, H. Clifton Bonney, Jr., and Kenneth C.

Peterson, for respondent.




     *
       Petitioner in docket No. 6163-03 is Santa Monica Pictures,
LLC (SMP), Perry Lerner, Tax Matters Partner. Petitioner in
docket No. 6164-03 is Corona Film Finance Fund, LLC (Corona),
Perry Lerner, Tax Matters Partner. By Order dated Jan. 16, 2004,
we consolidated these cases for purposes of trial, briefing, and
opinion. References to petitioner in this opinion are to Perry
Lerner in his capacity as tax matters partner of SMP and Corona.
                               - 2 -

TABLE OF CONTENTS

FINDINGS OF FACT     .......................................    13

I.     The Ackerman Group .................................     13

       A.   Perry Lerner ...................................    13
       B.   Peter Ackerman .................................    14
       C.   Somerville S Trust .............................    15
       D.   Rockport Capital, Inc. .........................    16
       E.   Rockport Advisors, Inc. ........................    16
       F.   Crown Capital Group ............................    16

II.    The Credit Lyonnais Group ...........................    17

       A.   Credit Lyonnais .................................   17
       B.   Consortium de Realisation .......................   18
       C.   Generale Bank Nederlands ........................   19

III.   Metro-Goldwyn-Mayer, Inc. ...........................    19

       A.   History of MGM Before 1990 ......................   19
       B.   Pathe Acquisition of MGM ........................   20
       C.   Sealion Corp. ...................................   20
       D.   Cashflow Problems of MGM-Pathe ..................   21
       E.   Facility Agreements with CLBN ...................   22
       F.   Credit Lyonnais Takes Control of MGM ............   23
       G.   1993 Financial Restructuring ....................   26
       H.   Carolco Pictures, Inc. ..........................   29
       I.   Sealion Settlement .............................    33
       J.   Credit Lyonnais Decides to Sell New MGM .........   33

IV.    Safari Acquisition Co. ..............................    34

       A.   The Safari Consortium ...........................   34
       B.   Safari Indicates Its Interest In New MGM ........   35
       C.   Investigation of MGM ............................   36
       D.   Kerkorian Moves In and Buys MGM .................   38
       E.   Debt Release and Assumption Agreement ...........   39
       F.   Subparticipation Agreement ......................   40
       G.   Dissolution of MGM Holdings and Formation
            of SMHC .........................................   41

V.     The CDR Transaction .................................    41

       A.   Initial Contact with Mr. Jouannet ...............   41
       B.   Negotiation and Drafting Process ................   43
                                 - 3 -

             1.   Rockport Capital Confirms Its Interest ......   43
             2.   Draft Term Sheet and Letter Agreements ......   44
             3.   Further Negotiation and Drafting ............   48
             4.   Santa Monica Pictures, LLC, is Formed .......   49

        C.   Final Agreements and Documents ..................    49
             1. Side Letter Agreement .......................     49
             2. Exchange and Contribution Agreement .........     51
             3. SMP LLC Agreement ...........................     53
                 a. Amendment No. 1 .........................     55
                 b. Amendment No. 2 .........................     55
             4. Deposit Account Agreement ...................     57
             5. Advisory Fee Agreement ......................     57
             6. Consent .....................................     58
        D.   Assignment to Santa Monica Finance, B.V. ........    58
        E.   Exercise of the Put .............................    59

VI.     Film Rights Contributed to SMHC .....................     59

        A.   Film Titles and Development Projects ............    59
        B.   History of the EBD Film Library .................    61
             1. Epic Productions ............................     61
             2. EBD (Rotterdam) Finance, B.V. ...............     62
             3. Selection of Film Titles for CDR ............     62
             4. Assignments Before the Contributions
                 to SMHC .....................................    63
             5. Storage Conditions of the EBD Film
                 Library .....................................    64

VII.    Due Diligence for the CDR Transaction ...............     65

        A.   James Rhodes ....................................    65
        B.   Troy & Gould ....................................    67
             1. Chain-of-Title and Record Search ............     67
             2. Access Letters ..............................     69

VIII.   Other Film Activities ...............................     70

IX.     Relationship with TroMetro Films, LLC ...............     71

        A.   John H. van Merkensteijn ........................    71
        B.   TroMetro Films, LLC .............................    71
        C.   TroMetro’s Purchases of SMP’s Receivables .......    72
             1. First Note Purchase Agreement ...............     72
             2. Second Note Purchase Agreement ..............     74
             3. Purchase Price Determinations ...............     75
             4. Payments on the TroMetro Notes ..............     75
                                 - 4 -


X.      Distribution Agreements .............................     76
        A. The TroMetro Distribution Agreement .............      76
        B. The Troma Distribution Agreement ................      77
        C. Troma Entertainment, Inc. .......................      77
        D. Troma’s Distribution of the EBD Film Library ....      78
            1. Distribution History ........................      78
            2. Distribution Revenue and Expenses ...........      79

XI.     Transactions with Imperial Credit Industries, Inc. ..     80

        A.    Imperial Credit Industries, Inc. ................   80
        B.    Shopping for Tax Deals ..........................   81
        C.    Proposed Transaction with SMP ...................   82
        D.    Proposed Transaction with Corona ................   84
              1. Formation of Corona Film Finance
                  Fund, LLC ...................................   84
              2. The Corona Transaction ......................    85
              3. Initial Purchase of SMP’s Interest
                  in Corona ...................................   88
              4. Additional Purchase of SMP’s Interest
                  in Corona ...................................   89
              5. Sale of the $79 Million Receivable ..........    91
              6. Imperial’s Capital Contribution ..... .......    92
              7. Treasury Bills ........................ .....    93

XII.     Subsequent Transactions Involving TroMetro
         and Troma ..........................................     93

         A.   Capital Contribution Agreement .................    93
         B.   Assumption Agreement ...........................    94
         C.   Transfer and Assignment of the Carolco
              Securities .....................................    94
         D.   SMHC and Troma Merger ..........................    94
              1. SMHC Merges into Troma .....................     94
              2. SMHC’s Dissolution .........................     95
              3. Tax Return Treatment of the Transaction ....     95
              4. Termination of the Distribution
                  Agreements .................................    96
         E.   Letter Agreement with TroMetro .................    97
         F.   Troma Finance, LLC .............................    97

XIII.    Business Characteristics of SMP, Corona, and SMHC ..     98

         A.   SMP ............................................    98
         B.   Corona .........................................    99
         C.   SMHC ...........................................    99

XIV.     Partnership Tax Returns ............................     99
                                  - 5 -


          A.   SMP ............................................    99
          B.   Corona .........................................   101
          C.   Mr. and Mrs. Ackerman ..........................   101

XV.       Notices of Final Partnership Administrative
          Adjustments ........................................    103

          A.   SMP ............................................   103
          B.   Corona .........................................   104

OPINION    ...................................................    105

I.        Partnership Tax Rules   .............................   108

          A.   In General .....................................   108
          B.   Claimed Application of Partnership Tax Rules ...   112

II.       Burden of Proof ....................................    113

III.      Economic Substance .................................    115

          A.   Parties’ Contentions ...........................   115
          B.   General Legal Principles .......................   117
          C.   Summary of Conclusions .........................   120
          D.   Subjective Business Purpose ....................   121
               1. Banks’ Purposes ............................    122
                   a. Banks’ Prior History With
                       Film Business ..........................   125
                   b. Banks’ Regulatory Environment ..........    128
                   c. Why the Ackerman Group? ................    128
                   d. Inattention to Film Rights in
                       Negotiations ...........................   129
                   e. Selection of EBD Film Rights ...........    130
                   f. Conclusion .............................    131
               2. Ackerman Group’s Purposes ..................    131
                   a. Mr. Lerner’s and Mr. Ackerman’s
                       Backgrounds ............................   132
                   b. Focus on Tax Attributes ................    134
                   c. Nature of EBD Film Rights ..............    135
                   d. Purported Interest in CDR Library ......    145
                   e. Purported Springboard for New Library ..    147
                   f. Acquiring NOLs for a Film Business .....    147
                   g. Contemporaneous Expression of Purpose ..    149
               3. Conclusion .................................    150
          E.   Objective Economic Substance ...................   151
               1. Economic Significance of Banks’
                   “Contributions” ............................   152
                             - 6 -

               a.  Advisory Fee and Put Price .............   153
                   i.   Banks’ Understanding ..............   155
                   ii. Ackerman Group’s Understanding ....    157
                   iii. Negotiation and Drafting Process ..   159
               b. Redemption and Liquidation Rights ......    167
               c. SMP’s Conversion Option ................    169
               d. Distribution Rights ....................    171
               e. Carolco Securities .....................    174
           2. Economic Benefits for the Ackerman Group ...    177
           3. EBD Film Library ...........................    180
               a. Petitioner’s Expert ....................    180
                   i.   Income Projections ................   181
                   ii. Cost Projections ..................    183
                   iii. Net Cashflows .....................   184
                   iv. Valuations ........................    184
                   v.   Market Approach ...................   185
               b. Respondent’s Expert ....................    186
                   i.   Income Projections ................   187
                   ii. Cost Projections ..................    189
                   iii. Net Cashflows .....................   190
                   iv. Valuations ........................    191
                   v.   Market Approach ...................   191
               c. Court’s Analysis .......................    192
                   i.   Reconciliation of Expert Opinions .   192
                   ii. Exclusion of Certain Film Titles ..    193
                   iii. Analysis of Expert Opinions .......   196
                   iv. Conclusion ........................    203
           4. Carolco Securities .........................    208
           5. Net Operating Losses .......................    215
           6. Conclusion .................................    216
      F.   Other Considerations ...........................   217
           1. SMP’s Other Film-Related Activities ........    217
           2. Relationship Between the Parties ...........    219
           3. Ackerman Group’s Exploitation of
               Tax Attributes .............................   219
           4. Congressional Intent .......................    222
      G.   Conclusion .....................................   226

IV.   Step Transaction Doctrine ..........................    227

      A.   Legal Principles ...............................   227
      B.   Parties’ Arguments .............................   229
      C.   Court’s Analysis ...............................   231
      D.   Conclusion .....................................   236

V.    Basis Arguments ....................................    237

      A.   Worthlessness Issue ............................   237
           1. Contribution of Worthless Assets ...........    238
                               - 7 -

             2. Worthlessness of Debts .....................    240
        B.   Bona Fide Indebtedness Issue ...................   244

VI.     Corona Transaction .................................    254

VII.    Sales of Receivables to TroMetro ...................    257

VIII.   Summary of Conclusions So Far ......................    259

IX.     At-Risk and Passive Activity Loss Rules ............    261

X.      SMP’s Basis in SMHC Stock ..........................    262

XI.     Accuracy-Related Penalties .........................    264

        A.   Burden of Production ...........................   265
        B.   Gross Valuation Misstatements ..................   267
        C.   20-Percent Accuracy-Related Penalties ..........   275
             1. Negligence .................................    275
             2. Substantial Understatement of Income Tax ...    279
        D.   Reasonable Cause ...............................   284
             1. August 1996 Memorandum From
                 Shearman & Sterling ........................   289
             2. Ernst & Young Memorandum ...................    292
             3. May 12, 1997, Shearman & Sterling
                 Memorandum .................................   293
             4. October 10, 1997, Shearman & Sterling
                 Memorandum .................................   298
             5. February 26, 1998, Shearman & Sterling
                 Memorandum .................................   301
             6. Grant Thornton Memorandum ..................    303
             7. Opinion From Chamberlain Hrdlicka ..........    307
             8. Conclusion .................................    311

XII.    Evidentiary Matters ................................    312

        A.   Daubert Issues .................................   312
             1. Mr. Crawford ...............................    313
             2. Ms. Nemschoff ..............................    316
                 a. Ms. Nemschoff’s Expert Opinion .........    317
                 b. Petitioner’s Arguments .................    318
                 c. Court’s Analysis .......................    319
             3. Mr. Shapiro ................................    322
                 a. Mr. Shapiro’s Expert Opinion ...........    322
                 b. Court’s Analysis .......................    325
        B.   Mr. Jouannet’s Response (Exhibit 226-P) ........   328
                                - 8 -

               MEMORANDUM FINDINGS OF FACT AND OPINION



     THORNTON, Judge:    These consolidated cases stem from

transactions that occurred in the wake of the 1996 sale of the

legendary motion picture company Metro-Goldwyn-Mayer (MGM) by the

French banking giant Credit Lyonnais.

     Peter Ackerman, his business partner Perry Lerner, and their

related entities (collectively, the Ackerman group) had helped

organize a consortium which made a bid to purchase MGM from

Credit Lyonnais.   The consortium lost out to Kirk Kerkorian’s

winning bid.   The Ackerman group then set out to acquire MGM’s

parent company, Santa Monica Holdings Corp. (SMHC), which Credit

Lyonnais still owned.

     SMHC was largely devoid of assets; it owed about $1 billion

to Credit Lyonnais and its cluster of subsidiaries, adjuncts, and

associated companies (the Credit Lyonnais group).1   There were,

however, tantalizing tax attributes:    Credit Lyonnais’s purported

tax basis in the SMHC indebtedness was about $1 billion; its

purported tax basis in the SMHC stock was about $665 million.



     1
       This debt represented part of the approximately $2 billion
that the Credit Lyonnais group had previously lent or advanced to
MGM during its brief, unprofitable relationship with MGM, first
as lenders to MGM and then, after foreclosing, as owners of MGM.
Credit Lyonnais had transferred the approximately $1 billion of
debt from the MGM operating company to Santa Monica Holdings
Corp. (SMHC) (or more precisely to its predecessor, MGM Group
Holdings Corp.) partly to facilitate the 1996 sale of the MGM
operating company to Kirk Kerkorian.
                                 - 9 -

     To acquire SMHC in a manner that might preserve the tax

attributes, the Ackerman group formed a new limited liability

company, Santa Monica Pictures, LLC (SMP), which elected to be

treated as a partnership for Federal tax purposes.   The Credit

Lyonnais group agreed to contribute to SMP the high-basis, low-

value indebtedness and SMHC stock after first contributing to

SMHC a library of what might charitably be called B-grade films.

In exchange, the Credit Lyonnais group was to receive preferred

interests in SMP and a $5 million “advisory fee”.2   Pursuant to a

side agreement, the Ackerman group committed to purchase these

preferred interests from the Credit Lyonnais group, upon demand,

for a $5 million “put” price.3

     In late 1996, the Credit Lyonnais group made the agreed-upon

contributions to SMP.   Some 3 weeks later, the Credit Lyonnais

group exercised its “put”, sold its SMP interests to Somerville S

Trust (Mr. Ackerman’s grantor trust), and so departed SMP.     SMP

was left holding, instead of the proverbial bag, the high-basis,

low-value assets that the Credit Lyonnais group had contributed

and, indirectly (through SMHC), the B-grade films.




     2
        More precisely, the $5 million advisory fee was to be
paid to one of the Credit Lyonnais group members, Credit Lyonnais
International Services (CLIS).
     3
       More precisely, the commitment to purchase the Credit
Lyonnais group’s preferred interests was made by one of the
Ackerman group members, Rockport Capital, Inc.
                              - 10 -

     Relying upon certain partnership basis rules (i.e., sections

704(c), 743 and 754), the Ackerman group claimed to succeed to

Credit Lyonnais’s purported $1 billion tax basis in the

contributed SMHC indebtedness and purported $665 million tax

basis in the SMHC stock.4   In separate transactions in 1997 and

1998, SMP sold to TroMetro Films, LLC (TroMetro) portions of the

SMHC indebtedness for much less than the claimed basis.    SMP also

formed another partnership, Corona Film Finance Fund, LLC

(Corona) and contributed to it part of the SMHC indebtedness.5

SMP then sold most of its ownership interest in Corona to

Imperial Credit Industries, Inc. (Imperial), for much less than

its claimed basis.   On its partnership tax returns for 1997 and

1998, SMP claimed capital losses totaling, altogether, about $300

million from these various transactions.   These claimed losses

passed through for the primary benefit of Mr. Ackerman.

     Corona, meanwhile, sold to TroMetro the SMHC indebtedness

that SMP had contributed at Corona’s formation.   On its




     4
       Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the taxable years at
issue and, in certain references, as amended. All Rule
references are to the Tax Court Rules of Practice and Procedure.
     5
       In our findings of fact, we use terms such as
“indebtedness” or “contributions” only for convenience and not to
denote any legal significance.
                             - 11 -

partnership tax return for 1997, Corona claimed a capital loss of

about $79 million from this transaction.6

     Respondent issued separate notices of final partnership

administrative adjustment (FPAAs) to Perry Lerner as tax matters

partner for SMP and Corona with respect to their partnership

taxable years ended December 31, 1997, and December 31, 1998.    In

the FPAAs, respondent disallowed SMP’s and Corona’s

aforementioned claimed capital losses.7   On a number of theories,

including the application of substance over form principles,

respondent argues that SMP and Corona are not entitled to the

indebtedness bases or the associated capital losses that those


     6
       This claimed loss essentially duplicated losses that Santa
Monica Pictures, LLC (SMP) had claimed from its sale to Imperial
Credit Industries, Inc. (Imperial), of SMP’s ownership interest
in Corona Film Finance Fund, LLC (Corona). Most of Corona’s
claimed loss passed through for the benefit of Imperial. As a
“fee” for the tax benefits it received, Imperial paid, indirectly
to SMP through Corona, almost $15 million.

     At some point in these proceedings, Imperial filed a
bankruptcy petition. Consequently, any partnership items of
Imperial, including the loss that passed through from Corona,
became nonpartnership items on the date the bankruptcy petition
was filed. Sec. 301.6231(c)-7(a), Temporary Proced. & Admin.
Regs., 66 Fed. Reg. 50561 (Dec. 4, 2001). Imperial is not a
party to these proceedings.
     7
       In the notice of final partnership administrative
adjustment issued to Corona for its 1998 taxable year, respondent
determined, as the lone adjustment in that FPAA, an $80 million
increase in Corona’s reported distributions. Respondent concedes
that this adjustment is no longer a partnership item and that
this Court lacks jurisdiction to redetermine that adjustment.
Based on that concession, the Court will dismiss the taxable year
1988 as moot at docket No. 6164-03.
                               - 12 -

entities claimed on their respective 1997 partnership tax returns

and that SMP claimed on its 1998 partnership tax return.

     Petitioner disagrees.    Petitioner contends, among other

things, that substance over form principles do not apply because,

when the contribution of SMHC stock and debt occurred (and

thereafter), the Ackerman group had the legitimate business

purpose of getting into the film business with the Credit

Lyonnais group.

     Ultimately, we must decide:    (1) Whether SMP is entitled to

a $147,486,000 capital loss on its sale to TroMetro of a $150

million receivable in 1997; (2) whether SMP is entitled to

capital losses of $11,647,367 and $62,237,061 on its sales to

Imperial of portions of its Corona membership interest in 1997;

(3) whether SMP is entitled to a $80,190,418 capital loss on its

sale to TroMetro of an $81 million receivable in 1998; (4)

whether Corona is entitled to a capital loss on its sale to

TroMetro of a $79 million receivable in 1997;8 (5) whether

accuracy-related penalties under section 6662(a) or (h) apply

with respect to the partnership adjustments to SMP’s 1997 and

1998 returns and Corona’s 1997 return.9

     8
       Corona claimed a $78,768,955 capital loss from the sale of
the $79 million receivable in 1997. We do not have jurisdiction
over the portion of this loss that passed through to Imperial;
i.e., $74,671,378. See supra note 5.
     9
         On SMP’s FPAA for 1998, respondent also determined a
                                                     (continued...)
                               - 13 -

                          FINDINGS OF FACT

     SMP is a Delaware limited liability company with its

principal place of business in New York, New York.    Corona is a

Delaware limited liability company with its principal place of

business in New York, New York.

     The parties have stipulated many facts, which are

incorporated herein by this reference.

I.   The Ackerman Group

     A.    Perry Lerner

     During the taxable years at issue, Perry Lerner was the

managing member and the tax matters partner of SMP and Corona.

     Mr. Lerner is a successful tax lawyer.    He graduated from

Clairmont McKenna College in Clairmont, California, in 1965 and

from Harvard Law School in 1968.    From 1968 to 1970, Mr. Lerner

worked as a clerk/attorney advisor to Judge Arnold Raum of the

U.S. Tax Court.    From 1970 to 1976 and again from 1979 to 1980,

Mr. Lerner worked for the law firm of Kindall & Anderson in Los

Angeles.    From 1976 to 1979, Mr. Lerner worked as an attorney

advisor for the U.S. Treasury Department, Office of International

Tax Counsel, in Washington, D.C.



     9
      (...continued)
$211,407 adjustment for certain long-term capital gain that SMP
did not pass through on its 1998 partnership tax return.
Respondent does not seek to impose accuracy-related penalties
pursuant to sec. 6662 with respect to this adjustment.
                              - 14 -

     From approximately 1980 to 1995, Mr. Lerner worked for the

law firm of O’Melveny & Myers, LLP.    He worked in the firm’s Los

Angeles office until 1986 or 1987, before leaving to head up the

firm’s London office.   In 1992, he returned to the firm’s Los

Angeles office for about a year before moving to the firm’s New

York office.   In 1996, Mr. Lerner retired from O’Melveny & Myers

to become a sole practitioner.

     B.   Peter Ackerman

     Peter Ackerman is a successful businessman.   He attended

Colgate University, where he received a bachelor’s degree.   He

attended graduate school at the Fletcher School of Law and

Diplomacy, ultimately receiving a Master of Arts and Law and

Diplomacy, and a Ph.D. in international affairs.

     From 1978 to 1989, Mr. Ackerman worked at Drexel Burnham

(formerly Burnham & Co.) with Michael Milken in the high-yield

and convertible bond department.   While there, he was exposed to

buying and selling high-yield bonds, recapitalizing (leveraging)

companies, restructuring troubled businesses, and financing and

investing in businesses.

     During the period of Mr. Ackerman’s employment there, Drexel

Burnham arranged the financing for major film companies,

including Warner Brothers, Paramount, Turner, CNN, and Orion.

Mr. Ackerman was actively involved in structuring the financing
                               - 15 -

for the transaction wherein Kirk Kerkorian sold the MGM library

(for the first time) to Ted Turner.

     In 1990, Mr. Ackerman was invited to become a visiting

scholar at the International Institute for Strategic Studies in

London.   He stayed there until 1994 while he wrote and published

a 400-page book called “Strategic Nonviolent Conflict.”   During

this period, Mr. Ackerman met Mr. Lerner.   Mr. Lerner represented

Mr. Ackerman in certain legal matters, including issues stemming

from Drexel Burnham’s bankruptcy and issues relating to Mr.

Ackerman’s estate planning.

     C.   Somerville S Trust

     During the taxable years at issue and at all relevant times,

Mr. Ackerman was the beneficiary of the Somerville S Trust, which

was treated as a grantor trust for Federal income tax purposes.

All items of income, expense, or loss from Somerville S Trust

were reported on Mr. Ackerman and his wife’s joint Federal income

tax returns.

     Somerville S Trust was the capital source for many of Mr.

Ackerman’s investments, including the transaction involving the

Credit Lyonnais group.   Mr. Lerner was the trustee of the

Somerville S Trust, and he was fully empowered to transfer or

invest its assets.
                                - 16 -

     D.   Rockport Capital, Inc.

     During the taxable years at issue and at all relevant times,

Mr. Ackerman conducted all his investment activities through a

wholly owned advisory company called Rockport Capital, Inc.

(Rockport Capital).   Rockport Capital was a Delaware subchapter S

corporation.   Mr. Lerner was an officer in Rockport Capital.

     E.   Rockport Advisors, Inc.

     After Mr. Lerner retired from O’Melveny & Myers in 1996, Mr.

Ackerman asked Mr. Lerner to continue representing him.   Mr.

Ackerman was interested in various investment opportunities that

were coming his way, and he often asked Mr. Lerner’s legal advice

about them.    Initially, Mr. Lerner devoted about half his time to

Mr. Ackerman’s affairs.   As a product of this representation, Mr.

Lerner formed Rockport Advisors, Inc. (Rockport Advisors), which

he owned.   Rockport Capital and Rockport Advisors operated

together with respect to Mr. Ackerman’s investment activities,

including the transaction involving the Credit Lyonnais group.

     F.   Crown Capital Group

     In early 1997, Mr. Lerner ceased using Rockport Advisors

with respect to Mr. Ackerman’s investments.   Instead, Mr. Lerner

created a new firm, Crown Capital Group, Inc. (Crown Capital),

located in New York, to investigate and manage Mr. Ackerman’s

investments.   Mr. Lerner owned 49 percent and Mr. Ackerman’s

nephew owned 51 percent of Crown Capital.
                               - 17 -

      Crown Capital provided the due diligence and management

services for Mr. Ackerman’s investments, including SMP, a theater

exhibition company (Resort Theaters), a textile company, a small

insurance company, a business involved in manufacturing Pokemon

game cards, a company that manufactured sample wallpaper and

carpet boards, a newspaper stuffing business, a grocery business,

and a number of private equity investments.    Oftentimes, Crown

Capital would make an investment in its own name and then

transfer it into some new entity established for Mr. Ackerman.

In some cases, Crown Capital also acted on behalf of SMP or SMHC,

although there was no written agency agreement between these

companies.

II.   The Credit Lyonnais Group

      A.   Credit Lyonnais

      During the early 1990s and the taxable years at issue,

Credit Lyonnais, S.A. (Credit Lyonnais), was a large European

banking and financial institution organized under the laws of

France.    Credit Lyonnais was the direct or indirect parent of

other banking and financial institutions, including Credit

Lyonnais Bank Nederland, N.V. (CLBN), a bank organized under the

laws of the Netherlands, and Credit Lyonnais International

Services (CLIS).    Credit Lyonnais acquired CLBN in the mid-1980s.

CLBN developed a large business of financing media entertainment

(e.g., film, television, etc.); it was partly responsible for
                               - 18 -

Credit Lyonnais’s indirect financing and ownership of film

companies, including MGM.10

     B.    Consortium de Realisation

     In 1995, Credit Lyonnais experienced a financial crisis.

Following the intervention of the French government, Credit

Lyonnais announced a restructuring program that was intended to

shore up its balance sheet going forward.   Under the

restructuring program, Credit Lyonnais’s troubled investments and

loans, including its loans to film companies such as MGM, were

effectively transferred into a wholly owned subsidiary,

Consortium de Realisation (CDR).   CDR was set up for the purpose

of liquidating and maximizing recovery on Credit Lyonnais’s “bad

assets”.

     When CDR was set up, the Credit Lyonnais employees who were

working on the troubled entertainment loans were given the option

of transferring to CDR to continue working on those loans or

taking other positions within Credit Lyonnais.     Rene-Claude

Jouannet, a longtime employee of Credit Lyonnais, transferred to

CDR, where he served as CDR’s general counsel.11




     10
       The Credit Lyonnais group’s loans to MGM and eventual
ownership of MGM are described in detail infra.
     11
       As we discuss infra, Mr. Jouannet played a significant
role in the transaction in which the Ackerman group acquired
SMHC.
                                - 19 -

     C.   Generale Bank Nederland

     In September 1995, CLBN was acquired by Generale Bank

Nederlands (Generale Bank).12    In this acquisition, CLBN’s “good”

and “bad” assets were transferred to Generale Bank.    Credit

Lyonnais lent Generale Bank the money to purchase the “bad

assets” of CLBN, including the debt that MGM owed to CLBN.      The

loan from Credit Lyonnais to Generale Bank was nonrecourse;

Generale Bank was not obligated to pay back the borrowed amount

except to the extent it realized anything on the bad assets.

III. Metro-Goldwyn Mayer, Inc.

     A.   History of MGM Before 1990

     Metro-Goldwyn-Mayer, Inc., was established in 1924 as a

major film studio based in Los Angeles, California.    Since its

establishment, Metro-Goldwyn-Mayer, Inc., has experienced

numerous reorganizations and name changes.    For convenience, we

sometimes refer to Metro-Goldwyn-Mayer, Inc. (and its successors)

generally as “MGM”.

     In 1981, MGM purchased United Artists (UA).    The combined

entity then changed its name to MGM/UA Entertainment Co.

(MGM/UA).   From 1981 through 1986, MGM/UA continued to produce

and distribute film and television products.    In 1986, Kirk


     12
       The actual name is “Generale Banque.” We follow the
parties’ convention in referring to it in Anglicized fashion as
“Generale Bank.” Sometimes, in quoted material, the reference is
to “Generale Banque” or “GB.”
                                 - 20 -

Kerkorian, the majority shareholder of MGM/UA, entered into a

series of transactions with Turner Broadcasting System (TBS),

resulting in TBS’s acquisition of the pre-1986 MGM film library.

See, e.g., Turner Broad. Sys., Inc. & Subs. v. Commissioner, 111

T.C. 315 (1998).   MGM/UA Communications Co. (MGM Communications)

was formed out of the remaining assets of MGM and UA, including

the UA film library.   In 1988, MGM Communications began to

explore selling all or part of these assets.

     B.   Pathe Acquisition of MGM

     In June 1990, the board of directors of MGM Communications

agreed to sell the company for approximately $1.33 billion

(excluding certain additional costs) to Pathe Communications

Corp. (Pathe), which was indirectly controlled by Giancarlo

Parretti and Florio Fiorini.13    Pursuant to this agreement, MGM-

Pathe Communications Co. (a wholly owned subsidiary of Pathe)

merged with and into MGM Communications (the 1990 merger).     The

surviving corporation was MGM-Pathe Communications Co. (MGM-

Pathe).   As a result of the 1990 merger, Pathe owned 98.5 percent

of MGM-Pathe stock.

     C.   Sealion Corp.

     In connection with Pathe’s acquisition of MGM, Credit

Lyonnais lent $150 million to Sealion Corp., N.V. (Sealion)

     13
       To finance this purchase price, Pathe Communications
Corp. relied, in part, on its available lines of credit from
CLBN.
                              - 21 -

pursuant to a credit agreement dated October 30, 1990.    Sealion

then lent the $150 million to Pathe, which in turn used the funds

to finance part of the acquisition of MGM Communications.

Sealion entered into a stock purchase agreement dated as of

November 1990, with Melia International N.V. (Melia), which owned

51.9 percent of Pathe’s outstanding common stock.    Pursuant to

the stock purchase agreement, Sealion purchased 900,000 shares of

MGM-Pathe’s common stock (constituting 1.5 percent of the common

stock of MGM-Pathe) from Melia.   Sealion in turn pledged its 1.5-

percent interest in MGM-Pathe to Credit Lyonnais as security for

the $150 million loan.   Thereafter, Sealion, Melia, and Pathe

controlled the boards of directors of Pathe and MGM-Pathe.

     D.   Cashflow Problems of MGM-Pathe

     Before the Pathe acquisition, MGM relied on cashflows from

its distribution agreements to conduct its day-to-day operations

and to generate revenue.   To finance Pathe’s recent acquisition

of MGM/UA Communications, however, Mr. Parretti entered into new

distribution agreements which were then factored with financial

institutions, thereby depriving MGM of approximately 80 to 90

percent of its ordinary cashflow.   Consequently, MGM-Pathe was

soon unable to finance its day-to-day operations, including

motion picture production and release.     To fund all its operating

costs, including the payment of interest, MGM-Pathe had to rely

on external capital in the form of continuous borrowing from the
                               - 22 -

Credit Lyonnais group.   MGM-Pathe’s weak financial condition was

well-known in the entertainment industry and made it harder to

attract film talent to MGM.

     E.   Facility Agreements with CLBN

     On March 22, 1991, Pathe and MGM-Pathe entered into a so-

called $250 million interim revolving credit facility with CLBN

(the $250 million facility), which incorporated all of MGM-

Pathe’s borrowing from November 1, 1990.14     All borrowing under

the $250 million facility was at the absolute discretion of CLBN

and was secured by MGM-Pathe’s assets and Pathe’s interest in

MGM-Pathe stock.

     On March 29, 1991, a group of MGM-Pathe’s creditors

(excluding CLBN) filed an involuntary chapter 7 bankruptcy

petition in U.S. Bankruptcy Court.      To pay off its creditors

(other than CLBN) and allow it to emerge from bankruptcy, MGM-

Pathe entered into a so-called $145 million facility agreement

(the $145 million facility agreement) with CLBN dated as of April

12, 1991.15   Borrowing under the $145 million facility agreement

was secured by MGM-Pathe’s assets, as well as the stock of Pathe

and MGM-Pathe.   As a result of the new financing, MGM-Pathe was

     14
       The name of this agreement did not necessarily control
the amount that was advanced under the agreement.
     15
       The name of this agreement did not necessarily control
the amount that was advanced under the agreement. Amounts
available under the $145 million facility agreement were in
addition to amounts available under the $250 million facility.
                               - 23 -

able to reach an accord with its creditors and emerge from

bankruptcy.

     In connection with the $145 million facility agreement,

Pathe and certain of Melia’s stockholders and subsidiaries

entered into certain agreements in April 1991, whereby those

parties guaranteed MGM-Pathe’s obligations under the $145 million

facility agreement and pledged to CLBN all shares of Pathe, MGM-

Pathe, and Melia owned by those parties, to secure all

indebtedness then owing by Pathe (and certain affiliates) to CLBN

(the 1991 pledge agreement).   The shares covered by these

agreements represented approximately 89.3 percent of the

outstanding common stock of Pathe and 98.5 percent of the stock

of MGM-Pathe, which shares were held in irrevocable voting trust

agreements in favor of CLBN.   As part of this process, Mr.

Parretti entered into corporate governance agreements with CLBN

wherein Mr. Parretti and Pathe ceded responsibility for the day-

to-day management of MGM-Pathe to Credit Lyonnais.    On June 17,

1991, as a result of certain actions by Mr. Parretti in violation

of the corporate governance agreements between him and CLBN, CLBN

removed Mr. Parretti and certain other directors of MGM-Pathe.

     F.   Credit Lyonnais Takes Control of MGM

     As of June 1991, Credit Lyonnais exercised effective control

over MGM-Pathe.   It controlled all management decisions at MGM-

Pathe and elected MGM-Pathe’s board of directors.    During this
                               - 24 -

period, Credit Lyonnais maintained a constant presence at MGM-

Pathe’s corporate offices.

      MGM-Pathe’s deepening financial problems, however, strained

its relationship with Credit Lyonnais.   For example, during the

quarter ended March 31, 1992, MGM-Pathe’s operating expenses and

financing costs exceeded its operating receipts, and its

management expected that operating expenses and financing costs

would continue to exceed operating receipts for the foreseeable

future.   MGM-Pathe’s market share was less than two percent; many

of its valuable assets had either been sold or factored to

finance Pathe’s acquisition of MGM-Pathe.   As a result, MGM-Pathe

remained entirely dependent on CLBN for additional capital to

fund its ongoing operations.   MGM-Pathe’s deepening financial

problems persisted well into 1993.

     As of March 31, 1992, CLBN had lent MGM-Pathe $124,288,000

pursuant to the so-called $250 million facility agreement and

$398,223,000 pursuant to the so-called $145 million facility

agreement.   MGM-Pathe was in default on these obligations.   On

April 16, 1992, CLBN notified Pathe and MGM-Pathe that it was

exercising its right under the 1991 pledge agreement to foreclose

on 59.1 million shares of the common stock of MGM-Pathe

(representing 98.5 percent of the outstanding common stock of

that company).   The letter stated that the foreclosure auction

was scheduled for May 7, 1992, and that CLBN intended to bid-in,
                               - 25 -

or cause to be bid-in, at least $400 million of the secured

indebtedness.    CLBN also advised Pathe and MGM-Pathe that $400

million would be the minimum bid-in amount and that the sale of

40.2 million shares would be subject to a prior pledge in favor

of Credit Lyonnais, as assignee of Sealion.

     Credit Lyonnais formed MGM Holdings Corp. (MGM Holdings) to

effect the foreclosure on the common stock of MGM-Pathe.     As of

May 1, 1992, CLBN sold to MGM Holdings approximately $483,489,000

of Pathe’s and MGM-Pathe’s indebtedness.16    Credit Lyonnais

foreclosed on the MGM-Pathe stock to recover amounts that it had

invested in MGM; it was not interested in any long-term

investment in a film business.   As a result of the foreclosure,

MGM Holdings owned 98.5 percent of MGM-Pathe’s common stock and

had the power to elect the entire board of directors of MGM-

Pathe.    Nevertheless, the Credit Lyonnais group was working on a

5-year time clock from the date of foreclosure, because U.S.

banking laws required the Credit Lyonnais group to sell MGM

within 5 years (i.e., on or before May 7, 1997).

     On May 20, 1992, MGM-Pathe changed its name to Metro-

Goldwyn-Mayer, Inc. (MGM).




     16
       The parties agreed to a purchase price equal to the
aggregate principal amount outstanding on the debt, together with
all interest, fees, and other amounts then due and owing.
                                - 26 -

      G.   1993 Financial Restructuring

      After the foreclosure, MGM was a tarnished brand.     As a

maker of motion picture products, it was minimally competitive.

MGM had effectively gotten out of the television business and had

no activities in ancillary media such as interactive and video

games.     MGM had a substantial film library, including the

considerable UA library, but it was not aggressively exploiting

it.   MGM’s financial position was precarious.      It was functioning

on a credit facility that CLBN had granted in an emergency

fashion.     Although the facility was supposed to be in the $150

million range, CLBN’s exposure had risen to half a billion

dollars.     MGM needed additional funding for its production

activities.     This funding came directly or indirectly from the

Credit Lyonnais group.     The Credit Lyonnais group meanwhile had

already invested approximately $1.6 billion in MGM-Pathe,

including amounts that it had lent to Pathe, to various entities

in connection with Pathe’s acquisition of MGM-Pathe, and to MGM-

Pathe.

      Credit Lyonnais determined that it needed to maintain MGM’s

operations to increase MGM’s value.       Because it appeared

impossible to sell MGM under satisfactory conditions, it was

necessary to rebuild it, which required both time and financial

means.     Consequently, effective April 1, 1993, CLBN provided MGM
                              - 27 -

a commitment for an additional $190 million, 3-year revolving

credit facility ($190 million facility).17

     In light of Credit Lyonnais’s escalating financial exposure

and MGM’s dwindling business prospects, Credit Lyonnais

formulated a business strategy for MGM which included:

(1) completely replacing the company’s management; (2)

restructuring MGM’s finances to replenish its equity capital and

to significantly reduce the weight of its debt; and (3)

establishing a 5-year business plan intended to reposition MGM

among the film industry’s “major players” and to increase the

value of its assets, particularly through an intensive program of

new film production.18

     In July 1993, MGM began a comprehensive restructuring of its

capital structure and its corporate management (the 1993

restructuring).   This restructuring consisted primarily of

splitting MGM into two entities.   The goal was to set up a

separate operating company which would be capitalized with $1

billion in equity and would have sufficiently reduced liabilities

to allow additional borrowing from lenders other than Credit

Lyonnais.   MGM was renamed MGM Group Holdings Corp. (MGM Group


     17
       The name of this agreement did not necessarily control
the amount that was advanced under the agreement.
     18
       Credit Lyonnais selected a 5-year business plan because
of U.S. laws requiring the bank to divest itself of MGM within 5
years of acquisition.
                              - 28 -

Holdings).   MGM Group Holdings contributed substantially all its

assets (including its film and television assets) and some

liabilities to a new subsidiary, which was later named Metro-

Goldwyn-Mayer, Inc. (New MGM).19

     In the 1993 restructuring, MGM’s debt to CLBN was divided

between MGM Group Holdings and New MGM.    MGM Group Holdings

retained approximately $960 million of the debt, which was

restated and consolidated in an amended, restated, and

consolidated credit agreement with CLBN.    MGM Group Holdings

executed a $965,904,188.96 note dated December 30, 1993, which

was due and payable on July 15, 1997.   This $966 million debt was

unsecured by New MGM’s assets; $800 million of the principal

amount was non-interest bearing.

     As of December 31, 1993, New MGM owed CLBN approximately

$618 million in principal and interest.    New MGM and CLBN entered

into an amended, restated, and consolidated credit agreement (the

New MGM credit agreement) in which the loans that New MGM assumed

in the 1993 restructuring were consolidated and converted into a

term loan with a due date of July 15, 1997 (the CLBN term loan).

     In accordance with the 1993 restructuring, New MGM and

Credit Lyonnais entered into a working capital agreement dated

     19
       As part of the 1993 restructuring, MGM Group Holdings
Corp. retained its accrued tax attributes, including its accrued
net operating losses (NOLs). The 1993 restructuring included the
appointment of a new management team under Frank Mancuso as chief
executive officer.
                                - 29 -

December 30, 1993 (the working capital agreement).     The working

capital agreement provided for payment of interest on the amounts

that Credit Lyonnais had previously lent to MGM.     These amounts

became due on July 15, 1997.     New MGM executed a $490 million

note dated December 30, 1993.     In connection with the working

capital agreement and the New MGM credit agreement, MGM Group

Holdings pledged its New MGM stock, as well as New MGM’s film and

other assets, to Credit Lyonnais.

     CLBN advanced $8,994,970.32 in additional funds to MGM Group

Holdings pursuant to a demand promissory note (CLBN demand note)

and an irrevocable notice of drawing, both dated October 26,

1994.     On April 26, 1995, MGM Group Holdings made an additional

drawing of $595,750.56 under the CLBN demand note.     In all, CLBN

advanced a total of $9,590,720.88 in additional funds to MGM

Group Holdings.

     H.     Carolco Pictures, Inc.

        In 1993, Credit Lyonnais, using MGM as a vehicle, made an

investment in Carolco Pictures, Inc. (Carolco), and sought to

take an active role in that company’s operations.     Carolco had

been a major motion picture producer, producing some of the

highest revenue-grossing motion pictures ever made, including

“Terminator 2: Judgment Day”, “Total Recall”, “Cliffhanger”,

“Basic Instinct”, and “Rambo: First Blood Part II”.     Carolco

initially produced four to six major motion pictures a year but,
                               - 30 -

like MGM, was forced to cut production in the early 1990s due to

serious financial problems.

     In 1993, Carolco underwent a financial restructuring (the

1993 Carolco restructuring) to reduce or satisfy Carolco’s

financial obligations and to provide additional capital to permit

Carolco to continue as a going concern.   As part of the 1993

Carolco restructuring, MGM, with other investors, agreed to

invest in Carolco in exchange for distribution rights to

Carolco’s films.20   On May 25, 1993, in connection with the

restructuring, MGM Holdings purchased 30,000 shares of Carolco

preferred stock for $30 million and Carolco subordinated notes

for $30 million (the Carolco securities).21   Credit Lyonnais

provided MGM Holdings the funds for investing in the Carolco

securities.

     As a result of the 1993 Carolco restructuring, Carolco’s

management began preparing some of Carolco’s motion picture

projects for eventual production.   By January 1995, however, due

to the unexpectedly high cost of certain motion pictures it

became apparent that Carolco would have inadequate capital to


     20
       On May 1, 1993, Carolco and MGM entered into two
distribution agreements; a “Domestic Output Agreement”, and an
“International Output Agreement”, in which MGM was to distribute
Carolco films.
     21
       Between Jan. 15, 1994, and Oct. 15, 1995, Carolco issued
additional securities to MGM Holdings in lieu of quarterly
interest payments on the Carolco subordinated notes.
                                - 31 -

execute its business plan going forward.   During the second half

of 1994 and early 1995, Carolco sold substantially all its rights

in such motion picture projects as “Crusades”, “Showgirls”, and

“Lolita” to raise operating capital and reduce payment

obligations.   Carolco obtained certain accommodations from its

investors.

     After discussions with its present investors and potential

new investors during 1994-95, it became apparent to Carolco that

the necessary additional capitalization required to continue

Carolco’s business plan was not going to be forthcoming.

Consequently, Carolco decided to sell its main film library and

certain other assets in hopes of generating cash with which it

could reduce its debt and pursue motion picture projects.

     In October 1995, Twentieth Century Fox Film Corp. (Twentieth

Century Fox) offered approximately $50 million for the Carolco

film library, the projects, and the studio.   Although accepting

this offer would have doomed Carolco’s prospects as a going

concern, Carolco decided to pursue the offer and began

negotiating a sale agreement.    On November 10, 1995, Carolco and

Twentieth Century Fox executed an agreement providing for the

sale of substantially all of Carolco’s assets for approximately

$47.5 million and requiring Carolco to file a voluntary chapter

11 bankruptcy petition.
                              - 32 -

     On November 10, 1995, Carolco filed a voluntary petition

under chapter 11 of the U.S. Bankruptcy Code.   On November 22,

1995, Carolco filed a motion asking the bankruptcy court to issue

an order allowing Carolco to sell its assets to Twentieth Century

Fox for $47.5 million.   On January 16, 1996, the bankruptcy court

held a hearing on Carolco’s motion, wherein Carolco announced

that Canal+ had offered $58 million for the Carolco film library

and related assets.   In an order dated March 21, 1996, the

bankruptcy court approved the sale of Carolco’s film library and

related assets to Canal+ for $58 million.

     Between September 13, 1996, and March 28, 1997, the debtors’

and creditors’ committee filed various successive plans of

reorganization.   Under each of these plans of reorganization, the

holders of Carolco subordinated notes were in class 10 and the

holders of Carolco preferred stock were in class 12.   In each

case, the securities holders were to receive nothing in Carolco’s

liquidation.

     In an order dated April 3, 1997, the bankruptcy court

confirmed the fourth and final amended plan of reorganization.

The bankruptcy court confirmed that SMHC (MGM Group Holdings’

successor), which then held the Carolco securities, was to

receive nothing for the Carolco securities under this plan of

reorganization because it was classified as a holder of class 10

and 12 claims.
                               - 33 -

     I.   Sealion Settlement

     In November 1995, Credit Lyonnais and Sealion entered into a

settlement agreement whereby: (i) Sealion assigned its 1.5-

percent interest in MGM Group Holdings stock to Credit Lyonnais,

and, in exchange, (ii) Credit Lyonnais accepted as repayment of

all sums that Sealion owed to it, the assignment to Credit

Lyonnais of the entire claim that Sealion held against Pathe

pursuant to its loan agreement with Pathe.

     J.   Credit Lyonnais Decides To Sell New MGM

     As of 1994, MGM was not saleable; its filmed entertainment

business was still in financial disarray.    Nevertheless, after

the 1993 restructuring and after nearly 2 years under its new

management team, MGM made a fair recovery.    The management team’s

actions began bearing fruit with some successful film releases

such as “Stargate”, “Get Shorty”, and the next two “James Bond”

movies.   MGM started to resemble a real operating motion picture

company once again.

     Nonetheless, Credit Lyonnais’s investment in MGM was

considerable and never ending.   As time went on, Credit Lyonnais

became very pessimistic about recovering its investment in MGM;

certainly after Credit Lyonnais transferred ownership of the MGM

stock to Consortium de Realisation (CDR) in 1995, Credit Lyonnais

had much less interest in putting money into MGM’s movies.    As a

result, the number of movies in production at MGM diminished
                                - 34 -

considerably.    Credit Lyonnais had reason to get out of its

investment in MGM as expeditiously as possible.

      At some point, Credit Lyonnais decided to sell all the

assets of MGM.    Credit Lyonnais assigned to CDR’s new management

team (which included Mr. Jouannet) the task of putting together

the investment banking support and other support necessary to

sell New MGM.    This team selected Lazard Freres & Co., LLC,

(Lazard & Freres) as its investment banking firm and exclusive

financial adviser for the sale of New MGM.     In early 1996, Credit

Lyonnais, through CDR, formally put New MGM up for sale to pay

off its outstanding debts.     Credit Lyonnais and MGM management

hoped and expected to sell MGM for approximately $2 billion.

IV.   Safari Acquisition Co.

      A.   Safari Consortium

      In early 1996, Mark Seiler contacted Mr. Lerner about

organizing a bid for New MGM.     Mr. Seiler was the U.S. president

of Capella Films, Inc., a motion picture company and a wholly

owned U.S. subsidiary of Deyhle Media Group, one of the largest

film distributors in Germany.22    Mr. Lerner introduced Mr. Seiler

to Mr. Ackerman.    At some point, a consortium called the Safari


      22
       At the time, the five or six “major” motion picture
companies were producing virtually all the motion pictures
exhibited in the world, and this consolidation was jeopardizing
the ability of Deyhle Media Group, and other distributors, to
acquire motion picture content for distribution. Deyhle Media
Group was interested in acquiring New MGM to assure a continuous
flow of motion picture product.
                               - 35 -

Acquisition Co. (Safari) was formed.    In an effort to secure

financing for a Safari bid, Messrs. Lerner and Ackerman met with

a Japanese company and a number of major film distributors,

including Twentieth Century Fox.

     B.    Safari Indicates Its Interest in New MGM

     On April 17, 1996, Messrs. Ackerman and Seiler wrote a

letter to Mr. Peter R. Ezersky, managing director of Lazard

Freres, submitting Safari’s preliminary indication of interest in

acquiring New MGM.    The letter stated an approximate range in

which Safari might be prepared to bid ($1.95 billion to $2.5

billion) and mentioned a number of conditions to be satisfied

before any bid would be final and effective.    When this bid was

submitted, Safari had not completed its due diligence of New MGM.

In formulating its final bid, Safari hired Donaldson, Lufkin &

Jenrette Corp., as its financial adviser, and Houlihan, Lokey,

Howard, & Zukin Capital (Houlihan Lokey), as its valuation

adviser.

     On April 24, 1996, Lazard Freres faxed a memorandum to

Capella Films confirming a visit to MGM on May 1 to 3, 1996, and

providing a draft list of information that was to be available

during that time in the New MGM data room.    The New MGM data room

was established in MGM’s offices in Santa Monica, and each of the

“qualified” bidders was permitted to bring in a team of advisers

to investigate MGM’s company information.
                               - 36 -

     C. Investigation of MGM

     Mr. Lerner was involved in investigating New MGM.    Mr.

Lerner testified that he spent nearly a week in the data room of

New MGM and talked to various members of New MGM’s corporate

management team regarding their view of the company and its

future.   In the course of this investigation, Mr. Lerner received

an MGM Corporation Information Memorandum and a confidential

memorandum that Lazard Freres had prepared in connection with the

sale of New MGM.   Safari hired Deloitte & Touche, LLP, and the

law firm of Kaye, Scholer, Fierman, Hays & Handler, LLP (Kaye

Scholer), to assist in investigating New MGM.

     On May 14, 1996, Deloitte & Touche submitted its preliminary

data room due diligence observations to Safari.   This document

explained the process and procedures followed in Deloitte &

Touche’s investigation of MGM, including its review of the

information in the New MGM data room.   It also identified certain

open issues with respect to MGM.

     On May 15, 1996, Kaye Scholer submitted its preliminary

memorandum to Safari summarizing its legal due diligence

investigation of New MGM.   Kaye Scholer reviewed:   (i) The

corporate organization of MGM, MGM’s principal subsidiaries, and

MGM Group Holdings; (ii) chain-of-title documentation for the

available portion of New MGM’s film library and other product-

related documents; and (iii) historical information for the MGM
                              - 37 -

and UA entities, including the more recent corporate

restructurings.   The Kaye Scholer memorandum also provided a

discussion of CDR’s tax basis in MGM Holdings stock ($605

million), MGM Holdings’s tax basis in MGM Group Holdings stock

($483 million), MGM Group Holdings’s tax basis in New MGM stock

($300 million), New MGM’s tax basis in its assets ($1.14

billion), as well as tax loss carryforwards, and net operating

loss carryforwards.

     A memorandum dated May 31, 1996, from Kaye Scholer to

Capella Films, which Mr. Lerner received, describes an “MGM

Acquisition/Partnership Structure” and explains:

          The proposed structure outlined herein would
     increase the amount receivable by CDR over a straight
     purchase. Under the proposed structure CDR would
     contribute the $873 million of debt owed to it by MGM
     to the capital of Holdings, which in turn would
     contribute the debt to Group, which in turn would
     contribute the debt to MGM. Such contributions would
     increase the tax basis of the stock of each of the
     companies. As a result, CDR would have a tax basis in
     the stock of Holdings of approximately $1.478 billion.
     CDR would then form a limited liability company (the
     ‘LLC’) by contributing the stock of Holdings in
     exchange for a 99% interest in the LLC. An unrelated
     party would receive a 1% interest in exchange for a
     nominal amount. Then CDR would sell half of its
     interest, or 49.5% of the LLC, to an investor who could
     benefit from the use of a capital loss (“Investor”).
     The LLC would not make an election under section 754
     * * * to adjust the basis of its assets. Group would
     then sell the stock of MGM to Capella and make an
     election under section 338(h)(10) of the Code to treat
     the stock sale as an asset sale. Group would use a
     portion of the proceeds to repay to CDR the $970
     million of debt. The remainder of the proceeds would
     be held by Group, other than the amount necessary to
     pay any taxes on the sale (inasmuch as MGM’s NOL’s may
                               - 38 -

     not be sufficient to offset the entire gain and some of
     Group’s NOLs are subject to limitations which prevent
     their use to offset MGM’s income on the deemed asset
     sale). After waiting for at least one year, Investor
     would buy CDR’s other 49.5% interest. Again the LLC
     would not make an election under section 754 of the
     Code to adjust the basis of its assets. As a result of
     these transactions, Investor would own 99% of the LLC,
     and Group and Holdings could be liquidated into the
     LLC. The capital loss on the liquidation (which would
     be approximately $1.4 billion) would be allocated to
     Investor.

     In June 1996, Houlihan Lokey prepared a “Pro-Forma Library

Valuation” as of August 31, 1996, valuing New MGM’s film library

at $2.6 billion, an amount greatly in excess of MGM’s capital and

debt.23   Mr. Lerner testified that it was a valuation which “we

thought was fairly good, a fairly good guess at what the assets

were worth”, but that Safari wanted to prepare its bid below this

estimate in hopes of getting a discount.    Accordingly, Safari

submitted a $1.2 billion bid, which it believed was the high bid.

     D.   Kerkorian Moves in and Buys MGM

     Safari was one of a number of bidders for New MGM.    New

MGM’s management was interested in finding parties who would fund

the acquisition of New MGM and retain existing management.    New

MGM’s management met with Messrs. Lerner and Ackerman to discuss

the possibility of doing a transaction with the management group.

New MGM’s management, however, decided against it; they lacked


     23
       Mr. Lerner testified that this valuation did not take
into account corporate taxes, overhead, and remake rights of
several important pictures such as the “James Bond”, “Pink
Panther”, and “Rocky” movies.
                                - 39 -

confidence in Messrs. Lerner’s and Ackerman’s capital sources and

were not comfortable that their proposed financing from Japan was

going to materialize.

     Unbeknownst to Safari, New MGM’s management had the right,

after all the final bids were in, to find another buyer within a

certain number of hours.   After all bids were submitted, New

MGM’s management approached Kirk Kerkorian who, through his

company, P&F Acquisition Corp. (P&F Acquisition), successfully

bid $1.3 billion for New MGM.    Safari was not given an

opportunity to rebid; it lost out on its attempt to buy New MGM.

     On July 16, 1996, P&F Acquisition entered into a stock

purchase agreement (the stock purchase agreement) with CDR, MGM

Holdings, MGM Group Holdings, and New MGM.   The stock purchase

agreement provided that all of New MGM’s and its subsidiaries’

indebtedness would be repaid in full upon the consummation of the

sale and that any New MGM indebtedness remaining unpaid would be

satisfied, canceled, or extinguished at or before the closing on

the sale.   The closing date was set as of October 10, 1996.

     E.   Debt Release and Assumption Agreement

     As of October 9, 1996, New MGM owed Credit Lyonnais

$378,748,588.93 under the working capital agreement.       The $1.3

billion purchase price that P&F Acquisition paid for New MGM

sufficed to pay off all of New MGM’s creditors except Credit
                                - 40 -

Lyonnais.24    Because the debt that New MGM owed Credit Lyonnais

($378,748,588.93) exceeded the New MGM sale proceeds that Credit

Lyonnais was to receive ($298,835,633.58), New MGM still owed

Credit Lyonnais $79,912,955.34.    On October 9, 1996, Credit

Lyonnais, MGM Group Holdings, and New MGM executed a debt release

and assumption agreement releasing New MGM from its obligations

on the remaining $79,912,955.34 of principal owed to Credit

Lyonnais under the working capital agreement and providing that

MGM Group Holdings assumed this remaining $79,912,955.34 of

indebtedness (the $79 million receivable).    MGM Group Holdings

(and its successor SMHC) never executed a note for the

$79,912,955.34 of indebtedness referred to in the debt release

and assumption agreement.

     F.   Subparticipation Agreement

     On September 25, 1996, CDR and Credit Lyonnais entered into

a subparticipation agreement concerning the working capital

agreement.    Under this agreement, CDR agreed to take a 100-

percent subparticipation in the working capital agreement,

assuming all risks connected to that loan.

     On October 11, 1996, Credit Lyonnais sent a letter to CDR

referencing the $79,912,955.34 excess debt from the New MGM sale

and stating:    “Pursuant to your agreement of October 1, 1996, we


     24
       Generale Bank (CLBN’s successor) was to be paid
$611,064,366.42 (which included accrued interest) for the amounts
that New MGM owed under the CLBN term loan.
                                - 41 -

have resolved and settled this insufficient payment by utilizing

your subparticipation to meet the amount owed.”    On December 13,

1996, CDR assigned the $79 million receivable to CLIS, effective

as of that date, pursuant to a document entitled “Cession de

Creance”.

     G.   Dissolution of MGM Holdings and Formation of SMHC

     On or about September 28, 1996, MGM Holdings contributed its

Carolco preferred stock and Carolco subordinated notes to MGM

Group Holdings.     On October 8, 1996, MGM Holdings was dissolved;

its assets were distributed to CLIS, MGM Holdings’s sole

shareholder.     On October 15, 1996, MGM Group Holdings changed its

corporate name to Santa Monica Holdings Corp. (SMHC).

V.   The CDR Transaction

     A.     Initial Contact With Mr. Jouannet

     After agreement was reached on the sale of New MGM, one of

Mr. Jouannet’s continuing jobs at CDR was to see what, if

anything, he could realize on the stock of MGM Group Holdings.

CDR and Mr. Jouannet were interested in “monetizing”    MGM Group

Holdings as soon as possible.

     Sometime before September 11, 1996, Mr. Lerner, on behalf of

Rockport Capital, and Mr. Jouannet, on behalf of CDR, discussed a

possible transaction involving MGM Holdings and MGM Group

Holdings.     The Ackerman group hired a French firm (unnamed in the

record) and the law firm of Shearman & Sterling, LLP (Shearman &
                              - 42 -

Sterling), in New York City, to assist in the proposed

transaction with CDR.

     Mr. Lerner testified that “When our conversation began with

Rene Claude [Jouannet] about acquiring MGM Holdings, I already

knew from the due diligence exercise before that there were, I

would say, complex tax issues arising from the acquisition of

that company”, including tax basis and NOL issues.   He testified

that he asked Shearman & Sterling to give him “an analysis of the

ways in which a transaction could be organized involving MGM

Holdings so that any tax attributes that might have existed could

be preserved.”   Shearman & Sterling prepared two memoranda

summarizing the anticipated U.S. tax consequences of certain

hypothetical transactions involving MGM Holdings.

     On November 1, 1996, Alvin D. Knott of Shearman & Sterling

sent a letter to William Wofford, an associate at White & Case,

requesting documentation of obligations that MGM Group Holdings

owed; balance sheets and income statements of MGM Group Holdings,

MGM, and Generale Bank; documentation of the loans from CLBN to

Pathe; documentation of the transactions in which MGM Group

Holdings acquired Sealion’s 1.5-percent interest in MGM Group

Holdings; and documentation of the liquidation of MGM Holdings.

On November 6 and 8, 1996, Mr. Wofford sent two letters to Mr.

Knott providing the requested information and documentation.    On

December 3, 1996, Mr. Knott sent a letter to Mr. Lerner enclosing
                                - 43 -

these letters and summarizing the information and documentation

received.    On December 6, 1996, Mr. Wofford faxed to Mr. Lerner’s

representative, James M. Rhodes:     (i) The debt release and

assumption agreement dated as of October 9, 1996, by and among

MGM Group Holdings, MGM, and Credit Lyonnais; and (ii) the

certificate of amendment of MGM Group Holdings, changing its name

to SMHC.

     B.    Negotiation and Drafting Process

     At some point, Mr. Lerner, on behalf of Rockport Capital,

and Mr. Jouannet, on behalf of CDR, decided to move forward with

a transaction involving MGM Group Holdings.     Negotiations

concerning this proposed transaction continued throughout October

and November 1996.     The law firm of White & Case, LLP,

represented the interests of CDR during the course of the

negotiation, drafting, and agreement process with the Ackerman

group.     Sean Geary was the lead attorney in White & Case’s

representation of CDR.

           1.   Rockport Capital Confirms Its Interest

     On September 11, 1996, Mr. Lerner sent a letter to Mr.

Geary, as counsel for CDR, confirming “the interest of Rockport

Capital * * * in MGM Holdings, Inc. * * * and the U.S. tax

attributes which may relate to the direct and indirect

investments by Credit Lyonnais, S.A., and * * * [CDR] in Metro-
                              - 44 -

Goldwyn-Mayer, Inc.”   The letter agreement did not mention any

films or film business.

         2.   Draft Term Sheet and Letter Agreements

     On October 16, 1996, at Mr. Lerner’s request, Shearman &

Sterling sent Mr. Geary a “Draft Term Sheet” proposing a

transaction with Generale Bank concerning MGM Group Holdings.

The draft term sheet contained a section entitled “Initial

Transactions”, providing:

     Generale Banque acquires all the stock of MGM Group
     Holdings (“Group”) and subsequently contributes
     obligations owed to it by Group in the approximate
     amount of $1.050 billion (collectively, the “Note”) to
     the capital of Group.

The draft term sheet proposed an alternative transaction whereby:

     if CLIS’s current basis in Group stock is significant,
     in lieu of the transactions described in the term
     sheet: (a) CLIS will contribute all of the stock of
     Group to Newco in exchange for Preferred Interests, (b)
     Generale Banque will contribute the Note to Newco in
     exchange for Preferred Interests, and (c) Newco will
     contribute the Note to Group.

The draft term sheet also contained a section entitled

“Transaction Structure”, providing:

     Step 1: Rockport Capital, Inc., and its associates
     (the “Initial Members”) form a Delaware limited
     liability company (“Newco”), and contribute assets
     (cash and securities) to Newco in an agreed amount to
     enhance and monetize the value of the Preferred
     Interests to be issued in Step 2.

     Step 2: Generale Banque contributes all of the stock
     of Group to Newco in exchange for preferred membership
     interests in Newco (“Preferred Interests”).
                             - 45 -

The draft term sheet contained a section called “Terms of

Preferred Interests”, which provided:

     The Preferred Interests will have a liquidation value
     equal to $     million, will have a 6% per annum
     dividend preference, and will be convertible after 5
     years into 51% of Newco’s common membership interests,
     provided that if the conversion right is exercised,
     Newco may redeem all of the Preferred Interests at
     their liquidation value plus accrued and unpaid
     dividends. The conversion right will be accelerated in
     the event Newco fails to make a dividend payment when
     due on the Preferred Interests, and in other pertinent
     circumstances.

In addition to these items, the draft term sheet contained a

section entitled “Conditions”, which, among other things,

required Generale Bank to give satisfactory representations and

warranties to Newco and Rockport Capital as to the original

amount of the loans evidenced by its “Note”, the amount

outstanding under those loans at the time of the contribution of

the note to Newco, and the fact that MGM Group Holdings and

Generale Bank continuously recorded the note as debt from the

date of its creation through the date of contribution.    It also

provided that Rockport Capital (and its associates) would decide

whether Newco should be structured as a partnership or a

corporation for Federal income tax purposes.   The draft term

sheet did not mention any films or film business.

     On October 21, 1996, at the request of Mr. Lerner, Shearman

& Sterling sent Mr. Geary a memorandum entitled “Draft Letter

Agreement” discussing the alternative transaction alluded to in
                              - 46 -

the draft term sheet and refining the terms and provisions in the

draft term sheet.   The memorandum stated that the letter

agreement “would require Generale Bank and CLIS simply to

transfer their respective assets to a Newco in exchange for

preferred interests which will be monetized.”25   Rockport Capital

would form a Delaware limited liability company (“Newco”) and

contribute assets (cash and securities) to Newco in an amount

mutually agreed by Rockport, CLIS, and Generale Bank, in exchange

for all the common interests in Newco; CLIS would contribute all

the stock of MGM Group Holdings to Newco in exchange for

preferred membership interests in Newco; and Generale Bank would

contribute to Newco, in exchange for preferred membership

interests, some $1.050 billion of obligations that MGM Group

Holdings owed to Generale Bank.   Regarding documentation, the

first draft letter agreement provided:

          3. Documentation. The Transactions will be
     documented in the form of an Exchange and Contribution
     Agreement * * * among Newco, CLIS and * * * [Generale
     Bank] which will contain customary representations,
     warranties and indemnification provisions, including,
     without limitation, (i) representations and warranties
     by CLIS concerning Group’s assets and the absence of
     any undisclosed liabilities, (ii) representations and
     warranties by CLIS as to its basis in the stock of
     Group, (iii) representations and warranties by * * *
     [Generale Bank] as to the original amount of the loans


     25
       Mr. Geary explained that “by this time [the time of the
draft letter agreement] clearly there was going to be a second
letter, a put letter. That’s what I understood to be monetized.
There was a put available. We didn’t have to wait, you know, for
the time of the deal.”
                              - 47 -

     evidenced by the Note [MGM Group Holdings’ debt
     obligations of $1.05 billion], the amount outstanding
     under such loans at the time of the contribution of the
     Note to Newco, and the fact that * * * [Generale Bank]
     and Group continuously recorded the Note as debt from
     the date of creation through the date of contribution,
     and (iv) provisions providing for the indemnification
     by CLIS and * * * [Generale Bank] of Newco, the Initial
     Members and their affiliates and agents against
     breaches of any of the foregoing representations or
     warranties.

     At some point, White & Case took control of drafting the

letter agreement.   Mr. Geary tried to produce something that

reflected his discussions with Mr. Jouannet.   Mr. Geary

incorporated into the drafting process a side letter agreement

giving Generale Bank and CLIS the right to put their preferred

interests in Newco (later SMP) to Rockport Advisors (or its

affiliate).   The put could be exercised “no earlier than December

31, 1996 and no later than December 31, 1997 upon two days

written notice from a Seller to Purchaser directing that the Put

be effected.”   The side letter agreement proposed a $6 million

purchase price for the preferred interests and an advisory fee

consisting of $4 million plus an amount (not to exceed $2

million) equal to three-quarters of 1 percent of the tax losses,

if any, in excess of $1 billion that would have been allocated to

all members of Newco (other than Generale Bank, CLIS, Rockport

Advisors, CDR, or their affiliates) upon consummation of the

various transactions.   The $6 million purchase price and the

advisory fee were to be deposited in a blocked account with a
                                - 48 -

bank designated by CDR.26    On November 21, 1996, after exchanging

numerous drafts of the letter agreement and the side letter

agreement, the parties reached a basic agreement.     No draft of

the letter agreement or side letter agreement mentioned any films

or film business.

          3.   Further Negotiation and Drafting

     Although the parties had reached basic agreement on the

terms of the proposed transaction, including the put in favor of

Generale Bank and CLIS, the transaction did not close at this

point.    The parties proposed supplementary terms to the letter

agreement and to the side letter agreement, as well as several

revisions to the terms of the side letter agreement.     These

proposals primarily concerned the Carolco securities--CDR wanted

to retain the benefit of whatever value might be realized on

those securities.    To this end, the parties added a contingent

amount to the put price that would be tied to any recovery on the

Carolco securities and also provided certain preferred

distribution rights tied to any proceeds realized on a

liquidation of Carolco.     In addition, the parties agreed that

Rockport Capital (instead of Rockport Advisors) and Mr. Lerner

would be the initial members of a limited liability company (that

would later become SMP), which would be structured as a



     26
       Over the course of the drafting process, the parties
agreed to a $5 million put price and a $5 million advisory fee.
                               - 49 -

partnership for Federal tax purposes and would be formed with an

aggregate contribution of $20 million.     After further

negotiations on the terms of the transaction, the attorneys for

both sides began distilling those terms into an exchange and

contribution agreement, a limited liability company agreement, a

deposit account agreement, and an advisory fee agreement.

          4.   Santa Monica Pictures, LLC, Is Formed

     On December 6, 1996, SMP filed its certificate of limited

liability company.    On or about December 10, 1996, SMP applied

for registration with the State of California for the purpose of

registering to transact intrastate business in California.

     C.   Final Agreements and Documents

     On December 11, 1996, the parties finalized the agreements

that they had negotiated over the course of several months.

          1.   Side Letter Agreement

     On December 11, 1996, Rockport Capital, CDR, Generale Bank,

and CLIS executed a side letter agreement pursuant to which

Rockport Capital irrevocably agreed to purchase, upon written or

facsimile notice, all the preferred interests of Generale Bank

and CLIS in SMP for a specified purchase price.     Under the side

letter agreement, CLIS and Generale Bank could exercise the put

by giving written or facsimile notice during the period
                               - 50 -

commencing on December 31, 1996, and ending December 31, 1997.27

     The purchase price for the preferred interests consisted of

a “Cash Purchase Price” and a “Contingent Amount”.   The Cash

Purchase Price was defined as the amount of CLIS’s and Generale

Bank’s initial preferred capital accounts in SMP ($5 million)

plus interest as of the purchase date.   The Contingent Amount was

defined as:   (i) The lesser of $7 million or the amount recovered

on the Carolco subordinated notes; plus (ii) the lesser of $3

million or the amount recovered on the Carolco preferred stock.

     By its terms, the side letter agreement was not effective

until:    (i) Each of the parties signed a counterpart of the side

letter agreement and received a full set of signed counterparts;

and (ii) Rockport deposited $5 million (i.e., the sum of the

preferred capital accounts of CLIS and Generale Bank on the

closing date of the exchange and contribution agreement) in an

account maintained at Chase Manhattan Bank.   The side letter

agreement also provided that CLIS and Generale Bank had no

obligation to make the contributions provided for in the exchange

and contribution agreement unless and until the side letter

agreement became effective.



     27
       Any written or facsimile notice was required to have an
attached instrument of assignment, a copy of which was attached
as “Exhibit A” to the put agreement. Exhibit A provided that any
assignment and transfer of the preferred interests to Rockport
Capital was to be effective upon payment to the seller of the
cash purchase price provided in the put agreement.
                               - 51 -

          2.   Exchange and Contribution Agreement

     On December 11, 1996, SMP, CDR, CLIS, Generale Bank, and

Rockport Capital entered into an exchange and contribution

agreement (the exchange and contribution).   Under this agreement,

CLIS and Generale Bank agreed to contribute assets to SMP in

exchange for preferred membership interests in SMP.     According to

the exchange and contribution agreement, CLIS was to contribute

its SMHC stock and the $79 million receivable.28     Generale Bank

was to contribute $974 million in receivables.     Schedule 1 of the

exchange and contribution agreement described the $79 million

receivable and the $974 million in receivables as follows:

     Holdings-CLIS Debt

     $79,912,955.34 principal amount of indebtedness,
     outstanding under the MGM Working Capital Credit
     Agreement dated as of December 30, 1993 between Metro-
     Goldwyn-Mayer Inc. (“MGM”) and Credit Lyonnais SA.
     originally owing by MGM and assumed by Santa Monica
     Holdings Corporation (then known as MGM Group Holdings
     Corporation and herein “Holdings”) on October 9, 1996,
     together with all accrued interest thereon.

     Holdings-GB Debt

     Indebtedness owing by Holdings to Generale Bank
     Nederland (formerly known as Credit Lyonnais Bank
     Netherlands) for borrowed money aggregating no less
     than $974,296,600.85, together with all accrued
     interests thereon, including that indebtedness
     evidenced by a promissory note dated December 30, 1993
     in the principal amount of $965,904,188.96 and by a
     promissory note dated October 26, 1994. * * *



     28
       As previously noted, on Oct. 15, 1996, MGM Group Holdings
had changed its name to Santa Monica Holdings Corp. (SMHC).
                              - 52 -

     CDR and CLIS represented and warranted:   (1) SMHC had an

authorized capitalization consisting of 200 million shares of

capital stock, of which 60 million shares of common stock, par

value $1.00 per share, were issued and outstanding; (2) the

aggregate amount of capital CLIS contributed to MGM Holdings from

the date of the creation thereof to the date of MGM Holdings’s

liquidation equaled approximately $605 million; and (3) CLIS had

received no payment of principal on the $79 million receivable

and had not written down any of the debt for accounting or tax

purposes.   Generale Bank also represented and warranted that it

had received no payment of principal on the $974 million in

receivables and had not written down the loans for accounting or

tax purposes.   CDR retained control of SMHC’s tax return filing

obligations for all taxable years or other taxable periods ending

on or before December 31, 1996.

     On December 12, 1996, White & Case faxed to Mr. Lerner and

his associates Schedules 1.6(b) and (c) to the exchange and

contribution agreement and a revised deposit account agreement.

Schedule 1.6(b) lists the “U.S. Video Film Rights” to 65 films

(identified by title only), the rights to 26 development

projects, and the rights to the Carolco preferred stock and
                                  - 53 -

$33,111,856.98 aggregate principal amount of the Carolco

subordinated notes.29

           3.   SMP LLC Agreement

     On December 10, 1996, Rockport Capital and Mr. Lerner formed

SMP pursuant to a limited liability company agreement (the SMP

LLC agreement).       The SMP LLC agreement indicated that among the

purposes for which SMP was formed was “to produce and distribute

filmed entertainment products and to own interests in entities

engaged in such activities”.

     The SMP LLC agreement provided that the members of SMP would

have the following membership interests:

                                               Common      Preferred
             Common           Preferred        capital      capital
            interest          interest         account      account

Rockport        50%              50%           $50,000      $50,000
Lerner          50               50             50,000       50,000


The agreement provided for 3 types of interests--Common I, Common

II, and Preferred.      Members holding Common I interests had

exclusive voting rights in SMP.        Members holding preferred

interests had no voting rights; however, they had the right to

convert all their preferred interests into Common II interests on




     29
       The exchange and contribution agreement (including its
attached schedules) did not define the term “U.S. Video Film
Rights”.
                                - 54 -

or after December 10, 2001.30   Members holding Common II

interests also had no voting rights in SMP.

     Under the SMP LLC agreement, if the members holding

preferred interests exercised their conversion rights, SMP had

the right to redeem all the preferred interests at a price equal

to the sum of the preferred capital accounts for all holders of

preferred interests.   SMP also had the option to convert the

preferred interests into debt of SMP beginning on December 31,

1997, and on conversion, the debt would have a principal amount

equal to $5 million for a term of 5 years at an interest rate of

8 percent per annum.

     Mr. Lerner was appointed SMP’s manager.   The SMP LLC

agreement provided that no member could sell, assign, transfer or

dispose of, directly or indirectly, by operation of law or

otherwise (including by merger, consolidation, dividend, or

distribution) any membership interest, without the prior written

consent of SMP’s manager.   It also provided that no member could

retire or withdraw from SMP without SMP’s manager’s written

consent except in certain defined circumstances.

     Pursuant to the SMP LLC agreement, with certain exceptions,

each SMP member (including any additional members) agreed that it



     30
       Members holding preferred interests could immediately
convert their preferred interests to Common II interests if
certain required annual distributions of excess cashflow were not
made.
                                - 55 -

would not, and would not cause any of its affiliates to, at any

time, reveal to any other person or use in any way detrimental to

SMP any nonpublic, confidential, or proprietary information

relating to the business and affairs of SMP that was acquired or

otherwise received by such person in connection with the

transactions contemplated in the LLC agreement.

               a.   Amendment No. 1

       Mr. Lerner and Rockport Capital executed an amendment

(“Amendment No. 1”) to the SMP LLC agreement dated as of December

11, 1996, which admitted CLIS and Generale Bank as new members of

SMP.    Amendment No. 1 recited that CLIS would contribute its SMHC

stock and the $79 million receivable to SMP, and Generale Bank

would contribute $974,296,600.85 of principal indebtedness owing

by SMHC, in exchange for preferred interests in SMP.31   CLIS and

Generale Bank executed ratification certificates agreeing to all

the terms of the SMP LLC agreement as amended by Amendment No. 1.

              b.    Amendment No. 2

       Mr. Lerner, as manager of SMP and as a director of Rockport

Capital, executed a second amendment (“Amendment No. 2”) to the

SMP LLC agreement dated as of December 11, 1996, admitting

Somerville S Trust as a member of SMP.    Amendment No. 2 required


       31
       From this point forward, the documents in the record
(including the relevant tax returns) refer to $974,296,600.85 in
indebtedness owing by SMHC. Previous documents alluded to a
principal debt of $975,494,909.84. For our purposes, we refer to
the $974 million in receivables from Generale Bank.
                                - 56 -

Somerville S Trust to contribute $19.8 million in cash to SMP in

exchange for a 99.5-percent common interest in SMP (to be held as

a Common I interest).

     Mr. Lerner, as trustee of Somerville S Trust, executed a

document entitled “Assignment” dated December 10, 1996, in which

Somerville S Trust contributed $19.8 million in cash and

marketable securities to SMP.32

     The members of SMP had the following membership interests in

SMP after December 11, 1996:

                                              Common     Preferred
                 Common        Preferred      capital     capital
                interest1       interest2     account     account

CLIS                 0%          36.76%             $0   $1,875,000
Generale Bank        0           61.27               0    3,125,000
Somerville       99.50               0      19,800,000            0
Rockport          2.25            0.85          50,000       50,000
Lerner            2.25            0.85          50,000       50,000
     1
       The common membership interests in SMP do not add up to
     100 percent.
     2
       The preferred membership interests in SMP do not add up to
     100 percent.




     32
       Amendment No. 2 indicated that the $19.8 million in cash
and marketable securities would be held by Somerville S Trust
“for the sole and exclusive benefit of the LLC and that said
amount shall heretofore be deemed assigned to and owned by the
LLC.” It also indicated that on or before Dec. 31, 1997, this
amount plus interest would be paid to an account established in
the name of SMP.
                              - 57 -

         4.   Deposit Account Agreement

     On December 11, 1996, Rockport, CDR, and Chase Manhattan

Bank entered into a deposit account agreement (the deposit

account agreement) pursuant to which Rockport agreed to place $5

million in a blocked account to be paid to Generale Bank and CLIS

upon the exercise of the put under the side letter agreement.

Pursuant to the deposit agreement, upon notice from CDR directing

a distribution to be made, Chase Manhattan Bank was irrevocably

directed to distribute the amount specified in the notice.

Rockport Capital irrevocably agreed that no amount on deposit in

the deposit account could be distributed at the direction of

Rockport Capital.   The deposit agreement provided that on January

2, 1998, the bank would withdraw and pay to Rockport Capital all

funds then on deposit, if no withdrawal had been made by then.

         5.   Advisory Fee Agreement

     On December 11, 1996, Rockport Capital executed a letter

(the advisory fee agreement) agreeing to pay CLIS an advisory fee

of $5 million and an additional advisory fee equal to three-

quarters of 1 percent of the tax losses, if any, in excess of $1

billion that would be allocated to all members of SMP other than

Generale Bank, CLIS, Rockport, or their affiliates as of the

exchange and contribution agreement closing date.   In the

advisory fee agreement, Rockport agreed that “notwithstanding any

provision of the * * * [letter agreement] to the contrary, the
                              - 58 -

Effective Date will not occur unless Rockport has made the

payment, if any, required by the preceding paragraph.”

          6.   Consent

     Prior to becoming members of SMP, CLIS and Generale Bank

required Mr. Lerner, as manager of SMP, to execute a document

(the consent) to provide advance consent to transfer CLIS’s and

Generale Bank’s preferred interests and to withdraw from SMP.33

White & Case drafted the consent on behalf of CLIS and Generale

Bank and dated it “___________, 1996”.34

      Prior to CLIS’s and Generale Bank’s becoming members of

SMP, Mr. Lerner, as manager of SMP, signed the consent agreeing

to CLIS’s and Generale Bank’s transfer of preferred interests in

SMP and withdrawal as members of SMP.

     D.   Assignment to Santa Monica Finance, B.V.

     On December 23, 1996, Mr. Geary sent Mr. Lerner:    (i) A

facsimile of an instrument assigning Generale Bank’s 61.27-

percent preferred interest in SMP to Santa Monica Finance, B.V.;

and (ii) an executed ratification certificate from the latter

entity.




     33
       CLIS and Generale Bank planned to transfer the preferred
interests to a CDR affiliate, Santa Monica Finance B.V., before
the put under the side letter agreement was exercised.
     34
       Mr. Lerner executed two other consents for the transfer
of preferred interests and the withdrawal of an unnamed “Member”
of SMP. These consents were also predated “     , 1996”.
                                 - 59 -

      E.   Exercise of the Put

      On December 26, 1996, Mr. Geary, pursuant to the

instructions of Mr. Jouannet, sent facsimiles to William Ponce,

Gary Mazzola, and Celia Murphy at Chase Manhattan Bank, and to

Mr. Lerner, transmitting notices from CLIS and Santa Monica

Finance, B.V., exercising their rights under the side letter

agreement and the deposit account agreement.35    The $5 million

that Somerville S Trust had deposited with Chase Manhattan Bank

was duly paid to CLIS and Generale Bank.     Per an informal

agreement between Rockport Capital and Somerville S Trust,

Somerville S Trust became the purchaser and owner of the

preferred interests.

VI.   Film Rights Contributed to SMHC

      A.   Film Titles and Development Projects

      The following film titles and development projects were

listed in Schedule 1.6(b) of the exchange and contribution

agreement as assets of SMHC:

U.S. Video Film Rights

1.    Alley Cat                      7.    Battle of the Valiant
2.    Astro Zombies                  8.    Beast, The
3.    Auditions                      9.    Blood Brothers
4.    Avenger                        10.   Blood Castle
5.    Banana Monster                 11.   Cardiac Arrest
6.    Battle of the Last Panzer      12.   Carthage in Flames


      35
       Mr. Geary exercised Generale Bank’s and CLIS’s rights
under the side letter agreement and deposit account agreement on
Dec. 26, 1996; however, the put period did not commence until
Dec. 31, 1996.
                              - 60 -

13.   Cold Steel for Tortuga      41.    Octavia
14.   Conqueror and the Empress   42.    Platypus Cove
15.   Crimson                     43.    Summer Camp Nightmare
16.   Demoniac                    44.    Bombay Talkie
17.   Duel of Champions           45.    Courtesans of Bombay
18.   Equinox                     46.    Hullabaloo over Georgia
19.   Erotkill                    47.    Shakespeare Wallah
20.   Escape from Hell            48.    Nasty Hero
21.   Escape from Venice          49.    To Love Again
22.   Fear                        50.    Sticks and Stones
23.   Fist of Fear, Touch of      51.    This Time I’ll Make You
      Death                              Rich
24.   Fraulein Devil              52.    Danger Zone
25.   Headless Eyes               53.    Hunter’s Blood
26.   Invincible Gladiators       54.    Sidewinder One
27.   Invisible Dead              55.    Firefight
28.   Jungle Master               56.    House of Terror
29.   Oasis of Zombies            57.    Ninja Hunt
30.   Return of the Conqueror     58.    Ninja Showdown
31.   Return of the Zombies       59.    Ninja Squad
32.   SS Camp 5                   60.    Outlaw Force
33.   SS Experimental Love Camp   61.    Plutonium Baby
34.   The Sword & The Cross       62.    Terror on Alcatraz
35.   Throne of Vengeance         63.    The Visitants
36.   Tiger of the Seven Seas     64.    War Cat
37.   Tormentor                   65.    White Ghost
38.   White Slave
39.   Zombie
40.   Mother & Daughter: Loving
      War

Development Projects

1.    Atlantis                     14.   Karma Sutra
2.    Captain’s Daughter           15.   “M”
3.    Child Prostitution           16.   Marriage License
4.    Detroit Boogie               17.   Nobody’s Boy
5.    Deadly Vision                18.   Pied Piper
6.    Dubrovsky                    19.   Price of Passion
7.    Shining City                 20.   Prince and the Pauper
8.    $1.98 Man                    21.   Princess and the Pea
9.    Ballhouse Jam                22.   Scorched Season
10.   Cinderella                   23.   Snow Queen
11.   Golden Goose                 24.   Strike on Babylon
12.   Goldilocks & 3 Bears         25.   Tom Sawyer
13.   Jack & the Bean Stalk        26.   Treasure Island
                                   - 61 -

     B.   History of the EBD Film Library

          1.    Epic Productions

     In the late 1980s, through some intermediate steps of

ownership, Credit Lyonnais created Epic Pictures Enterprises

(Epic Pictures) and Epic Productions, Inc. (Epic Productions).

Epic Pictures was created in 1987 or 1988 to take possession of

and manage certain motion picture assets.    Epic Productions took

possession of the stock of Epic Pictures and managed that company

after it was created.    In 1992, Credit Lyonnais lost confidence

in the existing management of Epic Productions and hired John

Peters to replace that management and serve as its CEO.36    Mr.

Peters worked as Epic Productions’ CEO from 1992 until July 1998.

     In late 1993 or early 1994, Credit Lyonnais began acquiring

other entertainment assets, particularly film libraries, from

companies to which Credit Lyonnais had lent money.    (When loans

from Credit Lyonnais became distressed, Credit Lyonnais would

acquire the film assets in workouts, bankruptcies, or other

proceedings.)    To take possession of, or title to, these film

assets, Credit Lyonnais created approximately six companies,

including Alpha Library Co., Inc. (Alpha) and Epsilon Library

Co., Inc. (Epsilon).    After Credit Lyonnais acquired these film


     36
       As chief executive officer (CEO) at Epic Productions,
John Peters had frequent contact with individuals associated with
Credit Lyonnais, including Hank de Kaiser in Rotterdam, Mr.
Jouannet and Michelle la Brund in Paris, and Bruno Hurstel, who
was a director on Epic Productions’ board.
                               - 62 -

assets, it turned them over to Epic Productions to manage.     As a

result, Epic Productions eventually was managing over 1,000 films

(the CDR library).

     Credit Lyonnais’s overall goal was to liquidate the film

assets that it acquired rather than to simply consolidate these

assets and pursue business in the entertainment realm.    By late

1995, Credit Lyonnais instructed Epic Productions to begin

planning the liquidation of the CDR library; this became the

focus of Epic Productions’ business operations.

          2.   EBD (Rotterdam) Finance, B.V.

     On December 18, 1995, CDR incorporated EBD (Rotterdam)

Finance, B.V. (EBD), as a special-purpose entity to take over the

so-called EBD film-related portfolio which was excluded from the

sale of CLBN to Generale Bank.37

          3.   Selection of Film Titles for CDR

     In 1996, during Epic Productions’ efforts to sell the CDR

library, someone at either Credit Lyonnais or EBD contacted Mr.

Peters and instructed him to find some low-value films and

development projects within the CDR library.38    Mr. Peters



     37
       The record is unclear on the precise role that EBD played
vis-a-vis Epic Productions, although it appears that EBD was in
some respect higher on the Credit Lyonnais/CDR chain than Epic
Productions.
     38
       Mr. Peters testified that the individual who contacted
him from Credit Lyonnais or EBD was likely Hank de Kaiser, Mr.
Jouannet, Bruno Hurstel, or Michelle la Brund.
                                - 63 -

selected the “U.S. Video Film Rights” to the 65 film titles and

the rights to the 26 development projects that were listed in

Schedule 1.6(b) of the exchange and contribution agreement.

          4.    Assignments Before the Contributions to SMHC

     As described below, a number of documents were executed

providing for transfers and assignments of the 65 film titles and

26 development projects that Mr. Peters had selected.

     According to a document entitled “Assignment” dated as of

December 10, 1996, Alpha assigned and transferred to CLIS:

(i) The “U.S. Video Film Rights” to 15 film titles; and (ii)

eight development projects for “$0.25 and other good and valuable

consideration.”39    According to this document, Alpha made no

express or implied warranties or representations with respect to

these assets.

     According to a second document entitled “Assignment” dated

as of December 10, 1996, Epsilon assigned and transferred to CLIS

18 development projects for “$0.25 and other good and valuable

consideration.”     According to this document, Epsilon made no

express or implied warranties or representations with respect to

these assets.

     According to a third document entitled “Assignment” dated as

of December 10, 1996, EBD assigned and transferred to CLIS the


     39
       The assignment, including its attached schedule, did not
define the term “U.S. Video Film Rights”; it identified the films
only by titles.
                               - 64 -

“U.S. Video Film Rights” to 50 film titles for “$0.50 and other

good and valuable consideration.”40     According to this document,

EBD made no express or implied warranties or representations with

respect to these assets.

     According to a fourth document entitled “Assignment”, dated

as of December 10, 1996, EBD, on behalf of itself and its

subsidiaries, Alpha, Epsilon, and Epic Pictures (collectively

“the EBD group”), assigned and transferred to CLIS the “U.S.

Video Film Rights” to 65 film titles (the EBD film rights) and 26

development projects (collectively “the EBD film library”) for

“$1 and other good and valuable consideration”.41

     According to a fifth document entitled “Resolutions of

Credit Lyonnais International Services”, effective December 10,

1996, CLIS assigned, transferred, and contributed all its rights

and interests in the EBD film library to the capital of SMHC.

          5.   Storage Conditions of the EBD Film Library

     In 1996, many of the films in the EBD film library were

stored at “the Epic warehouse”, which Epic Productions owned.

The Epic warehouse was a metal shell building, about 30,000

square feet, located near the airport in Burbank, California,


     40
       The assignment, including its attached schedule, did not
define the term “U.S. Video Film Rights”; it identified the films
only by titles.
     41
       The assignment, including its attached schedule, did not
define the term “U.S. Video Film Rights”; it identified the films
only by titles.
                               - 65 -

about 5 or 6 miles from Epic Productions’ offices.     At this

location, film materials were stored on metal racks along with

other materials, including reels of film, posters, publicity

materials, cardboard cassette boxes, cassette inventory, old

files, an ambulance, and an old Cadillac convertible.     Unlike

regular film laboratories and facilities, the Epic warehouse was

not a temperature- and humidity-controlled facility; it was not

bonded; and it did not have good inventory control.

       At one time, Epic Productions had a full-time employee who

supervised and provided security at the Epic warehouse; however,

as of sometime before 1996, Epic Productions had no supervision

or security at the Epic warehouse.      For this and other reasons,

Epic Productions stored no film materials in the Epic warehouse

that it regarded as highly valuable or irreplaceable.     If Epic

Productions had master film material for valuable films, it

stored them in secure laboratories with temperature and humidity

controls.

VII. Due Diligence for the CDR Transaction

       A.   James Rhodes

       Sometime in 1996, Mr. Lerner hired an attorney, James

Rhodes, to assist with some of the due diligence on the

“corporate side” for the transaction between Rockport Capital and

CDR.    Mr. Rhodes continued his work into 1997, tying up loose
                             - 66 -

ends and following up with White & Case and Mr. Jouannet to

complete the Ackerman group’s files.

     On December 11, 1996, Mr. Rhodes faxed to Mr. Wofford at

White & Case a revised draft of a “Basis Chronology”, which

contained an analysis of the bases of all the assets involved in

the transaction between Rockport Capital and CDR.   The basis

chronology included a section analyzing the basis of the MGM

Group Holdings stock, and it listed three transactions affecting

the basis of MGM Group Holdings’ stock:   (i) MGM Holdings’s

purchase of 98.5 percent of MGM Group Holdings stock in the 1992

foreclosure sale for $483,489,000; (ii) Credit Lyonnais’s

acquisition of Sealion’s 1.5-percent stock interest in MGM Group

Holdings that had been pledged to Credit Lyonnais as security for

a $150 million loan to Sealion; and (iii) MGM Holdings’s

contribution of Carolco securities in the face amount of $60

million to MGM Group Holdings on September 28, 1996.

     On May 12, 1997, Mr. Wofford sent a facsimile cover sheet to

Mr. Rhodes which stated:

          This letter is to confirm that, to our knowledge,
     none of Credit Lyonnais International Services
     (“CLIS”), Generale Bank Nederland (“GB”), or any
     affiliate of Credit Lyonnais S.A. or Consortium de
     Realisation (“CDR”) derived any U.S. tax benefit from
     the contribution of the stock of Santa Monica Holdings
     Corporation or the Holdings - CLIS Debt (as defined in
     the Exchange and Contribution Agreement (the
     “Agreement”) by and among Santa Monica Pictures, L.L.C.
     (the “Company”), CDR, CLIS, GB and Rockport Capital
     Incorporated, dated as of December 11, 1996) pursuant
                               - 67 -

     to the Agreement or the subsequent disposition by CLIS
     and GB of interests in the Company.

     B.   Troy & Gould

     In June 1997, Mr. Lerner engaged the law firm of Troy &

Gould, P.C., in Los Angeles, California, to perform due diligence

on the EBD film library.   Two highly regarded entertainment

lawyers at Troy & Gould, Gary Concoff and Jonathan Handel,

conducted the due diligence.   Before engaging Troy & Gould, Mr.

Lerner received no documentation tracing the chain of title for

the EBD film rights.

           1.   Chain-of-Title and Record Search

     Troy & Gould contacted individuals at certain law firms and

at various entities (principally Epic Productions) that were

believed to have held interests in the EBD film library.     On

December 9, 1997, Mr. Handel sent Mr. Lerner a memorandum

containing Troy & Gould’s conclusions regarding the nature of the

rights that SMHC acquired in the EBD film library.   The

memorandum summarizes its conclusions as follows:

     The documentation is too fragmentary to draw
     conclusions with any semblance of confidence. As a
     matter of general characterization, it would seem that
     Santa Monica Holdings is intended to have acquired
     domestic video rights for a term of years to the
     subject pictures and all rights to the subject
     development projects. The domestic rights appear to
     include Canada as to some but not all pictures. The
     term of the rights varies from picture to picture.

     Again, the foregoing characterization is subject to the
     caveat that we have no documentation whatsoever on most
     of the subject pictures and projects, and the
                             - 68 -

     documentation we do have is incomplete. In addition,
     there are outright gaps in the chain of title as to
     groups of pictures; that is, certain documents relating
     to transfers of libraries are missing.

     For the foregoing reasons, it is not possible to
     determine what rights have effectively been acquired.
     It also is unclear who possesses the rights other than
     domestic video in the various pictures, and who
     possesses the reversion rights in domestic video.

The memorandum related that Epic Productions provided chain-of-

title documentation for only 15 of the 65 film titles (and 22 of

26 development projects), and that many of the 15 film titles for

which Troy & Gould received documentation appeared to be the

subject of domestic video rights licenses to Embassy and

Concorde, but that some of those licenses expired in May 1997.42

     Troy & Gould stated that rights to completed pictures in the

EBD film library were apparently acquired by three entities,

Epic, Sultan (or its predecessor, Nelson), and Trans World

Entertainment; however, Troy & Gould could not determine how

these entities acquired rights from other entities appearing in

the chain of title, e.g., Embassy.    Troy & Gould concluded that

this failure represented a significant gap in the chain of title.



     42
       From its examination of these film titles, Troy & Gould
determined that the licenses were for a term of years, in most
cases 10 years from delivery, and that it appeared for the most
part that the licenses had recently expired or would soon expire.
Troy & Gould concluded that “as to pictures for which the video
license to Embassy or Concorde has expired, it would appear that
* * * [SMHC] has no rights whatsoever, unless there are other
assignments (for which we have no documentation) into our chain
of title from the producers or other rights holders.”
                               - 69 -

     Troy & Gould pointed out:   “There is no evidence * * * that

the Epic entities actually transferred their rights in the

subject pictures to EBD, despite the fact that EBD subsequently

purported to transfer rights in the pictures”; and “The

documentation of the chain of title thus appears unsatisfactory

as to the Epic pictures.”

     Troy & Gould characterized the various assignments of film

assets from Alpha, Epsilon, and EBD to CLIS as “quitclaim

assignments; that is, the transferors disclaimed all warranties

and representations as to the assets.”   Moreover, although the

assignments referred to all right, title, and interest in the

film assets, the attached schedules referred only to “‘U.S. Video

Film Rights’”.   Troy & Gould also indicated that it had no

documentation confirming CLIS’s assignment of the EBD film

library to SMHC; it characterized this lack of documentation as

“another significant gap in the chain of title.”   Troy & Gould

expressed further concerns that the term “U.S. Video Film Rights”

in Schedule 1.6(b) of the exchange and contribution agreement was

not defined and that the exchange and contribution agreement

contained no explicit statement that SMHC owned those rights.

         2.   Access Letters

     While Troy & Gould was conducting its due diligence on the

EBD film library, it was also attempting to obtain laboratory and

facility access letters to the physical materials of certain film
                                - 70 -

titles in order to enter the laboratories and facilities and

examine those physical materials.

VIII. Other Film Activities

      In 1997, 1998, and 1999, SMHC (largely through the efforts

of Mr. Lerner, sometimes working with Michael Herz, the vice

president of Troma Entertainment, Inc.) investigated and acquired

a number of film titles and film libraries in addition to the

film library acquired in connection with the CDR transaction.     A

June 16, 1999, memo that Mr. Lerner sent to Mr. Ackerman reported

on the film libraries that SMHC had acquired, summarizing the

“initial library and acquisitions”, the number of titles, and

their “Cost” as follows:

Library                    Number of Titles              Cost

MGM (original)                    80                 $5,000,000
Wisdom                             8                    120,000
City Lights                       15                    115,000
Five Stones                        5                     75,000
Vista Street                      24                    470,000
Moving Picture Factory            33                    320,000
                 Total           165
  New Production Total             2                   $615,000
                 Total           167                 $6,715,000

     The “Wisdom” library, which Crown Capital purchased in

November 1997 from Wisdom Entertainment, Ltd., contained eight

karate films.   The “City Lights” library, purchased by Crown

Capital in September 1997 from Nevada Media Partners, Inc.,

contained 15 full-length feature films.       The “Five Stones”

library, purchased by SMHC in October 1998 from Five Stones,
                                 - 71 -

Inc., contained five film titles.     The “Vista Street” library,

purchased by SMHC in March 1999 from Marketing Media Corp. d/b/a

Vista Street Entertainment, contained 24 film titles.     The

“Moving Picture Factory” library, purchased by SMHC in October

1998 from The Moving Picture Co., Inc., contained 34 film titles.

      SMHC also investigated a number of film titles and film

libraries that, for one reason or another, it did not acquire.

IX.   Relationship With TroMetro Films, LLC

      A.   John H. van Merkensteijn

      John H. van Merkensteijn was Mr. Lerner’s longtime friend,

client, and business associate.     In the 1970s, Mr. Lerner had

represented Mr. van Merkensteijn in some transactions.     Since

then, they have stayed in contact and have been friends.     Mr. van

Merkensteijn participated in transactions with Mr. Lerner both

before and after 1996.

      B.   TroMetro Films, LLC

      On December 15, 1997, Mr. van Merkensteijn formed TroMetro

Films, LLC (TroMetro), to be part of a distribution relationship

with SMHC and Troma and to purchase receivables from SMP.       Mr.

van Merkensteijn had no office of his own for TroMetro; instead,

he had items sent to Crown Capital’s office.
                                 - 72 -

       C.   TroMetro’s Purchases of SMP’s Receivables

       In 1997 and again in 1998, TroMetro purchased from SMP

portions of the $974 million in receivables that Generale Bank

had contributed to SMP in 1996.

            1.   First Note Purchase Agreement

       As of December 19, 1997, TroMetro and SMP entered into a

note purchase agreement (the first note purchase agreement) in

which TroMetro agreed to purchase “SMP’s right, title and

interest in and to the $150,000,000 Note” (the $150 million

receivable).     The consideration for the $150 million receivable

was:    (i) A certified check of $230,000; and (ii) a promissory

note that TroMetro executed in an unspecified amount.     SMP agreed

to deliver to TroMetro, at the closing of the transaction, a $150

million note endorsed by SMP and payable to the order of

TroMetro.

       As of December 19, 1997, Mr. van Merkensteijn, as manager of

TroMetro, executed an “Unsecured Promissory Note” payable to SMP

in the amount of $2,284,000 (the $2,284,000 Trometro note) in

connection with TroMetro’s purchase of the $150 million

receivable.      The terms of this note provided that interest would

accrue at 7 percent per annum, that interest and principal would

be fully amortized over 5 years, and that interest and principal

payments would be due and payable in five equal annual

installments beginning December 19, 1998.
                             - 73 -

     In connection with the sale of the $150 million receivable

at the end of 1997, Mr. Lerner executed a $150 million note (the

$150 million note) representing a portion of the $974 million in

receivables that Generale Bank had contributed to SMP.     The note

stated that MGM Group Holdings owed CLBN $150 million.43    Mr.

Lerner backdated the note as of December 30, 1993, and signed it

as president of MGM Group Holdings; however, Mr. Lerner was not

the president, or an officer, of MGM Group Holdings on that date.

     As a result of the sale of the $150 million receivable, SMP

reported the following information on its 1997 Form 1065, U.S.

Partnership Return of Income, with respect to the $150 million

receivable:

     Date acquired                             12/30/93
     Date sold                                 12/19/97
     Sales price                             $2,514,000
     Cost or other basis                   $150,000,000
     Gain or (Loss) for entire year       ($147,486,000)

The $147,486,000 loss flowed through to Somerville S Trust.44




     43
       The note purchase agreement restated that “SMP is the
holder of two Promissory Notes issued by * * * [SMHC] in the
respective principal amounts of $815,904,188.96 and
$150,000,000”.
     44
       On Dec. 29, 1997, Somerville S Trust contributed all its
outstanding member interests in Somerville, LLC to SMP. This
contribution was reflected on SMP’s 1997 partnership tax return
as a $145,236,168 increase in Somerville S Trust’s capital
account in SMP.
                               - 74 -

          2.   Second Note Purchase Agreement

     As of December 10, 1998, TroMetro and SMP entered into a

second note purchase agreement (the second note purchase

agreement) in which TroMetro agreed to purchase “10% of SMP’s

right, title and interest in and to the Note, representing a

$81,590,418 share of the face amount of the Note” (the $81

million receivable).45   The consideration for the $81 million

receivable was:   (i) A $150,000 certified check; and (ii) a $1.25

million promissory note from TroMetro.

     As of December 10, 1998, Mr. van Merkensteijn, as manager of

TroMetro, executed an “Unsecured Promissory Note” payable to SMP

in the amount of $1.25 million (the $1.25 million TroMetro note)

in connection with TroMetro’s purchase of the $81 million

receivable.    The terms of this note provided that interest would

accrue at 7 percent per annum, that interest and principal would

be fully amortized over 5 years, and that interest and principal

payments would be due and payable in five equal annual

installments beginning December 10, 1999.

     As of December 10, 1998, Mr. Lerner, as manager of SMP, and

Mr. van Merkensteijn, as manager of TroMetro, signed a document

entitled “Assignment.”   Pursuant to this document, SMP assigned




     45
        The second note purchase agreement stated that SMP was
the holder of an $815,904,188.96 promissory note that SMHC had
issued.
                               - 75 -

to TroMetro, and TroMetro purchased and assumed from SMP, SMP’s

right, title, and interest in the $81 million receivable.

     As a result of the sale of the $81 million receivable, SMP

reported the following information on its 1998 Form 1065 with

respect to the $81 million receivable:

     Date acquired                             12/30/93
     Date sold                                 12/10/98
     Sales price                             $1,400,000
     Cost or other basis                    $81,590,418
     Gain or (Loss) for entire year        ($80,190,418)

The $80,190,418 loss flowed through to Somerville S Trust.

          3.   Purchase Price Determinations

     Mr. van Merkensteijn testified that the purchase price for

the $150 million receivable and the $81 million receivable was

determined as percentages of the total value of SMHC’s assets,

after applying a discount.   He testified that the total value of

the assets in this calculation was based on an appraisal that Mr.

Lerner had obtained from Sage Entertainment.46    Mr. van

Merkensteijn did not obtain his own appraisal of SMHC’s assets.

          4.   Payments on the TroMetro Notes

     On December 21, 1998, TroMetro made a $557,046.35 payment to

SMP on the $2,284,000 TroMetro note.    This payment consisted of

$397,166 principal and $159,880.35 interest.     It was the only



     46
       At some point, Mr. Lerner had asked Sage Entertainment
for an opinion valuing the EBD film library. He had obtained an
opinion from Steve Kutner of that company valuing the library at
approximately $29 million.
                               - 76 -

cash payment TroMetro ever made on the $2,284,000 TroMetro note.

On December 21, 1998, TroMetro paid SMP $150,000 pursuant to the

second note purchase agreement.    TroMetro never made any

additional cash payments on the $1.25 million TroMetro note.

X.   Distribution Agreements

     In 1997, SMHC entered into a distribution agreement with

TroMetro which, in turn, entered into a distribution agreement

with Troma.   The distribution agreements covered a portion of the

EBD film library and several of SMHC’s acquired libraries.

     A.   The TroMetro Distribution Agreement

     As of December 23, 1997, SMHC and TroMetro entered into a

distribution agreement (the TroMetro distribution agreement).

Pursuant to this agreement, SMHC gave TroMetro a license to

distribute 33 of the 65 film titles within the EBD film library,

as well as the “Wisdom” library and the “City Lights” library.47

TroMetro never paid any royalties to SMHC pursuant to the

TroMetro distribution agreement.



     47
       The 33 film titles from the EBD film library were:
“Astro Zombies”, “Auditions”, “Avenger”, “Banana Monster”,
“Battle of the Last Panzer”, “Battle of the Valiant”, “The
Beast”, “Blood Brothers”, “Blood Castle”, “Carthage in Flames”,
“Cold Steel for Tortuga”, “Dual of Champions”, “Escape From
Hell”, “Fear”, “Fist of Fear, Touch of Death”, “Headless Eyes”,
“Invincible Gladiators”, “Return of the Conqueror”, “Return of
the Zombies”, “SS Experimental Love Camp”, “The Sword and the
Cross”, “Tiger of the Seven Seas”, “Tormentor”, “White Slave”,
“Octavia”, “Platypus Cove”, “Hullabaloo Over Georgia”, “To Love
Again”, “This Time I’ll Make You Rich”, “Danger Zone”,
“Sidewinder One”, “Ninja Showdown”, and “Ninja Squad”.
                                - 77 -

     B.   The Troma Distribution Agreement

     As of December 23, 1997, TroMetro and Troma Entertainment,

Inc. (Troma), an independent production and distribution company

in New York City, entered into a distribution agreement (the

Troma distribution agreement), covering the same film titles as

the TroMetro distribution agreement.48   Troma never paid any

royalties to TroMetro pursuant to the Troma distribution

agreement.

     C.   Troma Entertainment, Inc.

     Michael Herz and Lloyd Kaufman started Troma while they were

students at New York University Law School in 1974.49   Troma is

owned by Messrs. Herz and Kaufman, a private company called QIC

controlled by Alan Quasha, and Foster Partnership.

     In the early 1980s, Troma began distributing its films with

a film called “Squeeze Play.”    Troma eventually produced 25 to 30

films and acquired a number of films through purchases and

distribution deals.   Troma currently has 800 to 850 film




     48
       On Nov. 2, 1998, TroMetro and Troma entered into an
addendum, to which SMHC acknowledged and consented, amending the
Troma distribution agreement. Pursuant to this addendum, the
“Moving Pictures” library and the “Five Stones” library were
added to the Troma distribution agreement. No addendum was made
to the TroMetro distribution agreement.
     49
       Mr. Lerner was introduced to Mr. Herz by Mr. van
Merkensteijn.
                                 - 78 -

titles.50    All of Troma’s film titles are available on its

website, and there are distribution materials such as advertising

slicks for them.     Not all of Troma’s films, however, are in

current distribution.51

     D.     Troma’s Distribution of the EBD Film Library

            1.   Distribution History

     SMHC and SMP distributed no films prior to forming their

relationship with Troma.     Troma was the only distributor of SMHC

films.    Of the 65 film titles in the EBD film library, Troma

ultimately distributed six films:       “Astro Zombies”, “Banana

Monster”, “Battle of the Last Panzer”, “Escape from Hell”, “Fist

of Fear, Touch of Death”, and “Plutonium Baby”.52

     Several of these distributions ran into legal troubles.       On

March 27, 1998, Epic Productions informed Troy & Gould that

SMHC’s rights had expired in “Astro Zombies”, “Banana Monster”,




     50
       There are several stars in Troma’s films, including Billy
Bob Thornton and Kevin Costner. The character “Toxic Avenger” is
Troma’s ‘Mickey Mouse’, having been featured in four action
movies and a children’s cartoon that Troma distributed.
     51
       About 200 to 220 of Troma’s film titles have actually
been authored and digitized and are out in U.S. distribution on
DVD. The remaining film titles are not in distribution because
the process of preparing them for distribution is costly, and
because Troma needs to be sure that the market can absorb the
number of films that it presents for distribution on a monthly
basis.
     52
       Troma created distribution materials for the eight film
titles in the “Wisdom” library.
                                - 79 -

and “Fist of Fear, Touch of Death”.53    Moreover, on June 23,

1999, a representative of Gazotskie Films, Inc., informed Troma

Entertainment that SMHC “does not have, nor has it ever had, any

rights” relating to “Banana Monster” (a.k.a. “Schlock”), and

requested that Troma cease and desist its distribution of that

film title.     Also, on October 23, 1999, Jack H. Harris, the

president of Worldwide Entertainment Corp., informed Troma that

SMHC’s rights in the film title “Astro Zombies” had actually

expired in 1987, and requested that Troma cease and desist its

distribution of that film.

          2.    Distribution Revenue and Expenses

     In the course of distributing SMHC films, Troma incurred

expenses (e.g., for advertising slicks and media costs) which

SMHC either advanced or reimbursed pursuant to the TroMetro and

Troma distribution agreements.     Periodically, Troma sent Crown

Capital (on behalf of SMHC) statements of revenue and expenses

and invoices regarding these expenses and the distribution of

SMHC films.54


     53
       Epic Productions informed SMHC that its rights in
“Headless Eyes” had also expired.
     54
       For example, Troma sent Crown Capital (on behalf of SMHC)
a statement of revenue and expenses as of June 30, 1998, showing
no revenues, $234,000 in expenses, and an advance payment of
$230,000. Troma also sent Crown Capital an invoice for creation
of distribution materials (including production of press and
media) for the “Wisdom” library for the period June 1 to 30,
1998, showing expenses of $44,000. Troma sent to “TroMetro-Santa
                                                   (continued...)
                                - 80 -

      Mr. Herz testified that the agreement with TroMetro and SMHC

had always been for Troma to retain any net revenue from its

distribution activities to fund additional distribution expenses

rather than to remit royalties.55   SMHC reported and received no

income from licensing video rights to film titles or film

financing during 1997 and 1998.

XI.    Transactions With Imperial Credit Industries, Inc.

      In 1997, the Ackerman group engaged in discussions with

Imperial Credit Industries, Inc., culminating in the formation of

Corona Film Finance Fund, LLC.

      A.   Imperial Credit Industries, Inc.

      Before 1992, Imperial Bank acquired or started six different

operating businesses.    In 1991, Imperial Bank decided to take two

of those six businesses public, including a residential mortgage

business and thrift and loan.    In 1992, Imperial Bank



      54
      (...continued)
Monica” a statement of revenue and expense as of Dec. 31, 1998,
for films that Troma distributed on behalf of TroMetro and SMHC.
This statement shows $23,250 in revenue, $6,907.91 in
distribution expenses, and a $16,342.09 amount due TroMetro. On
Nov. 4, 1998, Troma sent Crown Capital another invoice for
$103,025 on the release of video and DVD for “Banana Monster”,
“Fist of Fear, Touch of Death”, “Astro Zombies”, “Battle of Last
Panzer”, and “Escape from Hell”. This invoice requested a
$50,000 advance payment.
      55
       In at least one case, the statement to “TroMetro-Santa
Monica” as of Dec. 31, 1998, states “Check Enclosed” for the
amount of revenues exceeding distribution expenses. Mr. Herz
testified that he did not think a check was in fact sent to
TroMetro or SMHC, given the agreement to retain net revenue.
                               - 81 -

successfully combined those businesses and took them public as

Imperial Credit Industries, Inc. (Imperial).56

     During 1996 and 1997, Imperial was a diversified financial

services company.    It was involved in franchise lending,

residential lending, income property lending, asset-based

lending, and warehouse lines for mortgage bankers.    Imperial’s

investments included, among other things, an equipment leasing

company, a boutique investment bank, and an auto financing

company.    In 1996, Imperial had 10 operating divisions.    Film

finance was not one of Imperial’s operating divisions.

     B.    Shopping for Tax Deals

     At some point in 1997, Imperial sold its interests in

Franchise Mortgage Acceptance Corp. (FMAC) and Southern Pacific

Funding Corp. (SPFC), resulting in capital gains to Imperial--

approximately $300 million from FMAC and $150 million from SPFC.

In the planning stage of these transactions, Kevin Villani, as

Imperial’s CFO, was asked to develop a plan with favorable

offsetting tax implications.

     On August 27, 1997, at a meeting of Imperial’s board of

directors, Wayne Snavely, who was Imperial’s CEO and chairman,

and Mr. Villani reported that Imperial had significant taxable

capital gains to be realized from securities sales in 1997.      Mr.


     56
       At one point, Imperial Bank owned 100 percent of
Imperial; after spinning Imperial out, however, Imperial Bank’s
ownership interest fell to 40 percent.
                               - 82 -

Villani was requested to develop a plan for presentation to the

Board that would include potential investments with favorable

offsetting tax implications.

     C.   Proposed Transaction With SMP

     Mr. Lerner was on Imperial’s board of directors during 1996,

1997, and 1998.   Mr. Lerner was aware that Imperial was actively

looking for a transaction that would generate large capital

losses to offset its capital gains.

     On October 7, 1997, Mr. Lerner sent Mr. Villani a memorandum

discussing a proposal whereby Imperial would purchase a 25-

percent interest in SMP for $5 million.    Mr. Lerner represented

that SMP had “assets totaling $49 million (with zero liabilities)

including:   $29 million in film library assets (appraised value)

and $20 million in cash[.]   ICII’s 25% share of the assets would

equal approximately $12.25 million, a multiple of the proposed

investment”.   The memorandum stated:   “Rockport intends to use

* * * [SMP] as a platform to finance and build a film library of

significant size that should enable * * * [SMP] to capitalize on

a changing dynamic that is occurring in the film industry.”    The

memorandum also stated:

     Tax Attributes. In addition to the foregoing, the
     Company may realize income tax benefits on the disposal
     of its assets in the form of capital losses. Based on
     a 25% ownership interest, * * * [Imperial’s] share of
     such losses would be approximately $400 million. We
     anticipate that the parties would enter into a tax
     sharing agreement providing for a sharing of the
     benefits attributable to this loss[.]
                             - 83 -

Imperial received and considered this memorandum.

     On October 24, 1997, Mr. Lerner sent Mr. Villani an email

stating:

     I am preparing a short term sheet for the film
     partnership investment we discussed last week. I
     haven’t heard any more from KPMG and I assume that they
     have no more comments. The two issues we need to tie
     down are the size of the investment and the
     compensation formula. A quarter of the partnership
     would give * * * [Imperial] a loss of about $430
     million. The board should approve the deal in broad
     outlines and we should then work out the details as
     quickly as possible since time is running out on the
     year and you have a lot of things to do. * * *

     On October 27, 1997, Mr. Lerner faxed Mr. Villani a

confidential letter outlining the proposed transaction between

SMP and Imperial:

          1. * * * [Imperial] will acquire 25 percent of
     SMP for $5.0 million (25 percent of SMP’s cash assets),
     payable in cash at the Closing. * * * [Imperial] may
     also have the option to increase its interest in SMP on
     agreed terms.

          2. Any tax benefits derived by * * * [Imperial]
     or its affiliates associated with an ownership interest
     in SMP, including the sale or disposition of any of its
     assets, will be shared with SMP’s current partners on a
     50-50 basis. Amounts received by SMP’s partners as a
     result of the sharing of tax benefits will be available
     for investments with * * * [Imperial] on a deal by deal
     basis. We anticipate that * * * [Imperial’s] share of
     SMP’s potential tax losses will exceed $430 million.

     On October 29, 1997, at a second meeting of Imperial’s board

of directors, Mr. Lerner proposed that Imperial invest in SMP.

Mr. Snavely testified that the proposed investment in SMP was

supposed to result in favorable tax treatment.
                                - 84 -

     On November 19, 1997, at a third meeting of Imperial’s board

of directors, Mr. Lerner formally offered Imperial a 25-percent

equity interest in SMP in exchange for a $5 million cash

investment.     At this meeting, Mr. Lerner distributed a handout

that described SMP.     He discussed SMP’s assets (including its

film rights), and he explained SMP’s securitization and other

financing plans.     Mr. Lerner also discussed “the potential market

for securitization of film libraries and the due diligence

performed to date by * * * [Imperial’s] external accountants.”

After discussing this proposal, Imperial’s board resolved to

invest in SMP.57

     D.    Proposed Transaction With Corona

           1.   Formation of Corona Film Finance Fund, LLC

     As of November 5, 1997, Mr. Lerner, on behalf of himself,

Peridon Corp. (Peridon), and SMP, executed an “Operating

Agreement” for the creation of Corona Film Finance Fund, LLC

(Corona) as a limited liability company (the Corona LLC

agreement).     The initial members of Corona were Mr. Lerner,

Peridon, and SMP.     Mr. Lerner contributed $5,000 cash, Peridon



     57
          Regarding this proposal, Mr. Snavely testified:

          There was discussions [sic] about an opportunity
     for us to invest in this business, and we did have some
     expertise in securitization, and there were discussions
     about acquiring film libraries, all of which was
     interesting, but we were also interested in making sure
     that it fit our tax strategies.
                               - 85 -

contributed $10,000 cash, and SMP contributed $250,000 cash and

the $79 million receivable.   As of November 5, 1997, Corona’s

capital accounts and percentage interests were as follows:

                      Capital Account       Percentage Interest

     Imperial                   $0                 0.00%
     SMP                 1,550,000                99.00
     Mr. Lerner              5,000                 0.33
     Peridon                10,000                 0.67
       Total            $1,565,000               100.00

     The Corona LLC agreement recited that the purposes for

Corona’s formation were “to finance the production and

exploitation of filmed entertainment products and to own

interests in entities engaged in such activities” and “to make

investments in connection with the foregoing activities and

otherwise.”    The Corona LLC agreement appointed Mr. Lerner as its

manager and authorized him to act on behalf of Corona to appoint

employees, officers, or additional managers, and to bind the

company in dealings with third parties.58

          2.   The Corona Transaction

     On December 11, 1997, Mr. Lerner sent an email to Irv

Gubman, Imperial’s general counsel, proposing that the previously

discussed transaction be done through Corona rather than SMP.

The email states:


     58
       On Dec. 16, 1997, the secretary of state of Delaware
certified: “Corona Film Finance Fund LLC is duly formed under
the laws of the State of Delaware and is in good standing and has
a legal existence so far as the records of this Office show as of
the sixteenth day of December, A.D. 1997.”
                             - 86 -

     Dear Irv. I have thought about our conversation last
     night and the risk at this point in time. I suggest
     the following: Lets just do the transaction for a loss
     of 70 mil (the amount you need, or perhaps a little
     more or less) through, as we discussed, a new
     partnership. This reduces the risk related to size. I
     like this structure much better as it solves your
     problem today. We can take next year as it comes.
     Thus, the plan would be as follows: We will create a
     new partnership [Corona] into which we will transfer
     high basis debt. * * * [Imperial] will buy a part of
     our partnership interest for a price related to the
     value of the partnership’s assets. This will be much
     less than the amount we originally discussed, probably
     around $500,000. On the pricing, my partner wants to
     keep the pricing the same, which we should discuss. In
     any event, think about this and let me know. We can
     get this done quickly as I have the entities set up.
     Thanks, Perry.

Mr. Lerner testified that he was uncomfortable with the large

size of the capital loss resulting from the proposed transaction

with SMP; he suggested a smaller capital loss.   He testified that

he purposely told Imperial that it would be very expensive for

them because he felt that SMP should profit from Imperial’s

capital loss.

     On December 12, 1997, Mr. Lerner sent a second email to Irv

Gubman concerning the proposed transaction with Corona.   In this

email, Mr. Lerner recommended that Imperial purchase part of

SMP’s partnership interest for an amount   “sufficient to give it

a share of the basis equal to around 60-65 million dollars.    This

loss will be triggered if the * * * [$79 million receivable] is

sold. * * * (I think that most of this should be claimed in 1997
                                - 87 -

as we have a buyer for it by the end of the year.)”    The email

further states:

     5. * * * [Imperial] will need to put capital in for
     the tax sharing, above and some debt to increase basis.
     * * * Paul [Lasiter] understands this point. I want to
     use paart [sic] of the cash to invest with The Lew
     Horowitz organization to finance movie production.
     This will come out of our share of the tax sharing
     payment. * * *

     On or about December 12, 1997, drafts were prepared of a

purchase agreement and an amendment and restatement of the Corona

LLC agreement.    In the purchase agreement, SMP agreed to sell and

Imperial agreed to purchase 80 percent of SMP’s interest in

Corona.   Mr. Gubman reviewed these drafts and made a handwritten

notation on the draft amendment and restatement of Corona’s LLC

agreement which proposed that “if Imperial’s Allocated Losses are

disallowed, then upon liquidation of the Company [Corona] all

moneys contributed to the Company by Imperial shall be returned

to Imperial and accrued interest shall be paid thereon at the

Treasury (IRS) rate.”59

     On December 17, 1997, at a fourth meeting of Imperial’s

board of directors, Mr. Snavely announced that Mr. Lerner had

submitted a revised proposal under which Imperial could invest in

Corona rather than SMP.    Imperial’s board reviewed and approved

the revised proposal.     Mr. Snavely testified that tax losses were


     59
       This notation was the only significant comment that Mr.
Gubman made on the draft amendment and restatement of the Corona
LLC agreement.
                               - 88 -

driving the Corona transaction and were the primary reason in

1997 for Imperial’s investing in the Corona transaction.

          3.   Initial Purchase of SMP’s Interest in Corona

     SMP and Imperial executed a purchase agreement (the purchase

agreement), as of December 15, 1997, providing for Imperial’s

purchase from SMP of a 79.2-percent membership interest in

Corona.   According to the purchase agreement, Imperial was to pay

$1,252,000 for the membership interest, of which $212,000 was to

be paid in cash and the $1.04 million balance was to be paid with

a note.   In connection with the purchase agreement, Imperial

executed a $1.04 million promissory note (the $1.04 million note)

dated December 15, 1997, payable to SMP.   On December 18, 1997,

Imperial paid $212,000 to SMP.   No payments of principal or

interest were ever made on the $1.04 million note.60

     In an amendment and restatement dated as of December 15,

1997, Corona’s LLC agreement was amended and restated to reflect

the admission of Imperial as a new member of Corona.   This

document reflected Imperial’s agreement to pay SMP a fee of 20

percent of the tax losses received from Corona.   This fee was to

be structured as a contribution by Imperial to Corona and a



     60
       Pursuant to the $1.04 million note, interest was to
accrue at a rate of 8 percent per annum and was payable
semiannually on June 15 and December 15 of each year. Imperial
agreed to pay the outstanding principal amount of the $1.04
million note together with accrued and unpaid interest thereon on
Dec. 15, 2002.
                                - 89 -

distribution from Corona to SMP.      As a result of Imperial’s

purchase of SMP’s membership interest in Corona, Corona’s capital

accounts and percentage interests were restated as follows:

                       Capital Account       Percentage Interest

     Imperial            $1,240,000                79.20%
     SMP                    310,000                19.80
     Mr. Lerner               5,000                 0.33
     Peridon Corp.           10,000                 0.67
       Total             $1,565,000               100.00


     On its November 5 to December 15, 1997, partnership tax

return, Corona reported Imperial’s initial purchase of SMP’s

interest as a $64,130,364 capital reduction by SMP and a

$64,130,364 capital contribution by Imperial.      Corona reported

these amounts at tax values, not accounting book values.      On its

tax return for the taxable year ended December 31, 1997, SMP

reported the sale of its interest in Corona to Imperial as

follows:

                 $1,252,000 Sales price
                 63,489,061 Basis
                (62,237,061) Long-term capital loss

The $62,237,061 loss that SMP reported flowed through to

Somerville S Trust and then through to Mr. Ackerman, who claimed

it on his tax return.

           4.   Additional Purchase of SMP’s Interest in Corona

     On December 23, 1997, Imperial purchased from SMP an

additional 14.65-percent interest in Corona pursuant to an

amendment to purchase agreement.      With this purchase, Imperial
                               - 90 -

had acquired a total interest in Corona of 93.85 percent.

Imperial paid $36,700 in cash for the additional interest and

increased the amount of its promissory note to SMP by $180,050

for a total note payable of $1,220,050 (the $1,220,050 note).

Imperial made no payments of principal or interest on this

note.61

     On December 23, 1997, the members of Corona executed an

amendment to the amended and restated Corona LLC agreement,

providing for Imperial’s purchase of the 14.65-percent additional

interest in Corona.   According to this amendment, Corona’s

capital accounts were restated as follows:



                      Capital account     Percentage interest

     Imperial           $1,469,000              93.85
     SMP                    81,000               5.15
     Mr. Lerner              5,000               0.33
     Peridon Corp.          10,000               0.67
       Total            $1,565,000             100.00

     On its partnership tax return for the period December 16 to

31, 1997, Corona reported Imperial’s additional purchase as an

$11,864,117 capital reduction by SMP and an $11,864,117 capital

contribution by Imperial.




     61
       Pursuant to the $1,220,050 note, interest was to accrue
at a rate of 8 percent per annum and was payable semiannually on
June 15 and December 15 of each year. Imperial agreed to pay the
outstanding principal amount of the $1,220,050 note together with
accrued and unpaid interest thereon on Dec. 15, 2002.
                               - 91 -

     On its partnership tax return for the taxable year ended

December 31, 1997, SMP reported the sale of the additional 14.65-

percent interest in Corona to Imperial as follows:

                  $216,750 Sales price
                11,864,117 Basis
               (11,647,367) Short-term capital loss

This $11,647,367 loss flowed through to the Somerville S Trust

and then through to Mr. Ackerman, who claimed it on his tax

return.

          5.   Sale of the $79 Million Receivable

     On December 29, 1997, Mr. Lerner, on behalf of Corona, and

Mr. van Merkensteijn, on behalf of TroMetro, executed a note

purchase agreement providing for Corona’s sale of the $79 million

receivable to TroMetro.   According to this agreement, the

purchase price to be paid by TroMetro was $1,144,000, to consist

of $120,000 cash and a $1,024,000 promissory note payable by

TroMetro to Corona.62

     On December 29, 1997, the $120,000 cash amount was paid by

wire transfer.   Mr. van Merkensteijn, on behalf of TroMetro,

executed a $1,024,000 promissory note dated December 29, 1997




     62
       In arriving at a purchase price for the $79 million
receivable, Mr. van Merkensteijn testified that he used the same
pricing formula as in TroMetro’s purchases of the $150 million
and $81 million receivables, and he similarly relied on the Sage
Entertainment appraisal of SMHC’s film assets.
                               - 92 -

(the $1,024,000 TroMetro note).63   On December 10, 1998, TroMetro

paid $205,191 principal and $82,600 interest on the $1,024,000

TroMetro note.    No other cash payments were made on the

$1,024,000 Trometro note.

     On its partnership tax return for the period December 16 to

31, 1997, Corona reported a $78,768,955 long-term capital loss on

the sale of the $79 million receivable.    In computing this loss,

Corona reported a $1,144,000 sale price and $79,912,955 basis for

the $79 million receivable.    The loss flowed through to Imperial

in the amount of $74,671,378 and to SMP in the amount of

$4,097,577.    SMP’s $4,097,577 loss then flowed through to

Somerville S Trust and finally through to Mr. Ackerman.     On

Schedules K-1 attached to its return, Corona reported the sale of

the $79 million receivable as a $74,671,378 decrease in

Imperial’s capital account and a $4,097,577 decrease in SMP’s

capital account.

          6.   Imperial’s Capital Contribution

     On January 15, 1998, Corona’s members executed a second

amendment to the amended and restated Corona LLC agreement,

providing that “At the end of any year in which there are


     63
       At some point, Mr. van Merkensteijn, on behalf of
TroMetro, executed a second promissory note also dated Dec. 29,
1997, in the amount of $1.180 million (the $1.180 million
TroMetro note). Mr. van Merkensteijn testified that the first
note was corrected to reflect a different amount. The $1,024,000
TroMetro note in the record has the handwritten notation
“Cancelled” on its first and last pages.
                                - 93 -

Allocated Losses to Imperial, Imperial shall promptly contribute

cash in an amount equal to 20.0% of such Allocated Loss.”        During

taxable year 1998, Imperial made a $14,595,652 capital

contribution in cash to Corona.    This contribution was made in

connection with the 20-percent fee that Imperial had agreed to

pay SMP for the tax losses that it received from the Corona

transaction.   SMP later received this $14,595,652 fee.

          7.   Treasury Bills

     In 1997, Imperial had insufficient basis in Corona to

recognize the tax losses that were going to flow through from

Corona.   Consequently, Imperial and Corona devised a scheme,

starting in 1997, in which Imperial would purchase U.S. Treasury

bills each yearend and simultaneously enter into a repurchase

agreement to sell those Treasury bills back at the beginning of

the next year.    At each yearend, in order to increase its tax

basis in Corona, Imperial temporarily assigned the Treasury bills

and repurchase agreement to Corona.      Imperial repeated the

Treasury bill transactions for its 1998 through 2001 taxable

years.

XII. Subsequent Transactions Involving TroMetro and Troma

     A.   Capital Contribution Agreement

     As of March 1, 1999, SMHC and TroMetro entered into a

capital contribution agreement.    Pursuant to this agreement,

TroMetro contributed, assigned, transferred, and conveyed to SMHC
                                 - 94 -

all the interests that TroMetro owned and held in the $81 million

receivable, the $150 million receivable, and the $79 million

receivable.    In exchange, TroMetro received a right to receive 20

percent of all classes of stock of SMHC (or its successor),

exercisable by TroMetro any time after March 1, 2001 (the

TroMetro stock option).

     B.   Assumption Agreement

     As of September 1, 1999, SMP, SMHC, and TroMetro entered

into an assumption agreement.     Pursuant to this agreement, SMP

assumed SMHC’s obligation under the TroMetro stock option.

     C.   Transfer and Assignment of the Carolco Securities

     On September 1, 1999, SMHC transferred and assigned to SMP

the Carolco preferred stock ($30 million face amount) and the

Carolco subordinated notes ($30 million face amount).

     D.   SMHC and Troma Merger

          1.   SMHC Merges Into Troma

     As of September 1, 1999, Troma’s stockholders and board of

directors approved actions in connection with the issuance of

common and preferred stock to SMHC.       As of September 2, 1999,

SMHC and Troma entered into a purchase agreement.       Pursuant to

this agreement, SMHC purchased 1,070.6 shares of Troma common

stock and 400 shares of Troma Series B convertible preferred

stock in exchange for all the assets listed on Schedule 3.3 of

the agreement and $2.22 million in cash (the SMHC and Troma
                               - 95 -

merger).   The assets listed on Schedule 3.3 were the EBD film

rights, the EBD development projects, the “City Lights” library

(except for 1 specific film), the “Wisdom” library, the “Moving

Pictures” library (except for 4 specified films), the “Five

Stones” library, and the “Vista Street” library.64

           2.   SMHC’s Dissolution

     On December 10, 1999, SMHC was dissolved.   SMP thereafter

became the owner of 1,070.6 shares of Troma common stock and 400

shares of Troma Series B convertible preferred stock.65

           3.   Tax Return Treatment of the Transaction

     On its amended 1999 corporate income tax return, SMHC

reported that on December 10, 1999, a “C” reorganization took

place between SMHC and Troma whereby Troma acquired all of SMHC’s

assets solely in exchange for Troma voting stock (the C

reorganization).66   SMHC also reported that “Immediately prior to

the ‘C’ reorganization   * * * [SMP], the sole shareholder made a


     64
       Schedule 3.3 included the film title “Mommy’s Epitaph”,
which was not a part of any of SMHC’s film libraries. It also
included a 22-film library that SMHC was to acquire for $485,000;
however, SMHC did not acquire this library. As a result, on
Sept. 2, 1999, SMHC and Troma amended the asset purchase
agreement with SMHC agreeing to contribute an additional $630,000
to Troma’s capital in lieu of the 22-film library.
     65
        Apparently, the stock certificates previously issued to
SMHC were marked “Void,” and new stock certificates were issued
to SMP.
     66
       On its amended 1999 partnership return, SMP reported that
the C reorganization between SMHC and Troma occurred on Sept. 2,
1999.
                              - 96 -

capital contribution consisting of obligations of the company

having a face value and adjusted basis of $738,307,459.”    SMHC

reported that “Subsequent to the asset transfer, * * * [SMHC]

liquidated and distributed the Troma Entertainment, Inc. stock

(which it received in exchange for its assets) to its sole

shareholder * * * [SMP].”

     On its amended 1999 partnership return, SMP reported its

total basis in the Troma stock as $1,409,759,123.

          4.   Termination of the Distribution Agreements

     On June 21, 2001, in connection with the SMHC and Troma

merger, TroMetro sent to Mr. Herz of Troma and Mr. Lerner of SMP

a letter confirming for SMP’s and Troma’s records:   (1) The

consideration that was due and payable by TroMetro to SMHC

pursuant to the TroMetro distribution agreement for the period

December 23, 1997, to September 2, 1999, was waived; and (2) the

consideration receivable by TroMetro from Troma pursuant to the

Troma distribution agreement for the period December 23, 1997, to

September 2, 1999, was waived.   In this letter, TroMetro asked

SMP and Troma to confirm for TroMetro’s records that:    (1) The

agreement to the termination of the TroMetro and Troma

distribution agreements; and (2) the agreement to waive any

consideration due under those distribution agreements.67



     67
       Mr. Lerner signed this letter on June 21, 2001; Mr. Herz
signed it but did not date it.
                               - 97 -

     At some point thereafter, the TroMetro distribution

agreement and the Troma distribution agreement were terminated.

Both TroMetro and SMHC waived any rights under those agreements

to all royalties that had accrued between December 23, 1997, and

September 2, 1999.

     E.   Letter Agreement With TroMetro

     On March 29, 2001, Mr. van Merkensteijn, on behalf of

TroMetro, and Mr. Lerner, on behalf of SMP, entered into a letter

agreement.   Pursuant to this letter agreement, TroMetro deferred

its right to exercise the TroMetro stock option for no more than

6 months.

     F.   Troma Finance, LLC

     As of December 12, 2001, Troma Finance, LLC (Troma Finance),

SMP, and TroMetro entered into an “Operating Agreement of Troma

Finance LLC”.   Pursuant to this agreement, Troma Finance was

formed and TroMetro was designated as its manager.68

     As of December 12, 2001, Troma Finance and TroMetro executed

a document entitled “Capital Contribution and Assignment and




     68
       Mr. Lerner testified that Troma Finance was formed with a
view of consolidating all the ownership interests in Troma into
one entity for purposes of making a sale of the company.
According to Mr. Lerner, Mr. van Merkensteijn was negotiating
with a certain party for the sale of Troma, and “he wanted to
make sure that all of the ownership interests were in one entity
so he wouldn’t have to keep going back around”.
                                 - 98 -

Assumption Agreement” between Troma Finance, SMP, and TroMetro.69

Pursuant to this agreement, SMP agreed to contribute to Troma

Finance:    (i) $3.4 million in cash, (ii) the $2,284,000 TroMetro

note, (iii) the $1.25 million TroMetro note, (iv) 1,070.6 shares

of Troma common stock, and (v) 400 shares of Troma Series B

convertible preferred stock.70    TroMetro agreed to contribute to

Troma Finance:    (i) The TroMetro stock option, and (ii) its 75-

percent interest in the Action Entertainment Co. (a New York

general partnership).    Troma Finance assumed TroMetro’s

obligations under:     (i) A $150,000 note issued by TroMetro to IFG

Film Fund, LLC, (ii) the $1,024,000 TroMetro note, (iii) the

$2,284,000 TroMetro note, and (iv) the $1.25 million TroMetro

note.

XIII. Business Characteristics of SMP, Corona, and SMHC

     A.    SMP

     SMP has never had any employees.     Until December 1997, SMP

had no bank account.    During the taxable years ended December 31,

1997 and 1998, SMP had no separate office of its own; it used the

same business address as Crown Capital.




     69
          SMP did not execute this document.
     70
       In lieu of a cash contribution, Mr. Lerner, as manager of
SMP, executed a $3.4 million promissory note dated Dec. 12, 2001.
                               - 99 -

     SMP neither received nor reported any income from film

financing, film library licensing, or video rights licensing

during its taxable years ended 1997 and 1998.

     B.    Corona

     Corona has never had any employees.   During the taxable

years ended December 31, 1997 and 1998, Corona had no separate

office of its own; it used the same business address as Crown

Capital.

     Corona received no income from film financing, film library

licensing, or video rights licensing during its taxable years

ended December 31, 1997 and 1998.

     C.    SMHC

     SMHC had no employees from December 11, 1996, until it was

dissolved in 1999.   All its work was done by Crown Capital.    SMHC

had no bank account from December 11, 1996 until December 1998.

During the taxable years ended December 31, 1997 and 1998, SMHC

did not have a separate office of its own; it used the same

business address as Crown Capital.

XIV. Partnership Tax Returns

     A.    SMP

     Following an extension to October 15, 1998, SMP filed its

1997 partnership tax return, which it dated October 14, 1998.

Following an extension to October 15, 1999, SMP filed its 1998

partnership tax return, which it dated October 14, 1999.   SMP
                               - 100 -

thereafter filed an amended 1998 partnership tax return, which it

dated October 22, 1999.   During the taxable years at issue, SMP

reported Mr. Lerner, Rockport Capital, Somerville S Trust,

Generale Bank, and CLIS as having varying interests in SMP’s

profits, losses, and ownership of capital.

     On its 1997 tax return, SMP reported that the adjusted basis

of the $974 million in receivables from Generale Bank was

$974,296,601; that the adjusted basis of the $79 million

receivable was $79,912,955; and that the adjusted basis of the

SMHC stock was $665 million.   On its 1998 return, SMP reported

that the adjusted basis of one portion of the $974 million in

receivables was $81,590,418; that the adjusted basis of the

remaining portion was $512,793,227; and that the adjusted basis

of the SMHC stock was $665 million.

     On Schedule D, Capital Gains and Losses, of its 1997

partnership tax return, SMP reported its sales of the $150

million (face value) notes receivable to TroMetro, and its sales

to Imperial of 14.8 and 79.2-percent interests in Corona.    As

described in more detail supra, SMP reported a long-term capital

loss of $147,486,000 on its sale of the receivable; a short-term

capital loss of $11,647,367 with respect to the sale of the 14.8-

percent Corona interest; and a long-term capital loss of

$62,237,061 with respect to the sale of the 79.2-percent Corona

interest.
                              - 101 -

     On Schedule D of its 1998 partnership tax return, SMP

reported its sale of $81,590,418 (face value) notes receivable.

As described in more detail supra, SMP reported a long-term

capital loss of $80,190,418 on this sale.

     B.   Corona

     Following an extension to October 15, 1998, Corona filed its

1997 partnership tax return (for the period December 16, 1997, to

December 31, 1997), which it dated October 14, 1998.   Corona

reported Mr. Lerner, Peridon, SMP, and Imperial as having varying

interests in Corona’s profits, losses, and ownership of capital.

Corona reported Mr. Lerner as its tax matters partner.

     Corona reported a $79,912,955 basis in the $79 million

receivable.   As described in more detail supra, on Schedule D of

its 1997 partnership tax return Corona reported selling this

receivable for a long-term capital loss of $78,768,955.

     C.   Mr. and Mrs. Ackerman

     Peter and Joanne Ackerman filed joint Federal income tax

returns for 1997 and 1998.   On their 1997 return, the Ackermans

reported a net long-term capital loss from SMP of $213,715,813

and a net short term capital loss from SMP of $11,545,023.

     Among other gains and losses, the $213,715,813 net long-term

capital loss included these items:   a $147,486,000 loss that

flowed through from SMP to Somerville S Trust to the Ackermans

when SMP sold the $150 million receivable in 1997; a $62,237,061
                             - 102 -

loss that flowed through from SMP to Somerville S Trust to the

Ackermans when SMP sold 79.2 percent of its interest in Corona in

1997; and a $4,097,577 loss that flowed through from Corona to

SMP to Somerville S Trust to the Ackermans when Corona sold the

$79 million receivable in 1997.71

     The $11,545,023 net short-term capital loss flowed through

from SMP to the Ackermans when SMP sold 14.65 percent of its

interest in Corona to Imperial in 1997.72

     On their 1998 return, the Ackermans reported a net long-term

capital loss from SMP of $80,190,418, which flowed through from

SMP to Somerville S Trust to the Ackermans when SMP sold the $81

million receivable to TroMetro in 1998.73




     71
       On its 1997 return, SMP reported a net long-term capital
loss of $213,715,689 on Schedule D, Capital Gains and Losses.
From this amount, SMP passed through net long-term capital gains
of $62 to Mr. Lerner and $62 to Rockport Capital, and a net long-
term capital loss of $213,715,813 to Somerville S Trust.
     72
       The sale of the 14.8-percent interest in Corona resulted
in a $11,647,367 loss on SMP’s 1997 tax return. SMP reported a
net short-term capital loss of $11,544,902. From this amount,
SMP passed net short-term capital gains of $60 to Mr. Lerner and
$61 to Rockport Capital and a short-term capital loss of
$11,545,023 to Somerville S Trust.
     73
       On Schedule D of its 1998 return, SMP reported a net
long-term capital loss of $79,979,011; however, it passed through
a net long-term capital loss of $80,190,418; i.e., the entire
amount of the loss that it reported on the sale of the $81
million receivable. SMP reported $211,407 as its share of net
long-term capital gain from other partnerships, estates, and
trusts. SMP failed to pass this amount through to its members
via Sch. K, Partners Share of Income, Credits, Deductions, etc.
                                 - 103 -

XV.   Notices of Final Partnership Administrative Adjustment

      A.   SMP

      On January 24, 2003, respondent issued Notices of Final

Partnership Administrative Adjustment (FPAAs) to SMP for its

taxable years ended December 31, 1997 and 1998.

      For 1997, respondent disallowed SMP’s claimed long-term

capital loss of $147,486,000 on the 1997 sale of the $150 million

receivable.      Respondent also disallowed SMP’s claimed short-term

capital loss of $11,647,367 and long-term capital loss of

$62,237,061 on the sales of its interests in Corona.        Respondent

determined instead that SMP recognized long-term capital gain of

$2,514,000 on the sale of the receivable, and short-term capital

gain of $198,941 and long-term capital gain of $1,034,809 on the

sales of its interests in Corona.74

      Respondent determined that, pursuant to section 6662(h), the

40-percent accuracy-related penalty for gross valuation




      74
       Respondent computed SMP’s short-term capital gain (STCG)
and long-term capital gain (LTCG) from the sales of its interests
in Corona as follows:

                                       STCG       LTCG          Total

Amount realized ($248,700 cash +
  $1,220,050 note)               $236,763      $1,231,987    $1,468,750
Adjusted basis (($250,000 cash +
  $0 basis in note)
  (94-percent interest))           37,822        197,178       235,000
Gain on sale of Corona interest   198,941      1,034,809     1,233,750
                                - 104 -

misstatements applies to all of SMP’s partnership adjustments for

1997.     Alternatively, respondent determined that, pursuant to

section 6662(a), the 20-percent accuracy-related penalty applies

on the grounds of negligence or disregard of rules and

regulations, a substantial understatement of income tax, or a

substantial valuation misstatement.

     For 1998, respondent disallowed SMP’s claimed long-term

capital loss of $80,190,418 on the 1998 sale of the $81 million

receivable.     Respondent determined instead that SMP recognized

long-term capital gain of $1.4 million on this sale.75

Respondent determined that, pursuant to section 6662(h), the 40-

percent accuracy-related penalty for gross valuation

misstatements applies to all of SMP’s partnership adjustments for

1998 (except for the aforementioned long-term capital gain

adjustment of $211,407).    Alternatively, respondent determined

that, pursuant to section 6662(a), the 20-percent accuracy-

related penalty applies on the grounds of negligence or disregard

of rules and regulations, a substantial understatement of income

tax, or a substantial valuation misstatement.

     B.    Corona

     On January 24, 2003, respondent issued an FPAA to Corona for

its taxable year ended December 31, 1997.     Respondent disallowed


     75
       Respondent also determined that $211,407 of pass-through
gain that SMP reported on Sch. D of its partnership tax return
for 1998 should have been passed through to its members.
                               -105-

Corona’s claimed long-term capital loss of $78,768,955 on the

sale of the $79 million receivable.     Respondent determined

instead that Corona recognized a long-term capital gain of

$1,144,000 on this sale.   Respondent determined that, pursuant to

section 6662(h), the 40-percent accuracy-related penalty for

gross valuation misstatements applies to all of Corona’s

partnership adjustments for 1997.   Alternatively, respondent

determined that, pursuant to section 6662(a), the 20-percent

accuracy-related penalty applies on the grounds of negligence or

disregard of rules and regulations, a substantial understatement

of income tax, or a substantial valuation misstatement.

                              OPINION

     As becomes apparent from the foregoing findings, the facts

in these cases are a virtual labyrinth.     At the heart of the

labyrinth, where one might expect to find, if not a Minotaur,

then at least an old movie lion, we find high-basis, low-value

assets (said to have spawned startling losses) and some B-grade

films.   To help thread the labyrinth, we briefly recap some

salient facts.

     In 1996, Mr. Lerner was involved with the Safari

consortium’s failed bid to acquire MGM.     Subsequently, Mr. Lerner

was contacted by CDR’s representative, Rene Claude Jouannet, who

had been assigned the task of selling the assets in MGM’s parent

company, MGM Group Holdings (later renamed SMHC).     Messrs. Lerner
                               -106-

and Jouannet struck a deal:   Rockport Capital, Mr. Lerner,

Generale Bank, and CLIS would join together as purported members

of a limited liability company, SMP, which elected to be treated

as a partnership for Federal tax purposes.   In exchange for

common interests in SMP, Rockport Capital and Mr. Lerner would

contribute $20 million cash or marketable securities.      In

exchange for preferred interests in SMP, Generale Bank would

contribute its $974 million in receivables from SMHC, and CLIS

would contribute its $79 million receivable and SMHC stock.      At

the time of these contributions, the receivables and SMHC stock

had purported bases totaling over $1.7 billion.    These

properties, however, had little, if any, value.

     As part of the transaction between CDR and the Ackerman

group, CDR negotiated a side letter agreement in which Rockport

Capital agreed to purchase Generale Bank’s and CLIS’s (sometimes,

collectively, the banks) preferred interests in SMP upon written

notice from those entities (put rights).   The banks’ put rights

were exercisable during a 1-year period beginning December 31,

1996.   The deal closed on December 11, 1996.   Less than 3 weeks

later, on December 31, 1996 (the first day of the 1-year put

period), the banks exercised their put rights.    Somerville S

Trust (standing in the shoes of Rockport Capital) purchased the

banks’ preferred interests in SMP.
                                -107-

     In 1997 and again in 1998, SMP sold to TroMetro portions of

the $974 million in receivables that Generale Bank had

contributed.   SMP reported a $147,486,000 loss on the sale of the

$150 million receivable in 1997 and a $80,190,418 loss on the

sale of the $81 million receivable in 1998.76   These losses

flowed through to Somerville S Trust under the partnership tax

rules.    Also in 1997, Mr. Lerner negotiated a deal with Imperial,

wherein SMP contributed the $79 million receivable to a new

limited liability company, Corona, which also elected partnership

tax treatment, and SMP then sold 79.2- and 14.65-percent

membership interests in Corona to Imperial.77   The transactions

produced losses for SMP of $62,237,061, and $11,647,367,

respectively, which flowed through to Somerville S Trust.      In

1997, Corona sold the $79 million receivable to TroMetro,

generating a $78,768,955 loss, $74,671,378 of which flowed




     76
       TroMetro paid $230,000 and gave a $2,284,000 note in
exchange for the $150 million receivable. TroMetro paid $150,000
and gave a $1.25 million note in exchange for the $81 million
receivable. TroMetro paid $397,166 principal and $159,880.35
interest on the $2,284,000 note. No additional amounts were paid
on these notes.
     77
       Imperial paid $212,000 cash and gave a $1.04 million note
for the 79.2-percent membership interest and paid $36,700 cash
and increased its note to $1,220,050 for the 14.65-percent
membership interest.
                               -108-

through to Imperial and $4,097,577 of which flowed through to SMP

and then to Somerville S Trust.78

      The core issue is whether respondent has properly

disallowed these claimed losses.    Petitioner’s claims to the

losses rest on the partnership tax rules, which are contained in

subchapter K (secs. 701 to 777) of the Code.    Although the

operation of these rules is not directly in dispute, the effects

of these rules permeate the transactions in question and inform

our analysis.   We start with an overview of these rules.

I.   Partnership Tax Rules

      A.   In General

      A partnership is not subject to Federal income tax at the

partnership level; instead, persons carrying on business as

partners are liable for income tax only in their separate or

individual capacities.   Sec. 701; see secs. 702, 704 (providing

rules for determining partners’ distributive shares), sec. 703

(providing rules for computing taxable income of a partnership).

A partner must take into account his or her distributive share of

each item of partnership income, gain, loss, deduction, and




      78
       Mr. van Merkensteijn paid $120,000 and gave a $1,024,000
note (revised to $1.180 million) in exchange for the $79 million
receivable. Mr. van Merkensteijn paid $205,191 principal and
$82,600 interest on this note. He paid no additional amounts.
Imperial paid $14,595,652 as a fee for the tax losses that it
received from the Corona transaction.
                                 -109-

credit.79   Sec. 702(a); Vecchio v. Commissioner, 103 T.C. 170,

185 (1994).   A partner’s distributive share of partnership loss

(including capital loss) is allowed only to the extent of the

partner’s adjusted basis in his or her partnership interest at

the end of the partnership taxable year in which the loss

occurred.   Sec. 704(d); Oden v. Commissioner, T.C. Memo. 1981-

184, affd. without published opinion 679 F.2d 885 (4th Cir.

1982).

     Generally, when property is contributed to a partnership in

exchange for a partnership interest, neither the partnership nor

any of its partners recognize gain or loss.   Sec. 721(a).   The

partner’s basis in a partnership interest acquired by a

contribution of property to the partnership is the amount of any

money contributed plus the contributing partner’s adjusted basis

in other contributed property at the time of the contribution

(“outside basis”).   Sec. 722.   Similarly, the partnership’s basis

in property contributed to a partnership by a partner is the



     79
       A partner’s distributive share is generally determined by
reference to the partnership agreement; however, if the
allocations in the partnership do not have “substantial economic
effect” (as determined under sec. 704 and the regulations), those
allocations are disregarded. See Estate of Ballantyne v.
Commissioner, 341 F.3d 802, 805 (8th Cir. 2003), affg. T.C. Memo.
2002-160. If the partnership agreement provides no allocation or
the allocations provided therein lack substantial economic
effect, a partner’s distributive share of partnership items shall
be determined in accordance with the partner’s interest in the
partnership (determined by taking into account all facts and
circumstances). Sec. 704(b).
                                 -110-

contributing partner’s adjusted basis in the property at the time

of the contribution.    Sec. 723.   Each partner’s proportionate

share of the partnership’s basis in its property is referred to

as “inside basis.”     Cf. Gindes v. United States, 228 Ct. Cl. 632,

661 F.2d 194, 197 n.9 (1981).

     Under section 704(c)(1)(A), items of income, gain, loss, and

deduction with respect to property contributed to a partnership

by a partner are specially allocated among the partners so as to

take account of any variation between the partnership’s basis in

the contributed property and its fair market value at the time of

contribution (this variation is sometimes referred to as built-in

gain or loss).   See sec. 1.704-3, Income Tax Regs. (providing

special rules for allocating items between noncontributing and

contributing partners).    This rule is generally designed to

prevent transfers of built-in gain or loss from the contributing

partner to the other partners.

     If the contributing partner transfers his partnership

interest, built-in gain or loss must be allocated to the

transferee partner as it would have been allocated to the

transferor partner.    Sec. 1.704-3(a)(7), Income Tax Regs.

If the partnership has made a one-time election under section

754, adjustments are made with respect to the transferee

partner’s inside basis, essentially so as to approximate the

result of a direct purchase of the property by the transferee
                                -111-

partner.80   See H. Conf. Rept. 108-755, at 401 (2004).

Consequently, if the partnership has made a section 754 election,

the transferee partner is not allocated any existing built-in

gain or loss in the property.   On the other hand, if the section

754 election is not made, inside basis in partnership property is

not adjusted upon the transfer of a partnership interest.   Sec.

743(a).   Consequently, in the absence of a section 754 election,

the transferee partner may be allocated the built-in gain or loss

when the partnership disposes of the property.81


     80
       More exactly, under sec. 743(b), in the case of a
transfer of a partnership interest by sale or exchange: (a) The
partnership increases its basis in partnership property by the
same amount as the transferee partner’s outside basis in his
partnership interest exceeds his inside basis in partnership
property; and (b) the partnership decreases its basis in
partnership property by the same amount as the transferee
partner’s inside basis in partnership property exceeds the
transferee partner’s outside basis in his partnership interest.
In the case of property contributed to the partnership by a
partner, the sec. 704(c) rules apply in determining the
transferee partner’s inside basis in partnership property. Sec.
743(b) (flush language). The increase and decrease in the
partnership’s basis constitutes an adjustment with respect to the
transferee partner only. Sec. 743(b) (flush language).
     81
       Recent legislation has limited the ability to transfer
losses among partners. In the American Jobs Creation Act of 2004
(AJCA 2004), Pub. L. 108-357, sec. 833(a) and (b), 118 Stat.
1589, Congress amended secs. 704(c) and 743 effective for
contributions and transfers after the date of enactment. With
respect to sec. 704(c), AJCA 2004 sec. 833(a) provides that the
built-in loss in contributed property is taken into account only
in determining the amount of items allocated to the contributing
partner; in determining the amount of items allocated to other
partners, the partnership’s basis in partnership property shall
be treated as being equal to its fair market value at the time of
contribution. With respect to sec. 743, AJCA 2004 sec. 833(b)
                                                   (continued...)
                               -112-

     B.   Claimed Application of Partnership Tax Rules

     Petitioner’s position is that when the banks contributed the

high-basis, low-value properties (the receivables and SMHC stock)

to SMP in exchange for preferred interests, the transaction was a

nontaxable event under section 721; SMP received bases equal to

the banks’ bases in the contributed properties.   When the banks

sold their preferred interests to Somerville S Trust, their

inside basis in the contributed parties went to Somerville S

Trust, as a transferee partner, pursuant to section 704(c).

Because SMP made no election under section 754, Somerville S

Trust’s inside basis in the contributed properties was not

adjusted.   When SMP subsequently sold portions of the $974

million in receivables from Generale Bank, Somerville S Trust was

allocated the losses on those sales.

     The Ackerman group created a nearly identical scenario when

SMP contributed the $79 million receivable to Corona in exchange

for a membership interest.   Petitioner’s position is that SMP

received an outside basis in Corona equal to SMP’s basis in the

$79 million receivable.   SMP then sold portions of its Corona


     81
      (...continued)
provides that, in the case of a sale or exchange of a partnership
interest, the adjustment to partnership basis is mandatory if the
partnership has a “substantial built-in loss” immediately after
the sale or exchange. There is a substantial built-in loss if
the partnership’s basis in partnership property exceeds by more
than $250,000 the fair market value of such property. AJCA 2004
sec. 833(b)(3). Because of their effective date, these new rules
do not apply to the transactions at issue in the instant cases.
                               -113-

membership interest to Imperial at a substantial loss.    Under

section 704(c), Imperial succeeded to SMP’s inside basis in the

$79 million receivable.   When the $79 million receivable was sold

to TroMetro, Imperial (and to some extent SMP) was allocated the

substantial loss from that sale, effectively duplicating the loss

that SMP had realized on the sales of its Corona membership

interest.

II.   Burden of Proof

      Generally, in actions to redetermine respondent’s

partnership-level adjustments in an FPAA, as in other actions in

this Court, the burden of proof is on petitioner, unless

otherwise provided by statute or determined by the Court.    Rules

142(a), 240(a); Saba Pship. v. Commissioner, T.C. Memo. 2003-31.

       Respondent has pleaded new matter in his amendments to

answer, filed April 23, 2004; specifically, that SMP’s reported

tax basis in its SMHC stock should be adjusted to zero and that

SMP’s sales of receivables to TroMetro should be treated as sales

of an option to acquire an equity interest in SMHC or its

successor.   Under Rule 142(a), respondent bears the burden of

proof with respect to this new matter.82




      82
       Petitioner contends that respondent’s pretrial memorandum
raises certain issues, generally relating to the bona fides of
the $79 million receivable, that constitute new matter. We
disagree. The issues in question relate to the adjustments
determined in the FPAAs.
                                -114-

     In certain cases, the burden of proof shall be on the

Commissioner if, in any court proceeding, the taxpayer introduces

credible evidence with respect to any factual issue relevant to

ascertaining the liability of the taxpayer for any tax imposed by

subtitle A or B of the Code.    Sec. 7491(a)(1).83   Nonetheless, in

the case of a partnership, corporation, or trust, section

7491(a)(1) applies only if the taxpayer meets the net worth

limitations that apply for awarding attorney’s fees pursuant to

section 7430; i.e., a corporation, trust, or partnership whose

net worth exceeds $7 million is ineligible for the benefits of

section 7491(a)(1).    Secs. 7491(a)(2)(C), 7430(c)(4)(A)(ii); 28

U.S.C. sec. 2412(d)(1)(B) and (2)(B) (as in effect on Oct. 22,

1986).    Petitioner has not alleged, and the record does not

establish, that SMP or Corona meets these requirements.

Accordingly, section 7491(a) does not apply.    See H. Conf. Rept.

105-599, at 240, 242 (1998), 1998-3 C.B. 747, 994, 996 (stating

that the taxpayer has the burden of proving it meets the

requirements in sec. 7491(a)(2)).

     Except for the items raised as new matter in respondent’s

amendment to answer, we conclude that petitioner bears the burden



     83
       Sec. 7491 was added to the Code in the Internal Revenue
Service Restructuring and Reform Act of 1998, Pub. L. 105-206,
sec. 3001, 112 Stat. 726, and is effective with respect to court
proceedings arising in connection with examinations commencing
after July 22, 1998. The parties agree that the examination in
these cases commenced after July 22, 1998.
                                    -115-

of proof with respect to the factual issues in these cases.        In

any event, we do not resolve any of the issues solely on the

basis of placement of the burden of proof.        Instead, we decide

the issues on the basis of the preponderance of the evidence.

III.    Economic Substance

        A.   Parties’ Contentions

        Respondent does not dispute the operation of the

partnership basis and loss provisions in these cases.        Respondent

also does not challenge whether SMP and Corona were formed as

bona fide partnerships or whether those entities should be

respected for Federal tax purposes.         Cf. ASA Investerings Pship.

v. Commissioner, 201 F.3d 505 (D.C. Cir. 2000), affg. T.C. Memo.

1998-305.     Instead, respondent contends that substance over form

principles, including the step transaction doctrine, require the

various transactions at issue to be recast as direct sales of the

high-basis, low-value receivables and SMHC stock (thereby

negating any transfers of built-in losses among purported

partners).

       More particularly, respondent contends that after the

Ackerman group failed to acquire New MGM, Mr. Lerner developed a

plan to acquire the tax benefits associated with the debt and

stock of MGM Group Holdings.     Pursuant to this plan, Generale

Bank and CLIS would contribute the high-basis, low-value

receivables and SMHC stock to SMP in exchange for preferred
                                -116-

interests, followed by a sale of the preferred interests to Mr.

Ackerman’s entities.   Because the only purpose for the

transaction was tax reduction, respondent argues, “Generale Bank

and CLIS should be disregarded as members of SMP and their

‘contributions’ to SMP followed by their ‘sale’ of the preferred

membership interests to Rockport should be recast as a direct

sale of the high basis/low value assets to Rockport for $10

million.”84

     Petitioner insists that the form of the transaction in

question should be respected.   Petitioner argues that there were

valid business reasons, apart from tax reasons, for the

transaction.   Petitioner argues that the Ackerman group and the

banks entered into the transaction as part of a plan to partner

in a film distribution business.   Petitioner contends that the

partnership form was chosen for valid business reasons, because

it was the only vehicle flexible enough to accommodate these




     84
        Respondent also argues that the so-called partnership
antiabuse regulation, sec. 1.701-2, Income Tax Regs., applies to
recast the banks’ contributions of the high-basis, low-value
receivables and SMHC stock as direct sales of those assets to
Rockport Capital (or its affiliate Somerville S Trust). In
general, the antiabuse regulation permits the Commissioner to
recast partnership transactions that make inappropriate use of
the partnership tax rules. Petitioner contends that the
antiabuse regulation is invalid. Because we decide these cases
utilizing existing judicial doctrines, we need not and do not
decide whether the partnership antiabuse regulation is valid or
whether it applies to any of the transactions in these cases.
Cf. Jade Trading, LLC v. United States, 60 Fed. Cl. 558, 562
(2004).
                                 -117-

business objectives, as well as the complexities of the

transaction itself.

     B.   General Legal Principles

     It is well established that the “incidence of taxation

depends upon the substance of a transaction” rather than its mere

form.   Commissioner v. Court Holding Co., 324 U.S. 331, 334

(1945).   In determining the substance of a transaction for

Federal tax purposes, we are guided by the foundational

principles that the U.S. Supreme Court stated in Gregory v.

Helvering, 293 U.S. 465, 469 (1935):     “The legal right of a

taxpayer to decrease the amount of what otherwise would be his

taxes, or altogether avoid them, by means which the law permits,

cannot be doubted.    * * *   But the question for determination is

whether what was done, apart from the tax motive, was the thing

which the statute intended.”     See also Knetsch v. United States,

364 U.S. 361, 365 (1960); Commissioner v. Court Holding Co.,

supra at 334.

     Under Gregory v. Helvering, supra, “it is immaterial whether

we are talking about ‘substantial economic reality,’ ‘substance

over form,’ ‘sham’ transactions, or the like; rather the question

is whether under the statute and regulations here involved the

transaction affects a beneficial interest other than the

reduction of taxes.”    United States v. Ingredient Tech. Corp.,

698 F.2d 88, 94 (2d Cir. 1983).
                                -118-

     The mere fact that the parties to the transaction might take

favorable tax consequences into account is not of itself fatal to

the transaction.    Frank Lyon Co. v. United States, 435 U.S. 561,

580 (1978).   As Judge Learned Hand observed in Chisholm v.

Commissioner, 79 F.2d 14, 15 (2d Cir. 1935), revg. 29 B.T.A. 1334

(1934):

     a man’s motive to avoid taxation will not establish his
     liability if the transaction does not do so without it.
     It is true that * * * [the Supreme Court] has at times
     shown itself indisposed to assist such efforts, and has
     spoken of them disparagingly; but it has never, so far
     as we can find, made that purpose the basis of
     liability; and it has often said that it could not be
     such. The question always is whether the transaction
     under scrutiny is in fact what it appears to be in
     form; a marriage may be a joke; a contract may be
     intended only to deceive others; an agreement may have
     a collateral defeasance. In such cases the transaction
     as a whole is different from its appearance. True, it
     is always the intent that controls; and we need not for
     this occasion press the difference between intent and
     purpose. We may assume that purpose may be the
     touchstone, but the purpose which counts is one which
     defeats or contradicts the apparent transaction, not
     the purpose to escape taxation which the apparent, but
     not the whole, transaction would realize. * * *
     [Citations omitted; emphasis added.]

     In applying these general legal principles, courts have

developed a number of more particularized judicial doctrines

including:    The sham transaction doctrine, the substance over

form doctrine, the step transaction doctrine, and the economic
                                 -119-

substance doctrine.   In the instant cases, we focus on the

economic substance doctrine.85

     “An activity will not provide the basis for deductions if it

lacks economic substance.”   Ferguson v. Commissioner, 29 F.3d 98,

101 (2d Cir. 1994), affg. Peat Oil & Gas Associates v.

Commissioner, 100 T.C. 271 (1993).       In general, transactions lack

economic substance if they “‘can not with reason be said to have

purpose, substance, or utility apart from their anticipated tax

consequences.’”   Lee v. Commissioner, 155 F.3d 584, 586 (2d Cir.

1998) (quoting Goldstein v. Commissioner, 364 F.2d 734, 740 (2d

Cir. 1966), affg. 44 T.C. 284 (1965)), affg. in part and

remanding in part on another ground T.C. Memo. 1997-172.86

     In Frank Lyon Co. v. United States, supra at 583-584, the

U.S. Supreme Court held that a transaction has economic substance

if “there is a genuine multiple-party transaction with economic

substance which is compelled or encouraged by business or

regulatory realities, is imbued with tax-independent


     85
       In a separate section infra, we discuss the application
of the step transaction doctrine.
     86
       In Jacobson v. Commissioner, 915 F.2d 832, 837 (2d Cir.
1990), affg. in part, revg. in part, and remanding T.C. Memo.
1988-341, the Court of Appeals for the Second Circuit stated that
a transaction is devoid of economic substance “‘if it is
fictitious or if it has no business purpose or economic effect
other than the creation of tax deductions.’” (quoting DeMartino
v. Commissioner, 862 F.2d 400, 406 (2d Cir. 1988), affg. 88 T.C.
583 (1987)); see also Ferguson v. Commissioner, 29 F.3d 98, 101
(2d Cir. 1994), affg. 100 T.C. 271 (1993).
                                 -120-

considerations, and is not shaped solely by tax-avoidance

features that have meaningless labels attached”.    See Newman v.

Commissioner, 902 F.2d 159, 163-164 (2d Cir. 1990) (analyzing

each of these factors), vacating and remanding T.C. Memo. 1988-

547.    Courts have construed this language to involve a

consideration of two related factors, the subjective business

purpose and objective economic substance of the transaction.

See, e.g., Lerman v. Commissioner, 939 F.2d 44, 53-54 (3d Cir.

1991), affg. Fox v. Commissioner, T.C. Memo. 1988-570; Casebeer

v. Commissioner, 909 F.2d 1360, 1363 (9th Cir. 1990), affg. in

part, revg. in part, and remanding on another ground 89 T.C. 1229

(1987); Kirchman v. Commissioner, 862 F.2d 1486, 1492 (11th Cir.

1989), affg. Glass v. Commissioner, 87 T.C. 1087 (1986); Rice’s

Toyota World, Inc. v. Commissioner, 752 F.2d 89, 91, 94 (4th Cir.

1985), affg. in part, revg. in part, and remanding on another

ground 81 T.C. 184 (1983); Winn-Dixie Stores, Inc. & Subs. v.

Commissioner, 113 T.C. 254, 279-280 (1999), affd. 254 F.3d 1313

(11th Cir. 2001).

       C.   Summary of Conclusions

       On the basis of all the evidence in the record, we conclude

that the transaction whereby the banks purported to become

partners in SMP, only to exit some 3 weeks later, was not in

substance what it appeared to be in form.    The exclusive purpose

of this apparent transaction, we conclude, was to transfer to the
                                -121-

Ackerman group enormous tax attributes associated with the banks’

high-basis, low-value receivables and SMHC stock.     To that end,

the banks purported to join SMP as partners, contributing these

receivables and stock.

     To transfer the tax attributes, however, the banks had to do

more than enter into the partnership; they also had to exit the

partnership, leaving their receivables behind.     And so they did,

as soon as possible, by “putting” their partnership interests to

one of the Ackerman group members.      In essence, then, the parties

purposed that the banks should join the partnership so as to

withdraw from it.    It is this schizophrenic purpose which

“defeats or contradicts the apparent transaction”.      Chisholm v.

Commissioner, 79 F.2d at 15.

     We conclude that, in substance, the banks did not become

partners of SMP; rather, they transferred their high-basis, low-

value receivables and SMHC stock, along with whatever associated

tax attributes might survive the transfer, to the Ackerman group

for $10 million.    In the following discussion, we describe in

detail the basis for our conclusions, focusing on the purposes

and economic realities of the transactions in question.

     D.   Subjective Business Purpose

     Under the first factor of the economic substance doctrine,

subjective business purpose, we must determine whether there was

a business purpose for engaging in the transaction other than tax
                                 -122-

avoidance.    See Bail Bonds by Marvin Nelson, Inc. v.

Commissioner, 820 F.2d 1543, 1549 (9th Cir. 1987), affg. T.C.

Memo. 1986-23.

     Petitioner contends that both the banks and the Ackerman

group had legitimate, nontax reasons for CDR, Generale Bank, and

CLIS to become partners.   More particularly, petitioner claims

that the banks were interested in partnering with Messrs. Lerner

and Ackerman in a “film distribution” business based in the U.S.

Petitioner claims that the 65 film rights that the banks

contributed to SMHC were valuable assets and were contributed to

SMHC as a viable “starter” library for a larger library that the

Ackerman group envisioned.   Petitioner contends that he and Mr.

Ackerman assumed that the banks wanted to continue this

relationship into the future and were surprised when the banks

exercised their put rights and departed SMP about 3 weeks after

purporting to become partners.

         1.    Banks’ Purposes

     At the outset, we note the dearth of direct evidence as to

the banks’ purposes in entering into the transactions with the

Ackerman group.   In asserting that the banks were interested in

partnering with Messrs. Lerner and Ackerman in a U.S.-based film

distribution business, petitioner relies exclusively on his own
                                -123-

self-serving testimony.87   Except for the testimony of Sean

Geary, CDR’s counsel in the transaction with the Ackerman group,

petitioner offered no testimony from any representative on the

CDR side of the transaction.   As we explain in more detail below,

Mr. Geary’s testimony, in most respects, contradicts petitioner’s

assertions.    In pertinent part, Mr. Geary testified that, to his

knowledge, the banks had no intent to produce or distribute film

products with the Ackerman group.

     Petitioner claims, however, that the banks’ long-term

intentions were known only by one individual, Mr. Jouannet, who

is deceased.   Petitioner claims that the banks’ “intentions went

to the grave with Rene Claude Jouannet”.88   We are unpersuaded


     87
       Mr. Ackerman testified to his understanding of the deal
with CDR; however, his testimony was based on what Mr. Lerner had
told him. Mr. Ackerman had no discussions with Mr. Jouannet or
any other representative of CDR, and the documents indicate that
he had no involvement in the negotiation and drafting process.
     88
       Petitioner sought to introduce a letter from Mr. Jouannet
to Mr. Lerner written in 1997, which discussed the transaction
with the Ackerman group. Because that letter is subject to an
evidentiary objection, we discuss that letter infra.

     Petitioner also points to a Feb. 27, 1997, letter that Mr.
Jouannet sent to Danny Rosett, Senior Vice President, Financial
Operations, at New MGM regarding SMHC’s financial statements.
(This letter was purportedly sent in response to a Feb. 18, 1997,
memorandum from Mr. Rosett. Mr. Rosett’s memorandum is not a
part of the record, and we have no basis for determining its
content.) In his letter, Mr. Jouannet states:

     Furthermore the description of the disposal by CLIS of
     the Company as a sale is not exactly what occurred.
     What exactly happened was an Exchange and Contribution
                                                   (continued...)
                                -124-

that other knowledgeable witnesses could not have been found

among the living.    In 1996, Credit Lyonnais, CDR, Generale Bank,

and CLIS appear to have been very large banking institutions.   It

also appears that Credit Lyonnais and CDR were quasi-governmental

entities which were subject to considerable oversight by the

French government.   It seems implausible that all direct



     88
      (...continued)
     Agreement on December 11, 1996, whereby among other
     things CLIS contributed to an unrelated company formed
     by Rockport Capital Inc. and called Santa Monica
     Pictures LLC all its stock in Santa Monica Holdings
     (and the $79.9 M$ debt of Santa Monica Holdings) in
     exchange for 36.76% of the Preferred Interests of Santa
     Monica Pictures LLC.

On the basis of this letter, petitioner contends that it is clear
that Mr. Jouannet believed that CLIS had not sold SMHC or the $79
million receivable but had entered into a partnership arrangement
with the Ackerman group. We cannot agree.

     The letter itself merely discusses the form that the
transaction took, i.e., that CLIS entered into an exchange and
contribution agreement with SMP and contributed its SMHC stock
and the $79 million receivable. It does not address the more
cogent question of whether there was an understanding that CLIS
would exercise its put rights on Dec. 31, 1996. Moreover, in the
absence of some corroboration, we must question the letter’s
reliability. As discussed infra, we are not persuaded that Mr.
Jouannet’s interests, and those of CDR, were necessarily adverse
to the interests of the Ackerman group and SMP, at least insofar
as the tax characterization of the transaction was concerned.
Further, Mr. Jouannet, as a representative of CDR, was bound by
the confidentiality provision of the LLC agreement; any statement
to New MGM confirming a sale by CLIS of SMHC might be construed
as a breach of that agreement. (New MGM was not a party to the
CDR transaction, and any disclosure to that entity was not
covered under any of the exceptions in the confidentiality
provision.) Finally, Mr. Jouannet’s statement, insofar as it
might be construed to favor petitioner’s position, would appear
inconsistent with the testimony of Mr. Geary, discussed infra.
                                -125-

knowledge of the particulars of the transaction with the Ackerman

group would have resided in one person, Mr. Jouannet.     Indeed,

representatives of Generale Bank and CLIS executed the various

agreements with the Ackerman group.     These representatives

included Bruno Hurstel of CDR, Richard Devin, chairman of CLIS,

and members of the executive board of Generale Bank.89

Petitioner called none of these individuals to testify as to the

banks’ intentions in the transaction with the Ackerman group.       We

infer that such testimony would have been unfavorable to

petitioner.   See Wichita Terminal Elevator Co. v. Commissioner, 6

T.C. 1158, 1165 (1946), affd. 162 F.2d 513 (10th Cir. 1947).

     Notwithstanding these evidentiary gaps, there is a great

deal of other evidence in the record which shows that the banks

did not intend to enter into any film distribution business with

Messrs. Lerner and Ackerman.

              a.   Banks’ Prior History With Film Business

     The question arises why the banks in 1996 would have wanted

to pursue a film business with anyone, much less with Messrs.

Lerner and Ackerman.   The Credit Lyonnais group’s prior

experiences in the film business had not been positive.

Beginning in 1991, the Credit Lyonnais group had immersed itself

in the fortunes of MGM; it proved to be a financial disaster.


     89
       Mr. Hurstel was the secretary and treasurer of SMHC, was
on the board of directors of Epic Productions, and was a
representative of CDR.
                               -126-

Because of its loans and advances to MGM, the Credit Lyonnais

group was unable to extricate itself from that company’s

financial perils.   Ultimately, the Credit Lyonnais group was

forced to wrest control of MGM from Mr. Parretti and foreclose on

the stock interests in MGM.   From that point until 1996, the

Credit Lyonnais group had to maintain a constant supervisory

presence at MGM in an effort to right that company and recoup its

loans and advances.   To do that, however, the Credit Lyonnais

group had to continue advancing MGM significant amounts to keep

it alive.   The 1993 restructuring and the infusion of a new

management team helped MGM to recover; however, by the end of

1995, the Credit Lyonnais group was finished with the film

business and MGM.   The Credit Lyonnais group had lent the MGM

companies upwards of $2 billion.   It recouped a portion of that

amount on the sale of New MGM in 1996; however, more than $1

billion in outstanding indebtedness remained owing from MGM Group

Holdings.   The Credit Lyonnais group had little or no hope of

recovering anything on this amount.

     In 1995 and 1996, the Credit Lyonnais group was financially

distressed.   Upon the intervention of the French government, CDR

was formed for the specific purpose of liquidating the Credit

Lyonnais group’s “bad” investments and loans, particularly its

investments and loans in the filmed entertainment area.    These

“bad” assets included MGM, MGM Holdings, and MGM Group Holdings,
                               -127-

and the loans and advances to those companies.   CDR’s goal was to

realize whatever amount it could on those “bad” assets.   Indeed,

with respect to MGM Group Holdings, CDR’s representative, Mr.

Jouannet, was assigned the task of realizing whatever value he

could in that company, as quickly as possible.   Seemingly, this

objective would not be realized if Generale Bank and CLIS were

locked up in a film distribution business with the Ackerman

group.

     The film rights that the banks ultimately contributed to

SMHC were culled from the 1,000-film CDR library.   John Peters of

Epic Productions testified that these CDR films were acquired

from distressed companies to which Credit Lyonnais had lent

money.   The films were acquired in numerous workouts,

bankruptcies, or other similar proceedings.   Credit Lyonnais had

turned the films over to Epic Productions and Mr. Peters to

manage; however, by late 1995, Credit Lyonnais instructed Epic

Productions to begin planning the liquidation of the CDR library.

The whole focus of Epic Productions’ business operations became

“the ultimate liquidation of this 1,000 film plus library.”   Mr.

Peters testified that Credit Lyonnais did not intend to pursue a

film distribution business with respect to these films.   On the

contrary, its overall goal was to liquidate the film assets that

it had acquired.
                                -128-

              b.   Banks’ Regulatory Environment

     In 1996, the regulatory environment was not conducive to the

banks’ investing in a partnership for film distribution.    A

number of witnesses, including Mr. Geary and Bahman Naraghi (an

employee of Credit Lyonnais), testified that under U.S. banking

laws, the Credit Lyonnais group faced a 5-year deadline to divest

itself of its nonbanking, MGM entertainment assets.     An October

4, 1994, memorandum prepared by Deloitte & Touche for Credit

Lyonnais regarding MGM states that Credit Lyonnais’s business

strategy with respect to MGM “must take into account CL’s

obligation to have sold its stake in MGM no later than May 7,

1997, due to the American regulations concerning investments in

non-financial enterprises by banks.”90   Presumably, this same

deadline (May 7, 1997) or a similar 5-year deadline would apply

to any supposed film venture with the Ackerman group.

             c.    Why the Ackerman Group?

     We further question what would motivate the banks to enter

into a film distribution business with Messrs. Lerner and

Ackerman.   Neither of those individuals had any experience in

running a film distribution business.    Mr. Lerner was a tax

lawyer; nothing in his background reveals any special credentials

in film distribution.   Mr. Ackerman was involved in a number of


     90
       On the basis of this evidence, it would appear that the
5-year period commenced May 7, 1992, when Credit Lyonnais
acquired MGM-Pathe as part of a foreclosure on outstanding debts.
                                -129-

financing transactions involving “major” motion picture

companies; however, Mr. Ackerman gave no indication that his

experience in financing extended to the particulars of running a

film distribution business.   Plus, the record suggests that the

banks had misgivings about the Ackerman group’s economic

underpinnings.91

              d.   Inattention to Film Rights in Negotiations

     Although the Ackerman group and CDR exchanged numerous

documents over the course of their negotiations, we find scant

reference to any film distribution business or film rights.

There is no evidence that the parties actively negotiated over

the particulars of the purported film business or the specific

film rights that would be contributed to SMHC.   The first and

only reference to a purported film distribution business appears

in the drafts of the SMP LLC agreement that Shearman & Sterling

drafted on Rockport Capital’s behalf.   Those drafts, including

the final draft, describe the purpose for which SMP was formed as

being, inter alia, to produce and distribute filmed entertainment

products.   With respect to this provision, Mr. Geary testified

that, to his knowledge, the banks had no intent to produce or

distribute film products through the transaction with the



     91
       Mr. Geary testified that, during the negotiations with
the Ackerman group, Mr. Jouannet and other individuals in the
Credit Lyonnais group began to worry “whether Lerner and his
people were good for” the $5 million put price.
                                -130-

Ackerman group.   He testified that he did not discuss this

provision with his client, and that in any event CDR would not

have asked to remove this provision because “we didn’t care too

much what was in here.”

             e.   Selection of EBD Film Rights

     Mr. Peters testified that in 1996, during Epic Productions’

efforts to sell the CDR library, someone at either Credit

Lyonnais or EBD instructed him to find some low-value films and

development projects within the CDR library.     The idea was to

find some titles and development projects that in Mr. Peters’

view had very little value, so that removal of those rights would

have no significant impact on the CDR library’s overall value.

For example, Mr. Peters testified that he selected films with

rights that were about to expire in the near future (e.g., in 1

or 2 years) and predominantly films that were low-budget,

exploitation genre films.   In addition, the totality of rights to

the film assets was not removed from the CDR library; instead,

only some subgroup (e.g., domestic home video or domestic

cassette rights) was removed.   Ultimately, Mr. Peters selected

the “U.S. Video Film Rights” to the 65 film titles and the rights

to the 26 development projects listed in Schedule 1.6(b) of the

exchange and contribution agreement.

     On the basis of Mr. Peters’ testimony, it is reasonable to

conclude that the Credit Lyonnais group had no intentions of
                                 -131-

contributing a viable “starter” film library to SMHC or to

partner in a film distribution business with respect to those

assets or the CDR library, generally.      Instead, the selection

process that Mr. Peters described strongly suggests that CLIS

contributed the film assets to SMHC for a far different

purpose.92

               f.   Conclusion

     In light of these various considerations, we are not

persuaded that the banks had any intention of partnering with

Messrs. Lerner and Ackerman in a film distribution business.        To

the contrary, it is clear that the Credit Lyonnais group desired

to end its failed relationship with its distressed filmed

entertainment assets and companies.      CDR’s role as Generale

Bank’s and CLIS’s representative in the transaction with the

Ackerman group reflects the banks’ interest in liquidating their

receivables and SMHC stock.

          2.   Ackerman Group’s Purposes

     Petitioner claims that he and Mr. Ackerman wanted to join

with the banks in a film distribution business and understood


     92
       Petitioner contends that “Mr. Peters’ testimony and
demeanor suggested an effort to hurt Petitioners” and questions
the accuracy and good faith of that testimony. Apart from these
general assertions, petitioner provides no basis for concluding
that Mr. Peters fabricated his testimony. Mr. Peters was subject
to petitioner’s cross-examination; nothing in his testimony
suggested any bad faith or fabrication. Despite petitioner’s
protestations, we find Mr. Peters’s testimony credible, thorough,
and very persuasive on the relevant points.
                               -132-

that the banks reciprocated this interest.     Petitioner contends

that he and Mr. Ackerman assumed that the banks wanted to

continue this relationship into the future.     Petitioner testified

that to their considerable surprise, the banks elected instead to

exercise their put option.

     Petitioner’s claimed understanding of the deal with CDR is

based entirely on his testimony.93     We find Mr. Lerner’s

testimony self-serving, contrived, and ultimately not credible.

The bulk of the evidence in the record contradicts petitioner’s

testimony and his purported understanding.

             a.   Mr. Lerner’s and Mr. Ackerman’s Backgrounds

     As previously noted, as far as the record reveals, Messrs.

Lerner and Ackerman were tax and financial professionals with no

experience in running a film distribution business.     Cf.

Ferguson v. Commissioner, 29 F.3d at 102 (citing inexperience of

a partnership’s promoters in the relevant business as one

indicator of lack of economic substance in the partnership).

Although Messrs. Lerner and Ackerman appear to have been the

principal negotiators on behalf of the Safari consortium in its

failed bid to purchase New MGM, we have virtually no information

regarding the companies that joined the Safari consortium or




     93
       As previously noted, Mr. Ackerman also testified to his
understanding of the CDR transaction, but his testimony was based
on what Mr. Lerner had told him.
                               -133-

precisely what their interests were.94   It appears that Deyhle

Media Group and Capella Films had a substantial stake in that

proposed acquisition and, in fact, had initiated the dialogue

with Messrs. Lerner and Ackerman.

     More importantly, beyond the testimonies of Messrs. Lerner

and Ackerman, we have no independent basis for determining the

precise roles that Messrs. Lerner and Ackerman played in the

Safari bid and what their motivations were.   Petitioner claims

that he and Mr. Ackerman joined the Safari consortium to further

their long-range goals of building a substantial film library.

It is equally plausible, however, that Messrs. Lerner’s and

Ackerman’s roles in the Safari consortium were consistent with

the areas of their respective expertise:   Mr. Lerner as a tax

expert and Mr. Ackerman as an expert in putting together

financing for film company acquisitions.   In any event, one thing

is clear from the Ackerman group’s involvement in the MGM

transaction:   At some point, the Ackerman group began eyeing the

substantial built-in tax losses that the Credit Lyonnais group

had in the MGM companies and began exploring the possible ways in

which it could exploit those built-in losses.




     94
       Petitioner listed Mark Seiler as a witness in his
pretrial memorandum; however, he did not call Mr. Seiler as a
witness at trial.
                               -134-

             b.   Focus on Tax Attributes

     As early as May 31, 1996, when Kaye Scholer submitted its

preliminary legal conclusions on MGM, Mr. Lerner had been fully

apprised of the potential of acquiring considerable built-in

losses in an acquisition involving the MGM companies.    The Kaye

Scholer memorandum also provided a roadmap to structuring a

partnership transaction that would allow CDR to transfer its

built-in losses (totaling approximately $1.4 billion) to a

purported “Investor” by utilizing a partnership that would fail

to make a section 754 election.   According to the memorandum, the

transaction “would increase the amount receivable by CDR over a

straight purchase.”

     Mr. Lerner’s first written contact with CDR regarding a

possible deal, a letter dated September 11, 1996, began by

confirming Rockport Capital’s interest in “the U.S. tax

attributes which may relate to the direct and indirect

investments by Credit Lyonnais, S.A., and * * * [CDR] in Metro-

Goldwyn-Mayer, Inc.”   The letter goes on to state that “Rockport

wishes to examine the Attributes so that it can propose to the

CDR certain structures incorporating the Attributes * * * which

will be of mutual benefit”.   The letter makes no mention of any

films or partnering to conduct any film distribution business.

     During the negotiations with CDR, the Ackerman group’s

entire focus was on the banks’ tax basis in the SMHC receivables
                                 -135-

and stock.    The Ackerman group’s only point of negotiation became

directed towards obtaining representations from Generale Bank and

CLIS regarding their tax bases in the receivables and SMHC stock,

and that they had not written down their bases for tax or

accounting purposes.

     Mr. Lerner’s own tax experience also gave him a general

appreciation of the tax significance of contributing high-basis

properties to a partnership and failing to make a section 754

election.    In fact, Mr. Lerner marketed to Imperial, and then

implemented, a tax plan that virtually mimicked the CDR

transaction in attempting to exploit these tax aspects.

               c.   Nature of EBD Film Rights

     Mr. Lerner testified that the Ackerman group was interested

in acquiring filmed entertainment assets and building a large

film library which “would be an extraordinary asset to hold for a

very long time.”    Mr. Lerner’s testimony appears implausible when

we consider the film rights that Schedule 1.6(b) of the exchange

and contribution agreement purportedly provided.      Schedule 1.6(b)

refers to “U.S. Video Film Rights”.      Those purported rights,

however, did not encompass the kind of rights that one might

associate with a long-term film library investment.      Indeed, the

term “U.S. Video Film Rights” seemingly refers only to video

distribution rights in the United States.       SMHC did not own all

the rights to the various film titles.      As Troy & Gould’s
                               -136-

investigation later revealed, many of the distribution rights had

expired or were set to expire shortly after CLIS contributed them

to SMHC.   We do not believe that the failure to define more

specifically the EBD film rights in the LLC agreement consistent

with Mr. Lerner’s stated purpose was simply an oversight.    The

Ackerman group was well represented in the transaction with CDR.

Presumably, such important matters would have been addressed if

the Ackerman group were in fact focused on starting a film

library with the EBD film rights.

     Responding to Mr. Peters’s testimony that the films selected

for the EBD library were films of no significant value,

petitioner seems to suggest that the banks may have conspired to

defraud the Ackerman group.   The bulk of the evidence in the

record, however, suggests strongly that the selection of the EBD

film rights was not a product of any fraud by the banks.    On the

contrary, for the reasons described below, we are led to the

conclusion that the Ackerman group was either fully aware of the

nature of the film titles that CLIS contemplated contributing to

SMHC or simply did not care about the nature of those film

rights.

     First, although the parties exchanged numerous drafts of

various documents between October 16, 1996, and December 10,

1996, none of those drafts alludes to any film rights, generally,

or the EBD film rights, specifically.   The first listing of the
                               -137-

EBD film rights appears to have been given to the Ackerman group

on December 12, 1996, one day after the purported closing on the

CDR transaction.95   Before then, there appears to have been no

mention or interest in those film rights on the part of the

Ackerman group in their negotiations with CDR.   Mr. Lerner, for

his part, could not recall when he was given a listing of the EBD

film rights.

     Second, even though the Ackerman group conducted due

diligence in the CDR transaction, the focus of this due diligence

was on Generale Bank’s and CLIS’s tax bases in the contributed

receivables and SMHC stock.   Prior to the closing on the CDR

transaction, due diligence with respect to the contributed film

rights was largely nonexistent.96   Indeed, the only evidence of


     95
       The final draft of the exchange and contribution
agreement in the record has an attached Schedule 1.6(b), which is
a list of the EBD film titles and development projects. The
record contains a facsimile dated Dec. 12, 1996, from White &
Case to Mr. Lerner and several other persons, transmitting an
attached Schedule 1.6(b) to the exchange and contribution
agreement. From the serial numbers on the pages of this faxed
attachment, which also appear on the pages of Schedule 1.6(b)
attached to the exchange and contribution agreement (but which do
not correlate with the serial numbers on the other pages of the
exchange and contribution agreement), it appears that White &
Case actually sent this attached schedule to the Ackerman group
on Dec. 12, 1996, one day after the purported closing on the
transaction.
     96
       In the exchange and contribution agreement, CDR and CLIS
represented and warranted: “Schedule 1.6(b) attached hereto sets
forth all the assets held by * * * [SMHC], all of which assets
are held free of all material Encumbrances created by * * *
[SMHC]. * * * [SMHC] has good title to all such assets.”
                                                   (continued...)
                               -138-

due diligence on the film rights is an appraisal that Sage

Entertainment conducted.   Mr. Lerner testified that approximately

4 to 6 weeks before the closing on the CDR transaction, he hired

Steve Kutner of Sage Entertainment to appraise the EBD film

library, that he had a large number of discussions with him about

various approaches to valuation, and that Mr. Kutner appraised

the EBD film library at $29 million.97   Mr. Lerner testified

that, on the basis of Mr. Kutner’s valuation, he felt “very


     96
      (...continued)
Schedule 1.6(b), of course, contains a listing of the EBD film
titles and development projects. The exchange and contribution
agreement provides indemnification from CDR (capped at $2
million) for any material breach of this representation and
warranty. See Exhibit 188-J, J001341, 1344. It is patently
unclear what is meant by the term “good title” and whether these
provisions afford any meaningful rights with respect to the EBD
film library. Petitioner’s representatives, Troy & Gould,
acknowledged this “recitation” of good title; however, they
concluded:

     despite this recitation, we do not have documentation
     of the assignment [from CLIS to SMHC]. Moreover, the
     term ‘U.S. Video Film Rights’ is nowhere defined in the
     Agreement, and the Agreement contains no explicit
     recitation that Santa Monica Holdings owns such rights.
     Rather, this phrase appears only as the heading on the
     Schedule; the phrase does not appear in the body of the
     Agreement.

     This is another significant gap in the chain of title.

Despite the obvious infirmities in SMHC’s rights to the EBD film
titles, there is no indication that the Ackerman group ever
claimed any indemnification under this provision.
     97
       Mr. Kutner did not include in this figure the value of
second-cycle exploitation or other rights, which he opined could
increase the value of the EBD film library by as much as 40 to 50
percent.
                               -139-

comfortable that with the investment we were making at least we

had assets worth as much as we were investing and that it could

be considerably more if managed properly.”

     Other than Mr. Lerner’s testimony, we have no basis for

gauging Mr. Lerner’s reliance on this appraisal.   Although Mr.

Kutner’s appraisal report would seem to form a critical part of

his case, petitioner did not call Mr. Kutner as a witness.

Consequently, Mr. Kutner’s appraisal report has not been received

into evidence and cannot be relied upon for establishing the

value of the film library.

     The appraisal report itself indicates that it is limited to

a financial analysis of the film library and its potential

earnings.   The report states that Mr. Kutner did not physically

inspect the materials for the various film titles, and he assumed

that the legal and physical status of the EBD film library “is in

good condition”.   The report does not provide any analysis of the

rights that SMHC acquired in the film titles (except for the

general reference to “U.S. Video Film Rights”) and appears to

assume that SMHC actually owned the full bundle of rights

associated with the EBD film titles.   The report also appraised

the EBD film library “as if it was free and clear of debt and

under responsible ownership and competent management”.

Presumably, however, when the EBD film library was assigned to

SMHC, it became subject to the $1 billion debt that SMHC owed.
                               -140-

     On the basis of the evidence in the record, we have no great

confidence that the appraisal report, as offered, was completed,

or was given to Mr. Lerner, before the closing on the transaction

with CDR.   The photocopy of the appraisal report that is in the

record is undated, except for a cover letter from Mr. Kutner to

Mr. Lerner dated December 9, 1996--just 2 days before the closing

of the CDR transaction and after most of the details of the

transaction were already established.   The appraisal report

anachronistically refers to the 65 film titles as the “Santa

Monica Holdings, Inc. Film Library” and states that SMHC owns

those 65 film titles; however, the 65 film titles were not

assigned to CLIS or SMHC (from CLIS) until December 10, 1996.98

The appraisal letter also alludes to other information which the

record demonstrates was not apparent on December 9, 1996.    For

example, as previously discussed, there is no indication that the

EBD film titles were ever identified to Mr. Lerner (or through

him, to Mr. Kutner) before December 12, 1996.   Also, Mr. Kutner’s

cover letter alludes to certain limitations and caveats relating

to the future distribution plans for the library, “which are more



     98
       The appraisal report states: “The opinions, conclusions,
and estimates of value presented in this report are based, in
part, on assumptions and financial data furnished to me by Santa
Monica Holdings, Inc., which I have assumed to be correct and
current.” Inasmuch as SMHC did not own the 65 film titles before
Dec. 10, 1996, or have any known relationship to those film
titles, Mr. Kutner’s purported reliance on information from SMHC
seems dubious.
                                 -141-

fully set forth in the section of the Appraisal styled ‘Limiting

Conditions for the Appraisal.’”    The appraisal report in the

record, however, does not contain any section entitled “Limiting

Conditions for the Appraisal.”

     Mr. Kutner’s $29 million valuation of the EBD film titles

appears highly inflated.   Indeed, that valuation greatly exceeds

(by more than three times) the highest value ($9 million) that

petitioner’s expert (Steven Wagner) arrived at in valuing the EBD

film titles.99   Mr. Kutner’s valuation takes into account

technologies (e.g., DVD) that the other experts in these cases

opined were either not foreseen in 1996, were only latently

observable at that time, or were no longer viable.100   In doing


     99
       We discuss the valuation conclusions of petitioner’s
expert, Steven Wagner, in more detail infra.
     100
        For example, Mr. Kutner projected $1,320,000 in DVD
revenue. Although DVD technology was predicted to emerge at some
point after 1996, the success of that technology was not readily
foreseen. For that reason, petitioner’s expert projected no
revenue from DVD sales in his valuation. Mr. Kutner also
projected $1,100,000 in royalty income from laserdisc sales.
According to petitioner’s expert, laserdisc sales in 1996 were
relatively insignificant, even though the technology had been
around for a few years. Neither petitioner’s expert nor
respondent’s expert (Richard Medress) took laserdisc sales into
account. Mr. Kutner also projected $2,410,000 in royalty income
from the revenue-sharing (Rentrak) model for the rental market.
Under this model, video rental stores would pay a small fee up
front to buy a rental film and would then share a portion of the
rental fees with Rentrak. In 1996, however, the rental market
still operated on a front-end sales model; i.e., video rental
stores made a one-time payment up front (e.g., $59 per copy) to
purchase copies of a film, which they could then rent an
unlimited number of times. Neither petitioner’s expert nor
                                                   (continued...)
                                -142-

so, Mr. Kutner’s appraisal went beyond what Mr. Lerner understood

to have been a valuation based on VHS videotape sales

projections.   Indeed, Mr. Lerner testified that “six or seven

years ago when we did all this all we knew about were VHS

videotapes.”   “At that time, we focused on what the technology

was thinking that there might be additional technology, so we

valued it only in terms of what we thought the then existing

technology might be and hoping that additional technology would

come along to enhance the value.”   Without Mr. Kutner’s testimony

or some corroborating evidence, we are not persuaded that the

Sage Entertainment appraisal was made in good faith or that Mr.

Lerner relied upon it in the course of the CDR transaction.

     The nature of the rights, if any, that SMHC obtained in the

EBD film titles was, and remains, patently unclear.   On December

9, 1997, Troy & Gould concluded that there were significant gaps

in the chain-of-title documentation for the EBD film titles and

rights to some of the film titles had expired or were expiring.

Troy & Gould concluded that:   “it is not possible to determine

what rights have effectively been acquired.   It also is unclear

who possesses the rights other than domestic video in the various

pictures, and who possesses the reversion rights in domestic

video.”    This point is clearly illustrated when we consider that


     100
       (...continued)
respondent’s expert projected any revenue from the revenue-
sharing (Rentrak) model.
                               -143-

two of the EBD film titles that Troma attempted to distribute,

“Astro Zombies” and “Banana Monster”, were the subject of

immediate cease and desist letters.    SMHC was also informed that

the rights to a third film that Troma attempted to distribute,

“Fist of Fear, Touch of Death”, had also expired.

     Further, it appears that the physical elements for a number

of the EBD film titles do not exist and that the general physical

condition of the materials for the remaining film titles is

suspect.   Indeed, Mr. Peters testified that the physical

materials for many of the film titles were stored at the Epic

warehouse, which was not a temperature- or humidity-controlled

facility, and was not bonded, subject to inventory control, or

otherwise secured.

     It is clear that by December 9, 1997, when Troy & Gould gave

their conclusions on the EBD film library, Mr. Lerner was well

aware that there were major problems with the EBD film rights and

that the film library had very little value.   If, as petitioner

claims, the EBD film rights were an integral part of a film

business with CDR, then these conclusions would have revealed

some very deep-seeded shenanigans on the part of CDR, Generale

Bank, and CLIS.   One would suspect that, in these circumstances,

Messrs. Lerner and Ackerman would have been very upset.

Nonetheless, in April 1998, we find Mr. Lerner meeting with a

representative of Generale Bank.   Mr. Lerner testified that he
                               -144-

was interested in reviving Generale Bank’s participation in SMP’s

film activities and had written a letter expressing this

interest.   The letter from Mr. Lerner states:   “I would like to

acquire additional film assets from GB and would like their

active participation in our partnership.”101

     On the basis of the evidence in the record, it appears that

the Ackerman group was largely unconcerned with the supposed film

assets that were to form the foundation of their proposed film

business with CDR.   There is no evidence that they ever requested

or received any information regarding the EBD film rights.

Although the record contains numerous drafts of various documents

relating to the CDR transaction, none of those drafts contain any

specific reference to the EBD film rights.     Consequently, it is

reasonable to conclude that the Ackerman group did not care what

film rights CLIS contributed to SMHC and that the contribution of

the EBD film rights was largely incidental to Generale Bank’s and

CLIS’s contributions of the high-basis, low-value receivables and

SMHC stock.




     101
        After Troy & Gould reached its conclusions, Mr. Lerner
sold portions of the $974 million in receivables from Generale
Bank to his friend, colleague, and business associate, Mr. van
Merkensteijn. In determining a purchase price for the
receivables, Mr. van Merkensteijn testified that he relied on the
Sage Entertainment $29 million appraisal. By this time, however,
it would have been clear, at least to Mr. Lerner, that this
appraisal was grossly overstated.
                                 -145-

     After the closing of the CDR transaction, Mr. Lerner, Mr.

Herz, and the law firm of Troy & Gould made efforts to confirm

the titles to the films and obtain physical elements for the

films.   We are unpersuaded, however, that these efforts amounted

to much more than window-dressing.       Mr. Peters testified that he

perceived Troy & Gould’s investigation to be abnormal considering

the age of the film titles, the original production cost of the

films, and the distressed nature of the companies that were the

source of the films.   He testified that although Troy & Gould’s

efforts might be completely appropriate with respect to other

kinds of films, they “might not be so appropriate” with respect

to the EBD film titles.

     Beyond its due diligence process, Troy & Gould and Mr. Herz

expended considerable effort to obtain facility and laboratory

access letters.   Those efforts extended into 1998, even after

Troy & Gould provided Mr. Lerner with its legal conclusions

regarding the EBD film titles.    Given the nature of the

particular film titles and Troy & Gould’s revelations, we are

unpersuaded that these efforts, too, were not mere window-

dressing.

             d.   Purported Interest in CDR Library

     Petitioner also claims that he and Mr. Ackerman were

interested in adding the 1,000-film CDR library to SMHC, and that

they thought that having an indirect interest in that company and
                                -146-

being partners with the banks would put them in a better position

to acquire that library.    Other than his self-serving testimony,

petitioner points to no evidence to suggest that the parties to

the transaction either discussed or contemplated any dealings

involving the general CDR library.      In fact, there is no

indication that the Ackerman group was given any sort of

preference in 1997 when CDR was being sold.102

     Petitioner also testified that CDR asked for the $5 million

advisory fee in connection with the remaining film titles in the

CDR library as a “guaranty payment” to enable the Ackerman group

to work with CDR.    He testified that the Ackerman group was

willing to pay that fee “because we thought we would be able to

get our hands on a much larger library, and certainly we did

pursue it at a later time.”    The advisory fee agreement

indicates, however, that the advisory fee was paid specifically

as an inducement for CDR, Generale Bank, and CLIS to execute the

letter agreement and exchange and contribution agreement.      None

of the various legal documents that the parties exchanged

contains any reference to a guaranty or any assurances regarding

the CDR library.    One would expect some legal representations

regarding this matter if the $5 million advisory fee was in fact

paid as a guaranty for the CDR library.



     102
        According to petitioner, Generale Bank and CLIS were
still partners in SMP at that time.
                                -147-

              e.   Purported Springboard for New Library

     Petitioner contends that he and Mr. Ackerman were interested

in using SMHC for its historical significance to build a new film

library.   We cannot agree.   For all intents and purposes, MGM

Group Holdings’ association with the MGM operating company ended

when Mr. Kerkorian acquired that company.    Any potential name

recognition in that company was obliterated when MGM Group

Holdings changed its corporate name to “Santa Monica Holdings

Corporation” on October 15, 1996.    In addition, in a letter

agreement with P&F Acquisition dated October 10, 1996, CDR, MGM

Holdings, and MGM Group Holdings agreed that they would not use

any of MGM’s trademarks; i.e., “MGM,” “Metro-Goldwyn-Mayer,” the

“MGM lion logo,” or any trademarks related thereto.     Without

these trademarks, Mr. Lerner seemingly would have been hard-

pressed to capitalize on MGM’s historical underpinnings using

SMHC.   Finally, there is no evidence that SMHC’s purported film

business was ever, in fact, bolstered by its prior status as the

MGM parent company.

              f.   Acquiring NOLs for a Film Business

     Petitioner also contends that he and Mr. Ackerman were

interested in using the net operating losses (NOLs) in SMHC to

offset future income from their prospective film business.      We

are unpersuaded that the Ackerman group had any legitimate

interest in SMHC’s NOLs.   Although there were sizeable NOLs in
                                 -148-

SMHC when CLIS contributed the SMHC stock to SMP, the use of

those NOLs was not guaranteed.    Use of the NOLs was subject to

the tax attribute rules of section 382.      Under those rules, use

of the NOLs would be contingent on structuring a transaction in

such a way as to meet the “ownership change” rules of section

382(g).    On this record, we cannot rule out the possibility that

CLIS’s contribution of the SMHC stock to SMP constituted an

“ownership change” for purposes of section 382(g) so that the

NOLs were unavailable after that point.103

     Although petitioner claims that his due diligence efforts

for the transaction with CDR were directed at determining the

potential use of the NOLs in SMHC, the focus of his due diligence

was not on the NOLs, but on the built-in tax losses in the

receivables and SMHC stock.    Mr. Lerner hired James Rhodes to

assist in the Ackerman group’s due diligence process.     Mr.

Rhodes’ due diligence investigation appears to have been focused

exclusively on the banks’ bases in the SMHC receivables and

stock.     For example, Mr. Rhodes’ “Basis Chronology” contained an

analysis of the bases in the SMHC receivables and stock; it does



     103
        Petitioner claims, without explanation, that an ownership
change for purposes of sec. 382(g) occurred when the banks
withdrew from SMP and that the NOLs were “substantially
diminished”. Petitioner claims, again without explanation, that
“SMHC’s net operating losses were not used because the SMHC
library was not sold, but rather was combined with the Troma film
library in a ‘C’ reorganization in 1999. That reorganization
completely eliminated the net operating losses.”
                                 -149-

not mention any NOLs.104   Also, on May 12, 1997, Mr. Rhodes

received a letter from White & Case, confirming that the banks

had not derived any U.S. tax benefit from the contribution of the

SMHC receivables and stock or the exercise of their put rights.

Shearman & Sterling also conducted due diligence on behalf of the

Ackerman group.     Like Mr. Rhodes’s investigation, Shearman &

Sterling’s investigation focused on the tax bases in the SMHC

receivables and stock.     See, e.g., Exhibit 166-J.   The memoranda

that Shearman & Sterling prepared for Mr. Lerner discussed, among

other things, section 382.     These memoranda, however, were

focused on that section’s potential application to the built-in

losses in the stock of MGM Holdings (and MGM Group Holdings) and

not NOLs.105

               g.   Contemporaneous Expression of Purpose

      On December 12, 1996, the day after the transaction with

CDR purportedly closed, Mr. Lerner faxed to Jerry Carlton of



     104
        Mr. Lerner testified that he hired Mr. Rhodes to
investigate whether any transfers occurred using the NOLs in
SMHC. He testified that he was concerned that “if there had been
a transaction which had either disposed of or written down or
taken a tax benefit in respect of any of those interest, that it
would have--might have been treated as a transfer affecting the
use of the net operating loss in * * * [SMHC].” According to Mr.
Lerner, the best indication of such a transfer affecting the use
of the NOLs is whether there has been a basis step-up or
stepdown. We find petitioner’s testimony specious.
     105
        In the context of the proposed transactions in the
memoranda, Shearman & Sterling concluded that “Holdings and Group
will undergo an ownership change” for purposes of sec. 382.
                                -150-

O’Melveny & Myers an article entitled “GE Capital Wins Bid for a

Portfolio of Bad Loans from Credit Lyonnais”.       The article was

from the December 12, 1996, issue of the Wall Street Journal and

discussed General Electric’s purchase of a $190.3 million

portfolio of “bad” French property loans from Credit Lyonnais.

In an attached memorandum letter to Mr. Carlton, Mr. Lerner

explains that “Attached is an article from today’s Wall Street

Journal * * * describing a transaction similar to ours.       This

gives good support for our business purpose for doing the deal.”

The article states in relevant part:

          U.S. financial-services giant General Electric
     Capital Corp. won the bidding for a portfolio of Credit
     Lyonnais’s bad French property loans, which have a book
     value of one billion francs ($190.3 million). The
     transaction was another sign that competition is
     heating up among U.S. vulture funds seeking to take
     advantage of France’s long-running real-estate crisis.

          The sale was carried out by Consortium de
     Realisation, an entity set up last year by the French
     state to take on most of Credit Lyonnais’s nonbanking
     assets as part of a rescue plan for the crippled state-
     owned bank. * * *

                *    *     *    *       *   *   *

          The sale of the bundle of 127 lines was the first
     by CDR, with more expected to follow. French banks and
     insurers have been severely hurt by their exposure to
     the domestic real-estate market, but for a long time
     they refused to write down their loans.

         3.   Conclusion

     In sum, the Credit Lyonnais group had a very troubled

history in the film business.   In 1996, they were seeking to
                               -151-

dispose of their troubled film assets as expeditiously as

possible.   At some point, Messrs. Lerner and Jouannet struck a

deal involving a purported acquisition of MGM Group Holdings

(SMHC) and the formation of a limited liability company.

Although petitioner claims that Mr. Jouannet wanted to enter into

a film distribution business with the Ackerman group, the

evidence in the record and the testimony suggest otherwise.      In

fact, Mr. Jouannet worked for CDR, which had the assigned task of

liquidating Credit Lyonnais’s losing film assets and loans,

including MGM and MGM Group Holdings.    Mr. Jouannet’s goal was to

realize whatever he could, as fast as he could.   He was not

interested in any film venture with the Ackerman group.    The

banks did not contribute a viable “starter” film library to SMHC,

as petitioner suggests.   Instead, what petitioner claims to have

been the cornerstone of a supposed film venture turns out to be

nothing more than a jumble of lackluster film titles.   We

conclude that the Ackerman group and the banks did not intend to

partner with one another in any film distribution business.

     E.   Objective Economic Substance

     Under the second factor of the economic substance doctrine,

objective economic substance, we must determine whether the

transaction had any economic significance beyond the creation of

tax benefits.   See, e.g., Casebeer v. Commissioner, 909 F.2d at

1365.   Our inquiry must consider “‘whether the transaction has
                                -152-

any practicable economic effects other than the creation of

income tax losses.’”    Jacobson v. Commissioner, 915 F.2d 832, 837

(2d Cir. 1990) (quoting Rose v. Commissioner, 868 F.2d 851, 853

(6th Cir. 1989), affg. 88 T.C. 386 (1987)), affg. in part, revg.

in part, and remanding T.C. Memo. 1988-341; see also Rosenfeld v.

Commissioner, 706 F.2d 1277, 1282 (2d Cir. 1983) (holding that

courts must consider “whether there has been a change in the

economic interests of the relevant parties.”), affg. T.C. Memo.

1982-263.

     Viewed according to their objective economic effects rather

than their form, Generale Bank’s and CLIS’s contributions to SMP

in exchange for partnership interests were economically

inconsequential events.   The banks’ purported partnering with SMP

had no meaningful economic significance other than as an

“ephemeral incident” to serve as a conduit for the banks’ built-

in losses.    Helvering v. Gregory, 69 F.2d 809, 811 (2d Cir.

1934), affd. 293 U.S. 465 (1935).   Moreover, the purported

partnering offered the Ackerman group no realistic economic

benefits apart from tax consequences.   For the reasons described

below, we conclude that the transaction’s objective economic

reality and consequences belie its form.

         1.   Economic Significance of Banks’ “Contributions”

     Petitioner argues that whether or not the banks intended to

enter into a film business with the Ackerman group, “all parties
                               -153-

recognized that the banks were committed as partners from the

time they signed the partnership documents.”   Petitioner’s

argument might be construed to suggest that the banks’

contributions to SMP and their receipt of preferred interests had

objective economic significance beyond petitioner’s asserted

business purpose for the transaction and the existence of the

Ackerman group’s tax considerations.   We disagree.   The banks’

tightly wrapped and virtually guaranteed exercise of their put

rights negates whatever economic significance might otherwise

have attached to the banks’ joining SMP.    The faint illusion of a

partnership interest cannot cloak the reality that the banks

planned, and had every economic incentive, to exit the

partnership as expeditiously as possible.   In substance, the

Ackerman group paid the banks $10 million ($5 million as an up-

front “advisory fee” and $5 million upon the banks’ exercise of

their put rights) in exchange for the banks’ high-basis, low-

value receivables and SMHC stock so that the banks could

“monetize”, and the Ackerman group could attempt to exploit, the

tax attributes associated with these assets.

             a.   Advisory Fee and Put Price

     All the various agreements between the Credit Lyonnais group

and the Ackerman group were tied to the side letter agreement,

the deposit account agreement, and the advisory fee deposit.    For

example, the side letter agreement provides that it shall become
                               -154-

effective (the “Effective Date”) on the date on which all the

following conditions have first been satisfied:   (1)   Each of the

parties shall have signed a counterpart of the side letter

agreement and each of Rockport Capital and CDR shall have

received a full set of counterparts; and (2) Rockport Capital

shall have deposited in a specified account $5 million; i.e., the

sum of the preferred capital accounts of Generale Bank and CLIS

on the closing date.   The side letter agreement further specifies

that “The parties hereto agree that, notwithstanding any

provision of the * * * [exchange and contribution agreement],

CDR, Generale Bank, and CLIS shall have no obligation to make the

Contributions as defined in * * * [that agreement] unless and

until the Effective Date has occurred hereunder.”   The deposit

account agreement, in turn, provides that Rockport Capital shall

on “the Effective Date deposit in the Deposit Account the amount

required to be deposited therein” pursuant to the side letter

agreement.

     Pursuant to the advisory fee agreement, “To induce CDR, CLIS

and GB to execute the Letter Agreement” and the exchange and

contribution agreement, Rockport Capital agreed to pay CLIS on

the “Effective Date” in U.S. dollars and immediately available

funds “(x) an advisory fee of $5,000,000 and (y) an additional

advisory fee equal to 3/4 of 1% of the tax losses, if any, in

excess of $1 billion that have been allocated to all members of
                                -155-

the Company other than GB, CLIS, Rockport or their affiliates” as

of the closing date on the exchange and contribution agreement.

In similar fashion, the advisory fee agreement provides that

“Rockport hereby agrees that notwithstanding any provision of the

Letter Agreement to the contrary, the Effective Date will not

occur unless Rockport has made the payment, if any, required by

the preceding paragraph.”

                  i.   Banks’ Understanding

     Sean Geary of White & Case was CDR’s principal U.S. counsel

in the sale of New MGM and its lawyer in the transaction with

Rockport Capital.106   He testified that at all times Mr. Jouannet

had in mind a price for the CDR transaction of approximately $10

million.

     The bottom-line result of the banks’ purported partnering

with SMP, and the exercise of their put some 3 weeks later, was

that the banks received their anticipated $10 million price for

the CDR transaction.    The advisory fee was paid to the banks up

front, as a precondition to the CDR transaction’s becoming



     106
        Mr. Geary has practiced law at White & Case for more than
30 years. He represented Credit Lyonnais and CDR for many years
before the CDR transaction and had a very significant role with
those companies vis-a-vis MGM. In fact, from January 1992 until
New MGM was sold in 1996, Mr. Geary served on the board of
directors of MGM-Pathe (and its successors). Although Mr.
Geary’s expertise was primarily in bank finance, his
representation of Credit Lyonnais and CDR was much broader--he
did “all their auditing on a big picture basis.” Mr. Geary
drafted the stock purchase agreement for the New MGM sale.
                                 -156-

effective.107   Mr. Geary testified that during the course of the

negotiations with the Ackerman group, Mr. Jouannet and other

individuals at the banks began to worry “whether Lerner and his

people were good for” the $5 million put price.     They therefore

decided that the put price should be placed in escrow in

connection with the closing on the transaction with the Ackerman

group.     To this end, Mr. Geary drafted a “Deposit Account

Agreement”, which was designed to guarantee payment of the put

price in the event that the put option was exercised.

     Mr. Geary testified that, in the transaction with the

Ackerman group, the banks were relying on the side letter

agreement that gave Generale Bank and CLIS the right to put

(“monetize”) their preferred interests in SMP to Rockport

Capital--“the side letter was always a precondition to CDR or

Credit Lyonnais signing anything else.”     He explained that

Generale Bank and CLIS did not care about the various provisions



     107
        On Dec. 12, 1996, Mr. Lerner, on behalf of Rockport
Capital, faxed to Citicorp Trust, a document requesting Citicorp
Trust to wire $5 million from Somerville S Trust’s account to an
account at Chase Manhattan Bank on Dec. 13, 1996. It appears
that this amount represented the $5 million advisory fee that the
Ackerman group was obligated to pay CLIS.

     The Ackerman group also agreed to pay the banks an
additional advisory fee equal to 3/4 of 1 percent of the tax
losses, if any, in excess of $1 billion that would be allocated
to all members of SMP other than Generale Bank, CLIS, Rockport,
or their affiliates as of the exchange and contribution agreement
closing date. The record is unclear whether the Ackerman group
ever paid the banks any additional amount of advisory fee.
                                  -157-

in the agreements:     “Because they were going to exercise their

put.”    For example, with respect to the SMP LLC agreement’s

reference to a film production and distribution business, Mr.

Geary testified that “I certainly can tell you that I was of the

belief when I received this that I didn’t care from my client’s

perspective what was in here other than a couple of things that I

marked up and sent back, the transfer provisions and one of the

confidentiality provisions.”

       Mr. Geary testified that, as of December 11, 1996, he knew

that Generale Bank and CLIS were going to exercise the put on

December 31, 1996, the earliest possible date for the put’s

exercise.    “I knew * * * [Mr. Jouannet] was going to exercise the

put.    He had a year to exercise the put.   I clearly knew from the

very beginning he was exercising the put.”     “As I’ve tried to

say, I always knew that the put was going to be exercised at some

point.    * * *   That was clearly my understanding of the deal.”

       We found Mr. Geary’s testimony exceptionally credible,

thorough, and persuasive.     His testimony shows convincingly that

the banks had no intention of partnering with the Ackerman group

and had planned from the beginning to exercise the put rights in

the side letter agreement as expeditiously as possible.

                    ii.   Ackerman Group’s Understanding

       Petitioner claims the he and Mr. Ackerman had no prearranged

understanding with CDR that the banks would exercise their put
                               -158-

rights.   Petitioner claims that he and Mr. Ackerman had every

hope and expectation that the banks would remain their partners

for an extended period.   We find, however, that they did have a

prearranged understanding.

     First, as Mr. Geary testified, the banks were relying on the

side letter agreement with Rockport Capital and fully intended to

exercise their put rights to accomplish their overall goal of

disposing of their interests in SMHC.   Mr. Lerner was intimately

engaged in the negotiation and drafting process at all levels,

including in his one-on-one negotiations with Mr. Jouannet.    It

defies reason that Mr. Lerner would have been unaware of the

banks’ plans.   Every aspect of the Credit Lyonnais group’s

history and of the negotiation and drafting process pointed

towards the banks’ exercising their put rights.   In fact, the

totality of facts in the record persuades us that the banks’

exercise of their put rights was integral to the Ackerman group’s

plans, was fully contemplated by them, and was part of the deal.

     Also, in one of the drafts of the SMP LLC agreement that

emerged in the course of the negotiations, Mr. Geary commented

that CDR would require Mr. Lerner to provide consents at closing

permitting the transfer of Generale Bank’s and CLIS’s preferred

interests to a CDR affiliate and the subsequent transfer of those

interests to Rockport Capital, pursuant to the side letter
                                 -159-

agreement.108   See Exhibit 173-J, J001736.   Mr. Geary testified

that he wanted to make it clear that the manager (i.e., Mr.

Lerner) consented to the transfers “because they were what was

being planned.”    Before closing on the transaction with CDR, Mr.

Lerner executed a consent giving effect to Mr. Geary’s comments.

The consent was predated “____________, 1996.”109    We infer from

Mr. Geary’s comments and this consent that there was an

understanding on the part of Mr. Lerner that Generale Bank and

CLIS would exercise their put rights at the earliest possible

point, on December 31, 1996.

                   iii.   Negotiation and Drafting Process

     Petitioner suggests that the “intensity and duration of the

negotiations” between the Ackerman group and CDR connotes

substance to the banks’ purported partnering with SMP.       In

support of this suggestion, petitioner points to the numerous

drafts of the letter agreement, the side letter agreement,

supplementary terms, the exchange and contribution agreement, the




     108
        Mr. Geary’s comments were faxed to Mr. Lerner and his
representatives at Shearman & Sterling.
     109
        When questioned about the date on the consent, Mr. Lerner
testified that the consent was part and parcel of the banks’ put
rights. “It allowed them to implement the put if it were
exercised. Notice it was undated. And as part of the
implementation of the put, if they were to exercise it, it was
requested that I sign this.” When pressed about the “1996” date
on each of the consents, Mr. Lerner testified that “I would say
it’s undated.”
                              -160-

SMP LLC agreement, the deposit account agreement, the interest

option agreement, and the advisory fee agreement.

     As described more fully below, our careful review of the

numerous drafts to which petitioner alludes does nothing to

bolster petitioner’s claims but leads us to two conclusions:

(1) That the Ackerman group was focused exclusively on obtaining

the high-basis, low-value receivables and SMHC stock from the

banks and getting assurances from Generale Bank and CLIS

regarding their tax bases in those assets; and (2) that CDR,

Generale Bank, and CLIS were focused exclusively on establishing

the put rights, guaranteeing full payment on those rights,

securing an advance consent to transfer the put rights and

withdrawal from SMP, and reserving whatever value might be

recovered on the Carolco securities.

     Between October 16 and November 21, 1996, the parties

exchanged a draft term sheet and numerous drafts of a letter

agreement embodying the basic terms that Messrs. Lerner and

Jouannet had agreed upon in their discussions.   In these various

documents, it was contemplated that Generale Bank would

contribute its $974 million in receivables and CLIS would

contribute its MGM Group Holdings (SMHC) stock (and in later

drafts, the $79 million receivable) to “Newco” (a prefiguration

of SMP) in exchange for preferred interests.   Rockport Capital

and its associates would contribute cash and securities to Newco
                              -161-

in an agreed amount to enhance and monetize the value of Generale

Bank’s and CLIS’s preferred interests.110   This proposed

transaction “would require Generale Bank and CLIS simply to

transfer their respective assets to a Newco in exchange for

preferred interests which will be monetized.”    The drafts

provided that after 5 years the preferred interests were

convertible into Newco common membership interests and provided

that, if the conversion right were exercised, Newco could redeem

all of the preferred interests at their liquidation value.

Throughout the course of the drafting process, these fundamental

features of the deal between CDR and Rockport Capital did not

materially change, and they were incorporated into the various

agreements.111

     In these various drafts, CDR was not focused on the letter

agreement but was instead focused on the side letter agreement,



     110
        The Ackerman group originally proposed that Generale Bank
would acquire MGM Group Holdings stock, would contribute the $974
million in receivables to MGM Group Holdings, and would then
contribute the MGM Group Holdings stock to Newco for preferred
interests. In the draft term sheet, the Ackerman group proposed
an alternative transaction (involving CLIS’s contribution of MGM
Group Holdings stock) “if CLIS’s current basis in Group stock is
significant”.
     111
        At certain points, the identities of the parties changed.
For instance, CDR was substituted for Generale Bank and CLIS at
certain points. A CDR affiliate, Santa Monica (Rotterdam)
Finance B.V., at one point was to hold the preferred interests
for Generale Bank or CLIS. In the early drafts, Rockport
Advisors was identified as an initial member in Newco rather than
Rockport Capital.
                               -162-

which gave Generale Bank and CLIS the right to put their

preferred interests in “Newco” to Rockport Capital.   Mr. Geary

testified that by the time of the draft letter agreement,

“clearly there was going to be a second letter, a put letter.

That’s what I understood to be monetized.   There was a put

available.   We didn’t have to wait, you know, for the time of the

deal.”   According to Mr. Geary, it was unimportant to CDR or Mr.

Jouannet what the letter agreement said about the terms of the

preferred interests and the conversion rights, because CDR was

relying on the side letter agreement that required Rockport

Capital to purchase all of Generale Bank’s and CLIS’s preferred

interests for $5 million.

     Other than this “put” agreement, four points of negotiation

developed from CDR’s perspective:

     First, CDR insisted that the $5 million advisory fee be paid

as a condition to closing on the exchange and contribution

agreement and the $5 million put price be deposited in a blocked

account before closing, thus guaranteeing payment when the put

rights were exercised.   The banks decided that the put price

should be placed in escrow in connection with the closing on the

CDR transaction.   Mr. Geary drafted a deposit account agreement,
                                -163-

which was designed to guarantee payment of the put price when the

put rights were exercised.112

     Second, CDR wanted an earlier put period than the Ackerman

group had proposed.   In an early revised draft of the side letter

agreement, the Ackerman group proposed:     “The Put will be

effected upon two days written notice from a Seller to Purchaser

given no earlier than December 31, 1997 directing that the Put be

effected.”   CDR, however, insisted on the following put period:

“The Put will be effected no earlier than December 31, 1996 and

no later than December 31, 1997 upon two days written notice from

a Seller to Purchaser directing that the Put be effected.”

     Third, CDR wanted assurances that Generale Bank or CLIS

could transfer their preferred interests to an affiliate and

withdraw from SMP without triggering the transfer and withdrawal

restrictions in the SMP LLC agreement.113   Mr. Geary therefore

demanded that consents by SMP’s manager would be required at

closing, permitting the transfer of Generale Bank’s and CLIS’s

preferred interests to a CDR affiliate and the subsequent


     112
        At one point, the deposit account agreement was changed
to provide that the depositing bank would withdraw and pay to
Rockport Capital any funds still on deposit on Jan. 2, 1998.
     113
        Pursuant to the transfer provisions: No member could
sell, transfer, or dispose of its membership interest without the
manager’s written consent; no member could retire or withdraw
from SMP without the manager’s written consent, except in certain
defined circumstances; and no person could become a member of SMP
without the manager’s written consent and the new member’s
assumption of all the terms and conditions of the LLC agreement.
                                 -164-

transfer of those interests to Rockport Capital pursuant to the

side letter agreement.

     CDR was also concerned that communications with the

affiliate might cause problems with the stringent confidentiality

provision in the agreement.114   Mr. Geary therefore insisted on an

exception to the confidentiality provision for information that

is disclosed on a confidential basis to a proposed transferee of

some or all of the membership interests of a member.

     Fourth, CDR became very focused on the Carolco securities

and wanted to retain whatever value might be realized on those

securities.   Indeed, following the basic agreement that the

parties reached on November 21, 1996, CDR proposed several

variations of an agreement tied to the Carolco securities.

Initially, CDR had proposed alternate classes of preferred

interests in Newco (SMP), Class A and B preferred interests,

which would be issued to Generale Bank and CLIS along with 5

percent of the common interests to Generale Bank and CLIS.115    The

parties agreed that Somerville S Trust and Mr. Lerner would have

options to acquire:   (i) The Class B preferred interests at a



     114
        The confidentiality provision provided that SMP’s members
would not reveal to any other person any nonpublic, confidential,
or proprietary information relating to SMP’s business that was
acquired in connection with the transactions contemplated by the
LLC agreement.
     115
        The Class B preferred interests were given a $7 million
capital account and certain annual distribution rights.
                                -165-

price equal to the lesser of $7 million or the value of the

Carolco subordinated notes; and (ii) the 5-percent common

interests at a price equal to the lesser of $3 million or the

value of the Carolco preferred stock.    Both options were

exercisable for a period of 12 months after the earlier of 5

years from the date of issue or the liquidation of the Carolco

subordinated notes and the Carolco preferred stock,

respectively.116   Eventually, the parties eliminated the alternate

classes of preferred stock and the issuance of 5 percent of the

common interests to Generale Bank and CLIS; they agreed instead

to certain preferred distributions and an additional contingent

put price tied to the liquidation value of the Carolco

subordinated notes and Carolco preferred stock.117   Through these



     116
        Mr. Geary became concerned with the proposed options on
the alternate Class B preferred and 5 percent common stock
interests. Mr. Geary was uncertain what economic motivation
anyone might have for exercising the call option and indicated to
Mr. Lerner and his representatives that “any explanation of such
motivations may leave unanswered questions in Paris”. Given this
problem, Mr. Geary added a paragraph 16 to a new draft of the
side letter agreement giving CLIS the right to require Rockport
Capital to purchase its Common II and Class B preferred
membership interests in SMP at prices tied to the liquidation
value of the Carolco securities. At the conclusion of the
drafting process, however, the parties did not execute the
interest option agreement and paragraph 16 was removed from the
side letter agreement.
     117
        The pertinent events and times for measuring the
contingent amount were set forth in detailed paragraphs in the
side letter agreement defining “the SN Liquidation Date,” “the SN
Measurement Date,” “the PS Measurement Date,” and “the PS
Liquidation Value.”
                               -166-

provisions, CDR effectively tied up any value that might be

realized on the Carolco securities.

     On the other hand, the Ackerman group was primarily

concerned with certain representations and warranties that they

wanted with respect to Generale Bank’s and CLIS’s tax basis in

the receivables and SMHC stock.   This concern is apparent in an

early draft of the letter agreement, in which the Ackerman group

proposed:

          3. Certain Representations and Warranties of CLIS
     and GB. (a) CLIS hereby represents and warrants that
     CLIS’s basis computed under United States Federal
     income tax principles in the stock of Holdings is not
     less than $________.

          (b) GB hereby represents and warrants that GB’s
     basis computed under United States Federal income tax
     principles in the Note [SMHC’s $1.050 billion debt
     obligations to Generale Bank] is not less than
     $________.

Mr. Geary testified that he had never seen representations and

warranties like these.   He found that these items were too

complicated and exposed Generale Bank and CLIS to all sorts of

liabilities.   Consequently, he had these open-ended

representations and warranties removed.   Later, the Ackerman

group proposed a “Rider 12A” to the exchange and contribution

agreement providing the following representation and warranty:

SMHC “shall not have made any payment on the Holdings-CLIS Debt

or Holdings-GB Debt and neither the Holdings-CLIS Debt nor the

Holdings-GB Debt has been written down for accounting or tax
                                    -167-

purposes.”      In the final draft of the exchange and contribution

agreement, Generale Bank and CLIS warranted and represented that

they had received no payment of principal on the $974 million in

receivables and the $79 million receivable, respectively, and

that those receivables had not been written down for accounting

or tax purposes.        Pursuant to this final draft, the Ackerman

group was entitled to indemnification from CDR of up to $10

million for any breaches of these representations or warranties.

                   b.    Redemption and Liquidation Rights

     Petitioner contends, however, that Generale Bank and CLIS

had an interest in maximizing their return from a redeveloped

SMHC.      Petitioner points to the redemption rights (and ostensibly

the conversion rights) provided in the letter agreement and

distilled into the SMP LLC agreement.        Under the SMP LLC

agreement, Generale Bank and CLIS were given conversion rights

for their preferred interests in SMP which were exercisable on or

after December 10, 2001.118      The preferred interests were

convertible into nonvoting Common II interests.119      In the event

that SMP received a conversion notice, it had the option to

redeem the preferred interests, in whole but not in part, at a


     118
        The agreement provided that the conversion right would be
immediately exercisable in the event SMP failed to make a certain
required distribution.
     119
        The preferred interests were convertible on a basis equal
to the “Convertible Percentage”, which the LLC agreement provided
would initially equal 45 percent.
                                -168-

redemption price equal to the sum of the preferred capital

accounts for all holders of preferred interests.120   In explaining

the conversion feature, Mr. Lerner testified:    “Credit Lyonnais

was very concerned that the company would become increasingly

valuable over the period of time that we were adding film

libraries to it, and they wanted the opportunity to convert from

a preferred stock position, which had fixed value plus return, to

a full equity position”.    He added, “They were willing to let’s

say remain in a preferred position for awhile, but ultimately

they wanted the option to get more of the animal, which is to say

increase their interests to a level where they could participate

in what we thought would be the equity build up of the

investment.”

     We cannot agree that the conversion right denotes any long-

term commitment on the part of Generale Bank and CLIS, or that it

otherwise lent economic substance to the banks’ purported SMP

interests.    The conversion feature appears in the initial draft

term sheet that Shearman & Sterling prepared at the request of

Mr. Lerner.    This item does not appear to have been an item that

was specifically negotiated by CDR or Mr. Geary or one that they

really cared about.    Indeed, Mr. Geary testified that although

the conversion feature was always part of the deal between


     120
        Amendment No. 1 credited $3,125,000 to Generale Bank’s
preferred capital account and $1,875,000 to CLIS’s preferred
capital account.
                                -169-

Rockport Capital and CDR, Generale Bank and CLIS were relying on

the side letter agreement because they did not want to have to

wait for the conversion of their preferred interests into common

stock which would take 5 years.

     Furthermore, as explained below, when considered in

conjunction with SMP’s option to convert the banks’ preferred

interests into debt, it does not appear that the banks’

conversion feature would have been likely to provide any

meaningful inducement for the banks to remain in SMP.

              c.   SMP’s Conversion Option

     SMP had the option to convert the banks’ preferred

interests, in whole but not in part, into debt of SMP.     SMP could

exercise this conversion right any time on or after December 31,

1997 (the last date by which the banks could exercise their put

option).    If the conversion right w exercised, the resulting debt

(so-called “preferred debt”) would have a $5 million principal

amount and a 5-year term; it would bear interest at an 8-percent

annual rate, payable annually from one year after the issuance of

preferred debt to the maturity thereof.      If the conversion option

were exercised, SMP would have the option of redeeming the

preferred debt, upon 30 days’ notice, at 100 percent of the

principal amount ($5 million) plus any accrued and unpaid

interest.
                                  -170-

     The preferred debt option effectively allowed Mr. Lerner to

control whether the banks would remain as partners in SMP beyond

the put period.      If the banks did not exercise their put rights

by December 31, 1997, Mr. Lerner could convert the banks’

preferred interests into preferred debt at any time between

January 31, 1997, and December 10, 2001 (the date that the banks’

conversion rights would accrue).      If SMP exercised the preferred

debt option, the result would be the economic equivalent of an

interest-free loan by the banks of the $5 million put purchase

price from December 31, 1996 (the date the banks could have

exercised their put rights and claimed the $5 million put price)

until the conversion of the preferred interests into preferred

debt.      Taking into consideration the time value of money, the

banks would appear to have had every economic incentive to

exercise their put option as soon as possible, on December 31,

1996, for $5 million.121    If the banks remained in SMP beyond the


     121
        The SMP LLC agreement provided that each preferred
interest holder’s capital account would be credited with the
holder’s distributive share of “Net Income”. Under the LLC
agreement, SMP’s “Net Income” was allocated first to each holder
of preferred interests in an amount equal to 8 percent of the
balance of the holder’s preferred capital account on the last day
of the partnership’s fiscal year. It does not appear, however,
that these adjustments would have affected the put price: The
side letter agreement defines the put purchase price, in relevant
part, as an amount equal to: “the amount of the Preferred
Capital Account as described in the Limited Liability Company
Agreement of the Company and as in effect on the EC [exchange and
contribution agreement] Closing Date * * * for the original
holder or holders of such Preferred Interests”. We construe this
                                                   (continued...)
                               -171-

put period, SMP could convert the banks’ membership interests

into preferred debt, and the banks’ potential payback would be

limited to the same $5 million that they could have received

almost immediately by exercising the put option.

     Presumably, this conversion feature was of little concern to

the banks, because as we have found, they intended to exercise

their put option as soon as possible anyway.   The debt conversion

feature would appear to have provided SMP added assurance,

however, that the banks would exercise their put option, which

was an essential part of the Ackerman group’s plan to acquire the

banks’ built-in losses.

             d.   Distribution Rights

     Petitioner also points to certain distribution rights that

the banks were given in their preferred interests in SMP.

Amendment No. 1 to the SMP LLC agreement provided that SMP would

make annual distributions to its members of all “Excess Cash

Flow” according to the following priorities:

          (i) First. The holders of Preferred Interests
     shall receive pro rata in accordance with their
     respective Preferred Capital Accounts the lesser of (x)
     Excess Cash Flow and (y) an amount equal to 8% of the
     balance of the Preferred Capital Accounts on the last


     121
       (...continued)
language to mean that the put price would equal the original $5
million credited to the banks’ preferred capital accounts,
unadjusted for any “Net Income” adjustments to those accounts
that might subsequently occur. With that being said, the banks
had no incentive to stick around until Dec. 31, 1997, as opposed
to Dec. 31, 1996.
                              -172-

     day of the Fiscal Year (such amount being referred to
     herein as a “Full Distribution”) plus the sum of the
     Unpaid Distributions with respect to any prior annual
     distributions to such holders.[122]

          (ii) Second. The holders of Common Interests
     shall receive pro rata in accordance with their
     respective Percentage Common Interests an amount equal
     to Excess Cash Flow minus the amount of any
     distributions made to holders of Preferred Interests
     pursuant to paragraph (i) above.

Under the LLC agreement, the term “Excess Cash Flow” means, with

respect to any Fiscal Year:

     (x) the sum of (1) Operating Cash Flow, (2) net cash
     proceeds from the sale of any asset of the Company
     other than in the ordinary course of business, (3) cash
     proceeds of any payment in respect of debt owing to the
     Company (including debts of Members or Affiliates of
     Members) and (4) capital expenditures that the Company
     committed to make in prior Fiscal Years but has
     determined not to make, less (y) the sum of (1)
     payments on any debt obligation of the Company and (2)
     capital expenditures that the Company has committed to
     make in the relevant period.[123]

     Like the conversion rights, these distribution rights were

not a point of negotiation between the parties; the language

addressing these distribution rights appears to have been drafted

by Shearman & Sterling, on behalf of Rockport Capital.   Because


     122
        With respect to any annual distribution made to holders
of preferred interests, the term “Unpaid Distribution” means:
“the amount equal to the Full Distribution minus the Excess Cash
Flow; provided, that such amount shall not be deemed to be an
Unpaid Distribution if such amount has been previously
distributed to holders of Preferred Interests.”
     123
        “Operating Cash Flow” is defined as: “the gross revenues
of the Company from its businesses that are actually received
less the expenses associated with such businesses that are
actually paid.”
                               -173-

the distribution rights were contingent on SMP’s generating

excess cashflow, there was no guarantee that SMP would ever make

distributions.   It was highly unlikely that SMP would generate

excess cashflow.   In the first place, SMP was not an operating

company.   As a practical matter, it could not and would not

generate operating cashflow; its only assets were the $20 million

in cash and the SMHC receivables and stock.   SMP’s purported film

distribution business was in SMHC, a separate corporate entity

that was, by and large, devoid of assets and completely

insolvent.   Inasmuch as Mr. Lerner controlled both SMP and SMHC,

if the banks failed to exercise their put rights, it is highly

unlikely that Mr. Lerner would allow SMP to generate excess

cashflow, triggering these distribution rights.124   Instead, if

SMHC were to generate any income, Mr. Lerner could effectively

lock up that income in SMHC, wait out the put period, and convert

the banks’ preferred interests into preferred debt, which could

then be redeemed for $5 million.




     124
        The LLC agreement appointed Mr. Lerner manager of SMP and
authorized him to manage the business and affairs of SMP. Mr.
Lerner was given the ability to act on behalf of SMP in
connection with its day-to-day affairs or otherwise. His powers
included, specifically, the power to convert the preferred
interests into preferred debt or to redeem the preferred
interests (in the case of conversion notice), and to appoint
employees, officers, or additional managers of SMP.
                                -174-

             e.   Carolco Securities

     Petitioner points to Generale Bank’s and CLIS’s interest in

receiving the future value of the Carolco securities that SMHC

held as evidencing economic substance in the banks’ preferred SMP

membership interests.    Petitioner points out that even after

Generale Bank and CLIS exercised their put rights, SMP continued

to treat Generale Bank and CLIS as partners, sending those

entities Schedules K-1 for each year from the time the banks made

their contributions.

     Generale Bank’s and CLIS’s retained interest in the Carolco

securities does not reflect a long-term commitment to SMP or SMHC

or lend substance to their purported membership interests.

Although the Carolco securities were to be held in SMHC, whatever

value might have been realized on the Carolco securities had

nothing to do with SMHC, SMP, or any prospective film

distribution business.    Instead, Generale Bank and CLIS had tied

up whatever value that remained in the Carolco securities as a

contingent amount in their put purchase price.

     Amendment No. 1 also gave the banks certain preferred

distribution rights to any value that might be realized from a

liquidation of the Carolco securities.125   Petitioner points to


     125
        With respect to the Carolco subordinated notes, Amendment
No. 1 provided that as promptly as practicable after the “SN
Liquidation Date”, SMP would distribute to holders of preferred
interests pro rata in accordance with their respective preferred
                                                   (continued...)
                                -175-

these preferred distribution rights and claims that the existence

of these rights denotes some economic incentive on the part of

the banks to stay in SMP.    Nonetheless, these preferred

distribution rights parallel, almost precisely, the terms of the

contingent put price for the banks’ preferred interests.    They

afforded the banks no additional advantage from remaining in the

SMP partnership rather than exercising their put rights on

December 31, 1996--in either case, the banks would receive

whatever value might be realized on any liquidation of the

Carolco securities.    Because we find that the banks had every

economic incentive to exercise their put rights, these preferred

distribution rights are irrelevant.

     To the extent that petitioner may be suggesting that

Generale Bank and CLIS continued as partners in SMP because of

the contingent payment amount, we disagree.    When Generale Bank

and CLIS exercised their put rights at the end of December 1996,

they divested themselves of whatever remaining interests they had

in SMP.    The contingent payment amount was not a continuing

partnership interest; instead, that amount was part of an open



     125
       (...continued)
capital accounts the lesser of: (i) $7 million; and (ii) the “SN
Liquidation Value.” With respect to the Carolco preferred stock,
Amendment No. 1 provided that as promptly as practicable after
the “PS Liquidation Date”, SMP would distribute to the holders of
preferred interests pro rata in accordance with their respective
preferred capital accounts the lesser of: (i) $3 million, and
(ii) the “PS Liquidation Value”.
                               -176-

transaction which was tied to Generale Bank’s and CLIS’s exercise

of the put rights.   Moreover, the fact that SMP continued to send

Generale Bank and CLIS Schedules K-1 cannot obscure that those

entities effectively exited SMP on December 31, 1996.    The only

question at that point was whether Generale Bank and CLIS would

receive any additional payment for their preferred interests on

account of the Carolco securities.

     Petitioner points to a document entitled “Amendment No. 3”,

which provides that Generale Bank and CLIS, as the original

holders of the preferred interests in SMP, would have continuing

interests in certain annual distributions relating to the

liquidation of the Carolco subordinated notes and the Carolco

preferred stock that SMHC held.126   These distribution rights

closely track the distribution rights that were originally

provided in Amendment No. 1 and, likewise, parallel the

contingent put price in the side letter agreement.127   Insofar as

the exercise of the put rights already established the banks’



     126
        Apparently, on the basis of this document, Mr. Lerner, on
behalf of SMP, continued to send Schedules K-1 to Generale Bank
and CLIS.
     127
        Pursuant to the side letter agreement, Generale Bank and
CLIS were entitled to receive a “Contingent Amount” on the
exercise of their put rights. This contingent amount was payable
to the banks by Rockport Capital on (1) the “SN Liquidation Date”
in an amount equal to each seller’s percentage of the lesser of
$7 million and the “SN Liquidation Value” and (2) the “PS
Liquidation Date” in an amount equal to each seller’s percentage
of the lesser of $3 million and the “PS Liquidation Value”.
                                -177-

rights to the contingent payment amount, as part of an open

transaction, the distribution rights in Amendment No. 3 are

redundant and unnecessary.    The banks were already entitled to

any value that might be realized on the Carolco securities.

There was no need to “rejoin” SMP to receive their contingent put

price.

     Further, it is unclear whether Generale Bank or CLIS ever

acceded to the execution of Amendment No. 3.    Petitioner claims

that he executed this amendment to the SMP LLC agreement after

speaking to Mr. Jouannet sometime in 1997.    Mr. Lerner claims

that he instructed his attorneys at Shearman & Sterling to

prepare this amendment, which he then signed as manager of SMP.

No representative of Generale Bank or CLIS signed this amendment.

There is no evidence that Generale Bank or CLIS was aware of this

amendment.    Mr. Jouannet never asked Mr. Geary to review

Amendment No. 3, even though Mr. Geary testified that Mr.

Jouannet would have asked him to review such a document prior to

having CDR’s interest affected by it.

         2.    Economic Benefits for the Ackerman Group

     “Economic substance depends on whether, from an objective

standpoint, the transaction was likely to produce economic

benefits aside from tax deductions.”    Winn-Dixie Stores, Inc. v.

Commissioner, 113 T.C. at 285 (citing Kirchman v. Commissioner,

862 F.2d at 1492; Bail Bonds by Marvin Nelson, Inc. v.
                                -178-

Commissioner, 820 F.2d at 1549).   Courts have refused to

recognize the tax consequences of transactions which do not

appreciably affect the taxpayer’s beneficial interests except for

tax reduction.    See, e.g., Knetsch v. United States, 364 U.S. at

366; ACM Pship. v. Commissioner, 157 F.3d 231, 248 (3d Cir.

1998), affg. in part, revg. in part, dismissing in part, and

remanding on other grounds T.C. Memo. 1997-115.

     In exchange for the banks’ “contributions” to SMP, the

Ackerman group paid an upfront $5 million advisory fee to CLIS

and irrevocably agreed to purchase the banks’ preferred interests

for $5 million, which it placed in a blocked account upon the

closing of the transaction.   As explained in greater detail

below, however, these inducements exceeded the value of the

contributions that the banks made to SMP.   The SMHC receivables

and stock that Generale Bank and CLIS contributed to SMP did not

add any appreciable value to that enterprise.   Any value that

might have existed in those contributed properties was contingent

on SMHC’s ability to generate income.   All objective indications

are that SMHC had no such ability and could not reasonably have

been expected to have any such ability, without a mass infusion

of new capital.

     At the time of the transaction between the banks and the

Ackerman group, SMHC held only three significant “assets”:     (1)

The EBD film library; (2) the Carolco securities; and (3) large
                               -179-

amounts of unused NOLs.   On the basis of all the evidence in the

record, we conclude that none of these assets had any significant

value.   The EBD film library was a “broken” collection of B film

titles with missing physical elements, a fragmented chain-of-

title history, and limited or expiring distribution rights.    The

banks had effectively tied up any value that SMHC might realize

on the Carolco securities.   Use of the NOLs in SMHC was dependent

on avoiding an ownership change for purposes of section 382 and,

more importantly, was dependent on SMHC’s generating income,

which could not occur without new capital.

     Whatever intangible value might have arisen from the banks’

participation in the enterprise is obviated by the parties’

prearrangement and the economic reality (just discussed) that the

banks would exit the partnership as soon as possible--which they

did, 20 days into their purported film business with the Ackerman

group.   Thus, given the absence of appreciable value in the

contributed properties and the banks’ intentions of exiting the

partnership, the objective realities of the transaction compel

the conclusion that, apart from tax benefits, the Ackerman group

had no reasonable expectation of recouping the $10 million they

paid the banks as an inducement to enter into the partnering

transaction.   Consequently, the economic realities lead us to

conclude that this $10 million amount was paid, not as an

inducement for entering into the partnership, but for the $1.7
                                     -180-

billion in tax attributes that the Ackerman group acquired in the

transaction.

     In the discussion that follows, we explain in detail the

basis for our conclusion that SMHC’s three assets (the EBD film

library, the Carolco securities, and the unused NOLs) had no

significant value at the time of the transaction in question.

            3.    EBD Film Library

     The parties have offered expert witnesses to opine on the

value of the EBD film library at the time of the transaction in

question.    As explained below, after carefully considering this

expert testimony, we conclude that the EBD film library had no

significant value at the time of the transaction in question.

                 a.   Petitioner’s Expert

     Steven L. Wagner is a principal at Deloitte & Touche.      He

specializes in business valuation and issues relating to the

entertainment industry.      Mr. Wagner is accredited by the

Association for Investment Research and Management as a chartered

financial analyst, is an accredited member (business valuation)

of the American Society of Appraisers, and has participated in

the financial advisory services industry for more than two

decades.

     Mr. Wagner submitted an expert report appraising, as of

December 11, 1996, the 65 film titles that CLIS contributed to

SMHC on December 10, 1996.      His report assumes:   (a) That all the
                                 -181-

physical elements associated with the 65 film titles are

available, and (b) alternatively, that physical elements for only

some of the film titles are available.       In estimating the fair

market value of the EBD film titles, Mr. Wagner relied upon the

income approach.    Because of the market limitations associated

with B film titles, Mr. Wagner forecast income only for VHS

(Video Home System) sales into the rental market.

                   i.   Income Projections

     Mr. Wagner projected the number of gross units shipped per

film title on the basis of information obtained from Adams Media

Research (AMR), a media and entertainment data research firm.128

Mr. Wagner isolated the AMR data for 270 film titles that he

found to be comparable to the EBD film titles.129     Using

“STARmeter” ratings found on the “Internet Movie Database

(‘IMDb’),” Mr. Wagner then separated the 270 film titles into two

groups:    (i) titles with more well-known actors; and (ii) titles

with lesser-known actors.130   He further categorized the 270 film


     128
        AMR provided information for film titles that were
released direct-to-video by independent distributors for the
period 1994 through Sept. 30, 1996.
     129
        Mr. Wagner assumed that the EBD film titles would be
comparable to film titles that were released direct-to-video by
independent studios.
     130
        According to IMDb, its STARmeter rankings provide a
snapshot of an actor’s popularity based on input from IMDb users;
the ratings are based on several statistical indicators,
including the frequency and number of people who access a
                                                   (continued...)
                                  -182-

titles according to genre (action, adventure, drama, horror,

science fiction, suspense, and thriller).      Within each

categorization, he computed high, low, mean, and median units

shipped, as well as wholesale price statistics.

     Mr. Wagner separated the EBD film titles into:       (i) Titles

with more well-known actors and (ii) titles with lesser-known

actors.      He categorized them according to genre.   Using the

median gross units shipped from comparable film titles in the AMR

data, Mr. Wagner projected gross units shipped for the EBD film

titles.131

     On the basis of discussions with industry participants, Mr.

Wagner projected that the unit return rate for units shipped to

the rental market would be 7.5 percent of the gross units

shipped.      On the basis of the median wholesale prices per unit

for comparable AMR film titles, Mr. Wagner projected a $59




     130
       (...continued)
person’s web page or credits on the IMDb database. Mr. Wagner
analyzed IMDb’s STARmeter rankings using information from 2004.
     131
        Mr. Wagner applied a “discount” to the expected
performance of foreign-language films in the EBD film library.
He calculated this discount by comparing the average performance
of foreign-language films to various other genres and applying
this relationship (percentage of foreign-language units to other
genre units) to his film title categorizations. Mr. Wagner also
revised the data for film titles in the horror genre and the
well-known actors/action genre category to account for drops in
units shipped in those categories in 1996.
                                 -183-

wholesale price per unit for the EBD film titles.132      On the basis

of discussions with industry participants, Mr. Wagner opted for a

3-year release pattern (on average, just under two film titles

per month) for the EBD film titles.133      Mr. Wagner also opted for

an even release pattern for each title for each genre; i.e., if

there were 9 horror film titles, then 3 horror film titles would

be released each year.    On the basis of discussions with industry

participants, Mr. Wagner determined that 80 percent of a film

title’s revenue would be received in the first year of release

and 20 percent would be received in the second year of release.

     Incorporating these figures, Mr. Wagner computed gross sales

data for the EBD film library on title-by-title and year-by-year

bases.

                 ii.     Cost Projections

     Mr. Wagner projected costs for distributing the EBD film

titles including VHS conversion, duplication, distribution

(including shipping and packaging), cover art, and marketing




     132
        Mr. Wagner projected a lower $47 wholesale price per unit
for the less well-known actors/horror genre, because distributors
had lowered prices in 1996 to induce additional unit sales in
this category.
     133
        Mr. Wagner determined that for a typical release pattern,
a distributor releases up to three film titles per month
depending on the other film titles that the distributor is
releasing.
                                    -184-

costs.134    Mr. Wagner projected VHS conversion costs of $3,200 per

film title and duplication and distribution costs of $2.50 per

unit.      On the basis of discussions with industry insiders,

including Michael Herz, Mr. Wagner projected cover art and

marketing costs as $7,500 per film title.

                     iii.   Net Cashflows

        To arrive at a net annual cashflow, Mr. Wagner deducted

total projected expenses from projected revenues for each EBD

film title.      He then aggregated the net cash flows for the EBD

film titles to arrive at a net cashflow for the entire EBD film

library.      He applied a 40-percent tax rate to come up with the

after-tax cashflows for the EBD film library.

                     iv.    Valuations

     Mr. Wagner discounted the after-tax cashflows to December

11, 1996, using a real weighted average cost of capital of 10

percent (rounded), arriving at a present value of $6.8 million

for the EBD film library.       He also projected a $2.3 million

amortization tax benefit for the acquisition cost of the EBD film

library.      Using these figures, Mr. Wagner calculated a $9.1

million value, as of December 11, 1996, for the 65 film titles in

the EBD film library.       Alternatively, Mr. Wagner calculated a



     134
        In estimating these costs, he assumed that the buyer of
the EBD film library already had a distribution structure;
therefore, the costs associated with maintaining a distribution
structure were not included.
                                -185-

$6.9 million value, as of December 11, 1996, for the 52 film

titles in the EBD film library with confirmed physical materials.

                  v.   Market Approach

     Mr. Wagner did not rely on a market approach to value the

EBD film library because of the difficulty in finding comparable

film libraries.   Nonetheless, he reviewed several film and

television libraries that were sold in the 1990s:    (1)   In 1990,

MCA, Inc., sold 3,100 feature film titles and 14,000 TV episodes

to Matsushita Electric for $6.1 billion ($356,725 per title); (2)

in 1993, New Line sold 200 features to Turner Broadcasting for

$500 million ($2.5 million per title); (3) in 1995, Matsushita

Electric sold 3,200 features and 14,000 TV episodes to Seagram

Co., Ltd., for $5.7 billion ($331,395 per title); (4) in 1996,

Credit Lyonnais sold 1,500 features and 4,100 TV episodes to Mr.

Kerkorian for $1.3 billion ($232,143 per title); and (5) in 1997,

Orion/Samuel Goldwyn sold 2,000 features to MGM for $573 million

($286,500 per title).135   On the basis of this information, Mr.

Wagner concluded that the approximately $140,000 price per title

that he determined for the 65 EBD film titles “appears to be not

unreasonable.”



     135
        The film library that New Line sold to Turner
Broadcasting included the film titles: “Teenage Mutant Ninja
Turtles”, “Misery”, and “City Slickers”. The film library that
Orion/Samuel Goldwyn sold to MGM included the Academy Award-
winning film titles: “Amadeus”, “Platoon”, “Dances With Wolves”,
and “The Silence of the Lambs”.
                               -186-

             b.     Respondent’s Expert

     Richard L. Medress is the founder and president of Cineval,

LLC, an independent consulting practice that specializes in

theatrical and television film library valuations.    Mr. Medress

has more than 15 years of experience in the entertainment

industry and has valued a number of major studio and independent

film libraries for owners, lenders, and potential investors.

Before establishing his own consulting business in 1995, Mr.

Medress was a vice president in the Entertainment Industries

Group and in the Corporate Finance Division at Chemical Bank (now

JP Morgan Chase).    Mr. Medress is a member candidate of the

American Society of Appraisers.

     Mr. Medress submitted an expert report appraising the 65 EBD

film titles, as of December 11, 1996, under two scenarios.      Under

scenario 1, Mr. Medress assumed that SMHC owned the domestic home

video distribution rights to all 65 film titles, in perpetuity.

Under scenario 2, Mr. Medress adjusted his valuation for the

possibility that two of the film titles represent the same film,

and that the distribution rights to certain other film titles

expired shortly before or after December 11, 1996.    Mr. Medress

relied on an income approach, forecasting income for VHS sales in

the rental market and in the sell-through market (i.e.,
                                  -187-

distributor’s sale of video units directly to retailers (e.g.,

Wal-Mart)).136

                    i.   Income Projections

     Mr. Medress prepared income projections for a 10-year period

from 1996 through 2006, on the basis of “reasonable assumptions

of demand” for the EBD film titles in 1996.     Mr. Medress assumed

that most of the film titles in the EBD film library were

previously released in video in the United States, that demand

for the film titles was constrained by their age and their having

been previously exploited in video, and that the distribution of

many titles in the library was constrained by their sexual and

shock exploitation subject matter.137

      In scenario 1, Mr. Medress projected 10 film titles in

rental and 55 film titles in sell-through.     In scenario 2, Mr.

Medress projected 10 film titles in rental for each of the years

in the projection period, 47 sell-through film titles in 1997,

and 45 sell-through film titles for each of the years 1998

through 2006.138


     136
        Mr. Medress analyzed the possibility of distributing the
EBD film titles in DVD format; however, he concluded that
releasing those film titles in DVD format did not make economic
sense on the basis of the estimates in place in 1996.
     137
        According to Mr. Medress, certain video chains (e.g.,
Blockbuster) and retailers (e.g., Wal-Mart) would not stock film
titles of this nature.
     138
           Mr. Medress does not identify which 10 film titles from
                                                      (continued...)
                                  -188-

     Mr. Medress assumed that in 1997 (the first full year after

SMP acquired SMHC) 500 units would be shipped for each of the 10

film titles distributed in the rental market, and that this

amount would decline by 2.5 percent per annum as the film titles

continued to age.      For scenario 1, Mr. Medress divided the film

titles distributed in the sell-through market into 10 “Group 1”

film titles and 45 “Group 2” film titles.      For scenario 2, Mr.

Medress divided the film titles distributed in the sell-through

market into 9 “Group 1” and 38 “Group 2” film titles for 1997,

and 9 “Group 1” and 36 “Group 2” film titles for 1998 through

2006.      Mr. Medress assumed, in both scenarios, that 5,000 units

would be shipped for each of the “Group 1” film titles and 100

units would be shipped for each of the “Group 2” film titles, and

that after 1997 the unit shipments would decline by 2.5 percent

per annum.139

     Having determined that shipments of rental units that had

been in release for some time would have a low return rate, Mr.

Medress assigned the EBD film titles a 5-percent return rate.

For the EBD film titles distributed in the sell-through market,


     138
       (...continued)
the EBD film library would be distributed in the rental market.
Typically, as the figures reflect, units sell at higher price
points in the rental market (e.g., $44.95) than in the sell-
through market (e.g., $7.99).
     139
        Mr. Medress does not explain his division of the EBD film
library into “Group 1” and “Group 2” film titles or identify
which film titles were placed into those respective groups.
                               -189-

Mr. Medress assumed a 20-percent return rate, which he regarded

as “typical of sell-through product.”140

     Because of the age of the EBD film titles, Mr. Medress

selected a $44.95 wholesale price for rental units, which was at

the lower end of the range for direct-to-video titles released by

independent studios.   On the basis of his industry knowledge, Mr.

Medress used a $7.99 wholesale price for sell-through units.

     Mr. Medress did not incorporate a release pattern into his

projections; he assumed that income would be received evenly over

his 10-year projection period (with the exception of the annual

2.5-percent decay rate discussed above).

     Incorporating these figures, Mr. Medress computed gross

sales data for the EBD film library on a year-by-year basis.

                 ii.   Cost Projections

     On the basis of his industry knowledge, Mr. Medress

projected $2.75 in manufacturing, packaging, and shipping costs

per unit and marketing costs equal to 10 percent of gross sales.

Mr. Medress also projected administrative overhead at what he




     140
        Mr. Medress assumed that 98 percent of returned units
would be recycled into sales; he made an adjustment in the
following year for the manufacturing costs of the returned units.
                                -190-

termed an “appropriate” rate of 10 percent of gross sales.141

Mr. Medress did not project any conversion costs.

                 iii.    Net Cashflows

     After deducting manufacturing, packaging, shipping, and

marketing costs, Mr. Medress derived net receipts for the EBD

film library from its projected distributions in the rental and

sell-through markets for each of the years in the 10-year

projection period.   Mr. Medress combined the net receipts for the

rental and sell-through distributions and subtracted his

projected overhead from these yearly figures.

     Mr. Medress calculated a terminal value for the EBD film

library based on projected cashflows for 2006, assuming that

units shipped would continue to decline beyond 2006 at an annual

rate of 2.5 percent.    Mr. Medress then computed the total

cashflows for each year in his projection period, including the

terminal value of the EBD film library in his 2006 projections.

Mr. Medress applied a 44.5-percent (combined Federal and New York

State) tax rate and added an amortization tax benefit for each of




     141
        Mr. Medress projected overhead for the EBD film library
at a rate that he regarded as “typical” of a small distribution
company. He assumed that the EBD film library was, or would be,
part of a business that distributed other films, resulting in
lower overhead costs.
                                 -191-

the years in his projection period to arrive at net after-tax

cashflows.142

                  iv.    Valuations

     Mr. Medress determined the present value of future cashflows

using a discount rate of 11.8 percent calculated on an industry

basis with the buildup method, adjusting for inflation, company

size, and the fact that a film library of completed film titles

does not have the same business risk as the full range of

business activities of companies engaged in film production and

distribution.

     Under scenario 1, Mr. Medress concluded that the fair market

value of the 65 EBD film titles, as of December 11, 1996, was

$1.6 million (rounded).    Under scenario 2, Mr. Medress determined

that the fair market value of the EBD film titles, as of December

11, 1996, was $1.5 million (rounded).

                  v.    Market Approach

     Mr. Medress did not use a market approach in valuing the EBD

film library.   Nonetheless, as a reality check on his

conclusions, he compared the average value per title from his

analysis ($24,219) with the average price per title from the sale

of the LIVE Entertainment film library ($68,000), which occurred

approximately 4 months after December 11, 1996.   Mr. Medress


     142
        Mr. Medress amortized the projected purchase price for
the EBD film titles on a pro rata basis according to the
projected gross receipts from the film titles.
                                -192-

opined that the $68,000-price per title represents:   “an amount

that investors were willing to pay for a library that included

many titles that were significantly stronger than the titles in

the SMHC Film Library.”   In considering the lesser quality of the

EBD film titles, Mr. Medress concluded that his estimate of

$24,219 per title for the EBD film rights appeared reasonable.

             c.   Court’s Analysis

                  i.   Reconciliation of Expert Opinions

     Both experts used an income approach, a discounted cashflow

analysis, in valuing the EBD film rights.   In their discounted

cashflow analyses, both experts made sales projections based on

the number of VHS units shipped in the rental or sell-through

market.   In valuing the EBD film rights, both experts relied on

information from AMR and the IMDb database.   Both experts assumed

that SMHC had no responsibility for residual payments to guilds,

participations to talent, or shares to producers.

     Neither expert relied on projections for sales in the DVD

format.   Neither expert relied on the revenue-sharing pricing

model (Rentrak) for the rental market that evolved after 1996.

Neither expert considered direct sales of videos via the

Internet.   Neither expert assigned any value to the 26

development projects or the sequel rights to any of the EBD film

titles.
                                -193-

     Mr. Wagner and Mr. Medress are reasonably close in their

estimated return rates (7.5 percent vs. 5 percent, respectively)

for distributed units in the rental market.   Mr. Wagner does not

question Mr. Medress’ estimated 20-percent return rate for

distributed units in the sell-through market.    The experts do not

question each other’s weighted average cost of capital, discount

rate, or tax rate figures.   The experts are also in basic

agreement as to manufacturing, packaging, and shipping costs

($2.50 per unit to $2.75 per unit); however, they disagree on

marketing costs and whether, and to what extent, overhead expense

should be considered.   In making his income projections, Mr.

Medress considered the sexual and shock exploitation nature of

some of the EBD film titles; Mr. Wagner did not.   The experts

express general disagreement regarding their respective

methodologies and what assumptions should be considered in

projecting an income stream for the EBD film titles.

                 ii.    Exclusion of Certain Film Titles

     Both experts present alternative valuations that exclude

certain film titles from the EBD film library.   With respect to

some film titles, their exclusions overlap.

     Relying on the records that Troy & Gould obtained, Mr.

Wagner determined that the following 13 film titles in the EBD

film library did not have confirmed physical materials:    “Alley

Cat”, “Bombay Talkie”, “Cardiac Arrest”, “Courtesans of Bombay”,
                                     -194-

“Escape from Venice”, “Equinox”, “Mother & Daughter: Loving War”,

“Nasty Hero”, “Outlaw Force”, “Sticks and Stones”, “Throne of

Vengeance”, “War Cat”, and “Zombie”.143       On the record before us,

we believe that the absence of physical materials for these film

titles is a fact that was reasonably discoverable on December 11,

1996.         We also believe that the hypothetical willing buyer would

not have paid for rights to film titles that did not have

confirmed physical materials.        Consequently, our valuation of the

EBD film library does not account for the 13 film titles that Mr.

Wagner identified as not having confirmed physical materials.

     In making his scenario 2 projections, Mr. Medress excluded 9

film titles, including:        “Bombay Talkie”, “Courtesans of Bombay”,

“Danger Zone”, “Hullabaloo Over Georgia”, “Hunter’s Blood”,

“Mother & Daughter: Loving War”, “Octavia”, “Shakespeare Wallah”,

and “Sticks and Stones”.144       An internal memorandum that Troy &

Gould prepared during its due diligence confirms that the

distribution rights to those film titles were set to expire


        143
        Mr. Wagner made no sales projections for the film titles
“Escape from Venice” and “Equinox”, because those film titles
were not included in the IMDb database. In addition, Mr. Medress
treated the film titles “Return of the Conqueror” and “Throne of
Vengeance” as the same film in making his scenario 2 projections.
From other information that Mr. Medress submitted, it also
appears that the film titles “Equinox” and “The Beast” may be the
same film.
        144
        We have already excluded the film titles “Bombay Talkie”,
“Courtesans of Bombay”, “Mother & Daughter: Loving War”, and
“Sticks and Stones” because of the absence of confirmed physical
materials for those film titles.
                               -195-

before or shortly after December 11, 1996.    The Troy & Gould

memorandum indicates that the distribution rights to the film

title “Danger Zone” were set to expire on or about January 26,

1997; that the distribution rights to the film titles “Bombay

Talkie”, “Courtesans of Bombay”, “Hullabaloo over Georgia”, and

“Shakespeare Wallah” were set to expire on or before October 24,

1996; that the distribution rights to the film title “Hunter’s

Blood” were set to expire on or about June 3, 1997; that the

distribution rights to the film title “Mother & Daughter: Loving

War” were set to expire no later than March 31, 1997; that the

distribution rights to the film title “Octavia” were set to

expire on or about March 7, 1996; and that the distribution

rights to the film title “Sticks and Stones” were set to expire

on or about January 12, 1995.145   In the Court’s view, a

hypothetical willing buyer would not pay for rights that were

expired or expiring.   Since this information was reasonably

discoverable as of December 11, 1996, we exclude the film titles

that Mr. Medress identified from our valuation of the EBD film

library.146


     145
        This information from Troy & Gould is consistent with
John Peters’s testimony that, on the instructions of CDR or EBD,
he selected film titles with rights that were expired or
expiring.
     146
        Petitioner contends that even if the rights to some of
the EBD film titles “expired within two years after the
transaction, there would still be some value to those rights on
                                                   (continued...)
                                 -196-

                   iii.   Analysis of Expert Opinions

     In projecting gross units shipped for the EBD film titles,

Mr. Medress selected arbitrary figures:    In the rental market,

500 units for each film title; and in the sell-through market,

5,000 units for “Group 1” film titles and 100 units for “Group 2”

film titles.    Mr. Medress indicates that he relied on his

industry experience in arriving at these figures; however, he

does not specifically explain how he derived the figures on that

basis.     Mr. Medress also indicates that he incorporated into his

projections certain assumptions relating to the previous

distribution history and certain characteristics (such as age and

content) of the EBD film titles; he fails to explain, however,

precisely how these assumptions influenced or justified his

projections.

     Moreover, Mr. Medress does not indicate which film titles he

considered for distribution in the rental and the sell-through

markets, and which film titles are in “Group 1” and “Group 2.”

He does not explain the method that he used to divide the film

titles into groups or what accounts for the vast difference in



     146
       (...continued)
the transaction date.” Petitioner provides no evidentiary basis
for his contention, which appears to rest on speculation. We are
not persuaded by petitioner’s contention. It is reasonable to
assume that a hypothetical buyer would not pay any significant
amount for rights that were subject to such an attenuated
distribution period, especially with film titles that were
admittedly older “B” film titles.
                              -197-

units shipped between “Group 1” and “Group 2” film titles (5,000

units vs. 100 units, respectively).   Mr. Wagner, on the other

hand, made his income projections by comparing data from AMR,

using IMDb database star ratings and genre categorizations.

     Although Mr. Wagner relied on objective data to reach his

conclusions, his valuation fails to consider certain factors that

we find relevant to the valuation of the EBD film titles.    First,

in making his projections, Mr. Wagner assumed that none of the

EBD film titles had been previously distributed.147   Mr. Medress,

on the other hand, assumed that most of the EBD film titles had

been released in video in the United States before 1996.    In

making these assumptions, both experts researched existing

databases of film distribution information and other sources.

Mr. Wagner found no record of previous unit sales for the EBD

film titles in the rental market but admits that “it is not

possible to precisely ascertain whether the titles are in the


     147
        In his rebuttal report, Mr. Wagner claims that he treated
the EBD film titles as if they were near the middle of their
lifespan; i.e., factoring in some level of previous distribution.
Nonetheless, in making his income projections, Mr. Wagner relied
on AMR data, which provides information only for initial release
shipments and seemingly does not factor in any previous
distribution of AMR film titles. Mr. Wagner suggests that he
factored in the age of the EBD film titles by relying on the
median, rather than the higher mean, gross units shipped that he
gleaned from the AMR data. We are not convinced that Mr.
Wagner’s use of the median gross units shipped data somehow
compensates for the age of the EBD film titles. Indeed, Mr.
Wagner points out that the mean figures were higher because a few
of the AMR film titles did well, driving the mean beyond the
median.
                               -198-

early or late portion of their lifespan.”    Mr. Medress found

incomplete and unsatisfactory information regarding the

distribution history of the EBD film titles in both the rental

and sell-through markets.   Mr. Medress determined, however, that

most of the EBD film titles were previously distributed, relying

on a number of different sources.

     Mr. Medress relied on a letter from Michael Herz, on behalf

of Troma, to Troy & Gould which identified previous distributors

of 37 EBD film titles.   These film titles included:   “Alley Cat”,

“Astro Zombies”, “Avenger”, “The Beast”, “Bombay Talkie”,

“Cardiac Arrest”, “Courtesans of Bombay”, “Danger Zone”, “Escape

from Hell”, “Fear”, “Firefight”, “Fist of Fear, Touch of Death”,

“Headless Eyes”, “House of Terror”, “Hullabaloo Over Georgia”,

“Hunter’s Blood”, “Invisible Dead”, “Mother & Daughter: Loving

War”, “Nasty Hero”, “Ninja Hunt”, “Ninja Showdown”, “Ninja

Squad”, “Oasis of Zombies”, “Octavia”, “Outlaw Force”, “Platypus

Cove”, “Plutonium Baby”, “Shakespeare Wallah”, “Sidewinder One”,

“Summer Camp Nightmare”, “Terror on Alcatraz”, “This Time I’ll

Make You Rich”, “Tiger of the Seven Seas”, “To Love Again”, “The

Visitants”, “White Ghost”, and “Zombie”.    Mr. Medress also

searched the IMDb Pro database and found that the following film

titles had also been previously distributed:    “Banana Monster”,

“Battle of the Last Panzer”, “Blood Brothers”, “Crimson”,

“Demoniac”, “Duel of Champions”, “Equinox”, and “Return of the
                                -199-

Zombies”.148   Finally, Mr. Medress purchased 47 used video tapes

of EBD film titles; the packaging materials indicated that those

film titles were distributed prior to 1996.      The film titles

included:

Alley Cat                               Mother & Daughter: Loving War
Astro Zombies                           Nasty Hero
Avenger                                 Ninja Hunt
Banana Monster                          Ninja Showdown
Battle of the Last Panzer               Ninja Squad
Battle of the Valiant                   Oasis of Zombies
Bombay Talkie                           Octavia
Cardiac Arrest                          Outlaw Force
Courtesans of Bombay                    Platypus Cove
Crimson                                 Plutonium Baby
Danger Zone                             Return of the Zombies
Demoniac                                Shakespeare Wallah
The Beast                               Sidewinder One
Erotikill                               SS Experimental Love Camp
Escape from Hell                        Summer Camp Nightmare
Fear                                    Terror on Alcatraz
Firefight                               This Time I’ll Make You Rich
Fist of Fear, Touch of Death            To Love Again
Fraulein Devil                          Tormentor
Headless Eyes                           The Visitants
House of Terror                         War Cat
Hullabaloo over Georgia                 White Ghost
Hunter’s Blood                          Zombie
Invisible Dead

     Insofar as any of the EBD film titles were previously

released to the rental market, we believe that this would have a

significant effect on demand for those film titles and also would


     148
        Mr. Medress obtained point-of-sales data from Nielsen
VideoScan for 11 of the EBD film titles; however, his agreement
with that company precludes him from revealing the film titles.
Mr. Medress also reviewed the Video Source Book editions for
1985, 1987, 1989, 1992, and 1996, which indicated that 60 of the
EBD film titles were listed as available in 1992 or earlier.
Mr. Medress indicates that the Video Source Book is consistent
with the information he obtained from other sources.
                               -200-

tend to influence their distribution to the sell-through market

at lower price points as opposed to the rental market with its

higher price points.   For this reason, Mr. Wagner’s expert report

grossly overstates the income projections for the EBD film

titles.

     We were also troubled by Mr. Wagner’s assumptions that 80

percent of the projected revenues from the EBD film library would

be generated in the film title’s first year of release and 20

percent would be generated in the second year of release.    Mr.

Wagner’s assumptions effectively frontload his unit projections

into the first 2 years of distribution.   In combination with his

3-year release pattern, these assumptions have the effect of

projecting all cashflows for the EBD film library into a 4-year

period (1997, 1998, 1999, and 2000).   Since we are not persuaded

that the hypothetical willing buyer of the EBD film library would

distribute all the EBD film titles in so short a period, we are

led to conclude that Mr. Wagner’s revenue assumptions overstate

the present values of projected cashflows from the EBD film

library.

     Mr. Wagner assumed a median $59 wholesale price for the

rental market, whereas Mr. Medress used a $45 wholesale price at

the lower end of the spectrum of wholesale prices.   Given the age

and nature of the EBD film rights, Mr. Medress’ lower wholesale

price is more reasonable.
                                  -201-

     Mr. Wagner determined that the film titles in the EBD film

library were produced “several” years before the valuation date.

Specifically, three of the film titles were produced in the

1950s, 12 in the 1960s, 25 in the 1970s, 24 in the 1980s, and 1

in the 1990s:

Alley Cat                      1982   Invisible Dead                  1971
Astro Zombies                  1967   Jungle Master                   1972
Auditions                      1995   Mother & Daughter: Loving War   1980
Avenger                        1961   Nasty Hero                      1987
Banana Monster                 1971   Ninja Hunt                      1987
Battle of the Last Panzer      1969   Ninja Showdown                  1987
Battle of the Valiant          1963   Ninja Squad                     1987
Beast, The                     1971   Oasis of Zombies                1983
Blood Brothers                 1974   Octavia                         1984
Blood Castle                   1971   Outlaw Force                    1987
Bombay Talkie                  1970   Platypus Cove                   1986
Cardiac Arrest                 1980   Plutonium Baby                  1987
Carthage in Flames             1959   Return of the Conqueror         1964
Cold Steel for Tortuga         1965   Return of the Zombies           1973
Conqueror and the Empress      1964   Shakespeare Wallah              1965
Courtesans of Bombay           1985   Sidewinder One                  1977
Crimson                        1973   SS Camp 5                       1976
Danger Zone                    1951   SS Experimental Love Camp       1976
Demoniac                       1974   Sticks and Stones               1970
Duel of Champions              1961   Summer Camp Nightmare           1987
Equinox                        1971   Terror on Alcatraz              1986
Erotkill                       1973   The Sword & The Cross           1958
Escape from Hell               1979   The Visitants                   1988
Escape from Venice             1979   This Time I’ll Make You Rich    1975
Fear                           1988   Throne of Vengeance             1964
Firefight                      1987   Tiger of the Seven Seas         1963
Fist of Fear, Touch of Death   1981   To Love Again                   1980
Fraulein Devil                 1977   Tormentor[s], The               1971
Headless Eyes                  1971   War Cat                         1987
House of Terror                1972   White Ghost                     1986
Hullabaloo over Georgia        1978   White Slave                     1986
Hunter’s Blood                 1987   Zombie                          1979
Invincible Gladiators          1964

It is clear from these production dates and Mr. Wagner’s

observations that the EBD film library represented a library of

older film titles.     Both experts agree that older film titles,

except perhaps for classics, would be less in demand than recent

productions.
                               -202-

     In making his income projections, Mr. Wagner considered the

age of the EBD film titles in choosing between the higher mean

and lower median gross units shipped from the AMR data:

“Typically, this step in the process would have been performed

using the mean.   However, the SMH titles were older; and

therefore; the number of gross shipments was determined to be

lower than the mean indication from the AMR data.”   On this

basis, Mr. Wagner used the median gross units shipped and median

wholesale prices per unit that the AMR data suggested.

Nonetheless, it appears that most, if not all, of the 270 film

titles in the AMR data were recently produced.   For this reason,

we are not persuaded that choosing the median over the mean gross

units shipped and wholesale prices per unit from the AMR data

properly accounts for the age of the EBD film titles.    Instead,

the age of the EBD film titles suggests that the gross units

shipped and wholesale prices per unit for those film titles would

be at the lower end of the spectrum of the AMR data.    Insofar as

Mr. Wagner relies on the median data, he has overstated his

projections.

     Although Mr. Wagner did not assume any theatrical releases

(e.g., releases to movie theaters) in his expert report, in his

rebuttal report he points to certain data indicating that 16 of

the EBD film titles were theatrically released in the U.S.

domestic market and 22 of the film titles were theatrically
                                 -203-

released in the international market.149   Mr. Wagner did not

incorporate this data into his valuation analysis; however, he

posits that these theatrical releases would enhance his valuation

of the EBD film titles because of increased consumer awareness.

After examining the additional data that Mr. Wagner presented, we

cannot agree.

     Mr. Wagner’s data indicates that all but one of the domestic

theatrical releases occurred between 1951 and 1980.    The only

exception is “Summer Camp Nightmare,” which had an April 1987

release date.   Likewise, most of the international theatrical

releases occurred between 1960 and 1979.    Two films were released

in 1983, two in 1985, and one (“Nasty Hero,” which has no

confirmed physical materials) in 1992 .    Given the significant

time period between these supposed theatrical releases and 1996,

we are not convinced that the film titles would have benefited

from a theatrical release.    Moreover, we are not convinced that

the international theatrical release of admittedly “B” film

titles would translate into increased consumer demand in the U.S.

domestic market.

                   iv.   Conclusion

     In general, we found both expert opinions unsatisfactory.

On the one hand, Mr. Medress’ methodology contains considerable


     149
        Mr. Wagner found data for two other theatrical releases
but could not determine whether those film titles were released
to the domestic or international market.
                                -204-

gaps; for instance, he fails to explain certain important

assumptions and conclusions.   Mr. Medress’ methodology appears

highly subjective.   On the other hand, Mr. Wagner’s methodology

offers an objective basis for estimating the initial gross units

shipped for the EBD film titles; however, his income projections

are highly overstated.    Importantly, Mr. Wagner did not account

for any previous distribution of the EBD film titles.

     Despite our misgivings about Mr. Medress’ methodology, we

are persuaded that his income projections for the EBD film titles

are more realistic than Mr. Wagner’s highly overstated

projections.    If we were relying solely on the expert opinions,

we would conclude that the EBD film rights had a value as of

December 11, 1996, which did not exceed the value Mr. Medress

determined in his scenario 2; i.e., $1.5 million.      Nonetheless,

we find that certain additional factors, which the experts did

not consider, indicate a much lower value.

     In making their respective valuations, both experts were

hampered by the lack, or inconsistency, of information relating

to the EBD film titles.   Neither expert inspected the physical

materials for the EBD film titles.      Neither expert considered

whether the existing physical materials were capable of

reproduction.   Neither expert considered the impact of chain-of-

title and copyright issues relating to the EBD film titles.      The

record demonstrates, however, that there were significant gaps in
                                 -205-

the chain-of-title for most, if not all, of the EBD film titles.

Even a cursory review of available information as of December 11,

1996, would have demonstrated these gaps.    Moreover, CLIS’s

contribution of the film rights to SMHC and the transfers leading

up to that contribution do not establish specifically what rights

SMHC obtained in the EBD film titles.    In the Court’s view, a

hypothetical willing buyer either would have demanded some

reasonable assurance of SMHC’s rights in the EBD film titles or

would have required a substantial discount to account for the

gaps in the chain-of-title and possible liabilities for illegal

distribution.150

     At trial, John Peters of Epic Productions testified

regarding the nature and the condition of the EBD film titles

that CLIS contributed to SMHC.    Mr. Peters was charged with

selecting the EBD film titles for CLIS’s contribution to SMHC; he

was instructed to select film titles that would not affect the

overall value of the CDR library.    He selected films that had

very little value, films with distribution rights that were set


     150
        Bahman Naraghi, who has considerable experience in the
filmed entertainment business, testified that a company’s rights
in its motion pictures play a critical part in the filmed
entertainment business, because “That’s what is valued.” He
testified that chain-of-title confirms the validity of those
rights and provides the basis for proper copyright filing and
protection of copyrights. He testified that copyrights secure
the fundamental rights on any given film title in the form of
intellectual property in all jurisdictions of the world that
observe copyright laws and, therefore, guarantee the right to
receive income derived from the exploitation of film rights.
                                -206-

to expire, and low-budget exploitation-genre films.   Mr. Peters

selected only the “U.S. Video Film Rights” for the EBD film

titles.    Mr. Peters testified that many of the physical materials

for the EBD film titles were stored at the Epic warehouse, a

facility that was not secured and was not temperature- or

humidity-controlled.   Mr. Peters’s testimony and his unique

knowledge of the nature and condition of the EBD film titles

seriously undermine petitioner’s position that the EBD film

titles had a value in the range of $6.9 to $9 million.

     The veracity of Mr. Peters’s testimony is confirmed by

SMHC’s treatment of the EBD film titles following their

contribution.   SMHC, as the purported owner of the EBD film

rights, did not regard those film rights as having any value.

Indeed, following CLIS’s contribution of the EBD film library to

SMHC, SMHC reported on its draft financial statements for the

period ended December 10, 1996, that the value of the EBD film

library was not material to its financial statements.151   In a


     151
        Petitioner contends that SMHC’s financial statements are
not relevant to the valuation of the EBD film rights, because the
financial statements were completed after Dec. 11, 1996. SMHC’s
financial statements correspond to the period ended Dec. 10,
1996, and presumably reflect SMHC’s treatment of the EBD film
rights during that time period. Although the financial
statements were completed after Dec. 10, 1996, financial
statements are invariably completed after the financial period to
which they relate. Petitioner points to no event that changed
the value of the film rights between Dec. 10, 1996, and the date
the financial statements were completed. We find that SMHC’s
treatment of the EBD film library on its financial statements is
                                                   (continued...)
                                -207-

document entitled:    “Accounting in Santa Monica Holdings Book”,

dated June 1, 1997, Bruno Hurstel of CDR reiterated that CLIS’s

contribution of the EBD film library to SMHC on December 10,

1996, was “without amount”.    Also, consistent with its accounting

of the contribution, SMHC did not list the EBD film rights as an

asset of value on its corporate tax return for the period October

9 to December 31, 1996.152

     These additional factors indicate that the EBD film rights

had very little, if any, value and were in an unsatisfactory

condition when they were transferred from CLIS to SMHC.    In light

of the expert opinions and these additional factors, we conclude

that the EBD film rights had no material or consequential value

as of December 11, 1996.

     Petitioner claims that the EBD film rights still have

considerable value.    The record does not bear out this claim.

The Ackerman group and Troma have realized little or nothing on

the EBD film rights.    SMP and SMHC distributed none of the EBD


     151
       (...continued)
a relevant consideration in determining the value of the EBD film
library as of Dec. 11, 1996.
     152
        In fact, in 1997, Mr. Lerner was willing to sell a 25-
percent interest in SMP to Imperial for $5 million. Mr. Lerner
represented to Imperial that SMP had “assets totaling $49 million
(with zero liabilities) including: $29 million in film library
assets (appraised value) and $20 million in cash[.] ICII’s 25%
share of the assets would equal approximately $12.25 million, a
multiple of the proposed investment”. The $5 million sale price,
however, effectively represented 25 percent of the $20 million
cash asset with no value assigned to the film assets.
                                   -208-

film titles.      Troma distributed 6 of the film titles but with

very little success.      For example, Troma began distributing

“Battle of the Last Panzer” on May 25, 1999, and had $2,034.71 in

total VHS sales through 2000 and $182.97 during 2001.         Troma

began distributing “Escape from Hell” on May 25, 1999, and had

$6,496.64 in total VHS sales through 2000 and $3,867.24 during

2001.      It had $10,726.90 in total DVD sales during 2000 and

$2,529.23 during 2001.153     Troma began distributing “Plutonium

Baby” on October 24, 2000, and had $767.98 in VHS sales through

2000 and $66.48 during 2001.      Realization of these amounts would

hardly justify the distribution expenses that Troma likely

incurred.154

             4.   Carolco Securities

     The parties dispute whether the Carolco securities had any

value as of December 11, 1996.         Petitioner contends that as of

December 11, 1996, the Carolco securities had some indeterminable

value, perhaps as high as $10 million.         Respondent contends that




     153
        From these figures, it appears that the EBD film titles
had higher sales figures when they were distributed in DVD
format. Although DVD format was foreseeable in 1996, its
potential was still virtually unknown. For that reason, none of
the experts in these cases relied upon DVD sales in valuing the
EBD film library.
     154
        On Nov. 4, 1996, Troma sent an invoice to Crown Capital
requesting $103,025 for the release of video and DVD for “Banana
Monster”, “Fist of Fear, Touch of Death”, “Astro Zombies”,
“Battle of Last Panzer”, and “Escape from Hell”.
                                -209-

the Carolco securities had no value.    As explained below, we

agree with respondent.

     By November 1995, Carolco faced serious financial

problems.155   Once a powerhouse in motion picture production, in

1995 and 1996 Carolco was insolvent and unable to continue movie

production.    Its 1993 financial restructuring had proven

unsuccessful, and Carolco decided to sell its film library,

certain projects, and its movie studio.    In the fall of 1995,

Carolco accepted a $47.5 million offer from Twentieth Century

Fox, foreclosing any possibility of Carolco’s continuing as a

going concern.    On November 10, 1995, Carolco filed a chapter 11

bankruptcy petition.156

     Prior to December 11, 1996, the Debtors’ and Creditors’

Committee had filed its first and second plans of




     155
        For example, Carolco’s consolidated balance sheets for
1993 and 1994, show that liabilities exceeded assets, thereby
indicating negative net worth. These balance sheets also show
that the total stockholders’ deficiency (negative net worth)
increased from $21.07 million in 1993 to $64,521,000 million in
1994. Carolco’s consolidated statements of operations for 1993
and 1994, show net losses of $63,958,000 million in 1993 and
$43,451,000 million in 1994. Carolco’s consolidated statements
of cashflows for 1993 and 1994, show that net operating cashflow
was negative $6,322,000 for 1993 and negative $47,113,000 for
1994.
     156
        In the bankruptcy proceedings, Canal+ made a $58 million
offer for Carolco’s assets, which the bankruptcy court
subsequently approved on Mar. 21, 1996.
                                 -210-

reorganization.157   Under each of those plans, the holders of

Carolco subordinated notes were in class 10 and the holders of

Carolco preferred stock were in class 12.     In the planned

liquidation of Carolco, holders of class 10 and 12 assets were to

receive nothing.     According to the second plan of reorganization,

the liquidation of Carolco commenced with the sale of the Carolco

film library and continued with the sale of certain projects,

Carolco’s studio, and other assets.      As a result of the sale of

these items, Carolco would hold approximately $60 million cash,

which was the largest asset in the bankruptcy proceeding.      Other

than this cash asset, the only remaining assets of significant

value were certain projects and litigation claims.     A disclosure

statement accompanying the second plan of reorganization dated

December 3, 1996, presented three scenarios showing a range of

possible outcomes from the Carolco liquidation.     Carolco

estimated that under any of the three scenarios, class 9 through

13 creditors, including holders of the Carolco securities, would

receive nothing from the bankruptcy.     Considering the information

available as of December 11, 1996, it was highly unlikely that

SMHC would recover anything on the Carolco securities.     Clearly,

the plans of reorganization and the disclosure statement (which




     157
        The first plan of reorganization was filed on Sept. 13,
1996, and the second plan of reorganization was filed on Dec. 3,
1996.
                                 -211-

projected a “best case” scenario for the Carolco liquidation)

showed no recovery at all to the holders of Carolco securities.

     On SMHC’s draft financial statements for the period ended

December 10, 1996, it reported a charge of $60,075,000, which was

the entire carrying value of the Carolco securities, and

indicated that the purpose for this charge was to write down the

Carolco securities to net realizable value due to the bankruptcy

of Carolco.158    In a June 1, 1997, accounting of SMHC’s book

accounts, Mr. Hurstel reiterated that there was a contribution by

MGM Holdings of the Carolco securities to the capital of SMHC;

however, this contribution was accounted for on SMHC’s books as

“without amount”.     Similarly, on SMHC’s corporate income tax

return for the taxable period October 9 to December 31, 1996, the

Carolco securities were not listed as assets on Schedule L,

Balance Sheets, as of December 31, 1996.159    SMHC’s reporting


     158
           The draft financial statements state:

     The aggregate carrying value of these securities on the
     date contributed was $60,075,000. As Carolco is
     currently in bankruptcy proceedings, the Company has
     recorded a charge of $60,075,000 in these consolidated
     financial statements reflecting the write-down of these
     securities to net realizable value.
     159
        After CDR ceded control of SMHC’s tax return filing
obligations and after the bankruptcy court had confirmed the
fourth amended plan of reorganization, Mr. Lerner commenced
reporting the Carolco securities as assets with value on SMHC’s
corporate tax returns. For example, on SMHC’s corporate income
tax return for the year ended Dec. 31, 1997, the Carolco
securities were shown as an asset in the ending balance column of
                                                   (continued...)
                               -212-

position confirms our understanding of the value of the Carolco

securities on December 11, 1996.

     Petitioner nonetheless claims that there was some chance of

recovery on that date, and that the Carolco securities had value.

Petitioner first contends that the holders of the Carolco

securities had the right to object to confirmation of the plan of

reorganization on any grounds that might cause it not to be

confirmed.   See 11 U.S.C. sec. 1128(b) (2000) (a party in

interest may object to confirmation of a plan of reorganization).

According to petitioner, “An objection could be made on ‘any

ground,’ and it is possible that a creditor or interest holder

could negotiate a better return or distribution from the plan in

return for dropping its objection, even if it were a nuisance

settlement.”   Petitioner’s assertions appear to be nothing more

than speculation.   We cannot agree that SMHC’s right to object to

any plan of reorganization necessarily equates with some element

of “real value” in the Carolco securities.

     Petitioner also points to a report from Harch Capital

Management, Inc. (Harch Capital), dated December 3, 1996, which

concluded that the Carolco subordinated notes could have a value

between $4 million and $6 million, and the Carolco preferred



     159
       (...continued)
Schedule L. On SMHC’s corporate income tax return for the year
ended Dec. 31, 1998, the Carolco securities are shown in both the
beginning and ending balance columns of Schedule L.
                               -213-

stock could have a value between $3 million and $5 million.    We

place little reliance on that report.   In the first instance, the

Harch Capital report was not offered into evidence for the truth

of the matters asserted therein.    The Harch Capital report is a

4-paragraph, 1-page document, which contains no analysis or

explanation regarding the valuation figures.   Harch Capital

states:   “we are aware that Carolco is in bankruptcy and that

claims have been made with respect to the instruments in

question”, but otherwise suggests that it did not factor into its

“valuation”, any of the plans of reorganization that were filed

in the bankruptcy court.   In fact, the date of the report is the

same date that the second plan of reorganization and its attached

disclosure statement were filed with the bankruptcy court.

     Petitioner also relies on the fact that shares of Carolco

stock were trading in the market on December 11, 1996, and have

continued to trade until the trial date.   According to a rebuttal

report that Mr. Wagner submitted, 61,000 shares of Carolco stock

were traded on December 11, 1996.   That report reveals, however,

that Carolco stock was trading at $0.002 per share on that date.

In considering this trading, Mr. Wagner opined that the value of

the Carolco securities was “greater than zero.”   Mr. Wagner makes

no effort to place any more precise value on the Carolco

securities, and he fails to explain how this market trading

equates with any possible recovery by SMHC on those securities.
                                -214-

     Petitioner points to the negotiations between CDR and the

Ackerman group, in which CDR sought to retain whatever value

might be realized in the Carolco securities.    Petitioner contends

that these negotiations indicate that the Carolco securities had

some value.    It is unclear from the record, however, precisely

what CDR’s intentions were with respect to the Carolco

securities.    Clearly, at the time these negotiations were

ongoing, it was highly unlikely that the banks (through SMHC)

would recover anything on the Carolco securities.    Any recovery

at that time would have been highly speculative and contingent on

events that were not foreseeable.    Even if we were to assume that

CDR’s interest indicates some value in the Carolco securities, we

have no clear indication of what that value might be.

     Finally, any value that might have been realized on the

Carolco securities would not go to the Ackerman group.    Indeed,

Mr. Lerner testified that the Ackerman group evaluated the

Carolco securities, but they were concerned only with the

potential negative aspects of those securities; i.e.,

liabilities.    He testified that the Ackerman group had very

little control over the Carolco securities since Carolco was “in

bankruptcy proceedings, number one, and, number two, the ultimate

value would accrue to the benefit of Credit Lyonnais, which was

fine with us.”    Mr. Lerner testified that because of the various

ways in which CDR laced any realizable value in the Carolco
                                  -215-

securities to Generale Bank’s and CLIS’s preferred interests, it

was unlikely that any value from the Carolco securities would go

to SMP or the Ackerman group.

            5.   Net Operating Losses

     The parties agree that the unused NOLs in SMHC might have

had some potential, but speculative, value to an acquirer of that

company; however, we have no reasonable basis upon which to

determine what that value, if any, might be.160    Any value that

might exist in the NOLs was highly dependent on the acquirer’s

meeting the requirements of section 382, which limits the amount

of taxable income that might be offset by NOLs in the case of an

“ownership change”.      Moreover, even if these requirements had

been met and the NOLs had been preserved, SMHC would have had to

have generated sufficient taxable income against which to use the

NOLs.      As of December 11, 1996, without additional

capitalization, this prospect was, for the most part,

unrealistic.




     160
        Petitioner submitted the expert report and testimony of
Todd Crawford of Deloitte & Touche. Mr. Crawford opined that the
NOLs might have had a value in the range of $620,000 to
$1,245,000, after applying a 98- to 99-percent risk-related
discount. Mr. Crawford admitted at trial that his valuation was
subjective and speculative. For the reasons discussed infra, we
conclude that Mr. Crawford’s analysis is unreliable and not
admissible into evidence.
                                -216-

           6.   Conclusion

     We conclude that SMHC’s assets (the EBD film library, the

Carolco securities, and the unused NOLs) had no significant value

as of the date the banks made their “contributions” of SMHC

receivables and stock to SMP.161   Consequently, without an

infusion of new capital, SMHC had no realistic income-generating

capacity to create value in the SMHC receivables and stock.

Given the absence of appreciable value in the contributed

properties and the banks’ intentions of exiting the partnership,

we are not convinced that the Ackerman group entered into the

transaction with any realistic expectation of realizing any

economic return on the approximately $10 million that they had

paid the banks as an inducement to enter the transaction.

Instead, the Ackerman group incurred this $10 million “cost” not

as part of a real-world economic investment but in the hopes of

reaping enormous tax benefits and fees from the banks’ built-in

losses.    Consequently, the economic realities lead us to conclude

that this $10 million amount was paid, not as an inducement for

entering into the partnership but for the $1.7 billion in tax

attributes that the Ackerman group acquired in the transaction.




     161
        SMHC’s draft consolidated balance sheets for the period
ended Dec. 10, 1996, showed SMHC’s only assets to consist of
property and equipment in the amount of $69,000. Similarly,
SMHC’s tax return for the period ended Dec. 31, 1996, showed that
its assets then totaled $69,113.
                                  -217-

     F.    Other Considerations

           1.   SMP’s Other Film-Related Activities

     After the CDR transaction, SMP acquired the “City Lights”

library, the “Wisdom” library, the “Moving Picture” library, the

“Five Stones” library, and the “Vista Street” library.

Petitioner suggests these acquisitions should have some bearing

upon our evaluation of the CDR transaction.    We disagree.   There

is no evidence to suggest that these acquisitions were

contemplated at the time of the CDR transaction; these

acquisitions are entirely unrelated to any supposed film venture

with the banks.    In any event, the acquisitions are relatively

insignificant when compared to the enormous tax losses that the

Ackerman group claims to have reaped from the CDR transaction and

the $14,595,652 fee that Imperial paid SMP for its share of tax

losses on the Corona transaction.162

     Petitioner also points to a number of discussions that he

had in 1997, 1998, and 1999, which related to certain film-

related transactions and activities.163   According to Mr. Lerner,


     162
        The film libraries consisted of 85 film titles, for which
the Ackerman group paid a total of $1.1 million.
     163
        The discussions involved: (1) A possible distribution
deal between SMHC and Orion in 1997; (2) a possible sale by the
Jones Entertainment Group in 1997 of the rights to 5 film titles;
(3) negotiations in 1997 with CitiCorp Ventures, which was
interested in acquiring a film library for use in its chain of
theaters; (4) a possible distribution relationship with UnaPix
Entertainment in 1997; (5) negotiations with Comcast Corp.,
                                                   (continued...)
                               -218-

however, none of these transactions actually resulted in a

transaction between SMP, SMHC, and the other companies.   Further,

although petitioner submitted various exhibits indicating his

contacts with the various parties, we have no basis from which to

evaluate the content or the scope of the alleged discussions and

negotiations.   At best, the Ackerman group’s various attempts to

engage in film activities through SMP might be relevant in

determining whether SMP was a bona fide partnership for Federal

tax purposes; however, respondent does not dispute that SMP is a

bona fide partnership.   These film-related activities are

unrelated to the CDR transaction and do not persuade us that the

banks intended to enter a film distribution business with the

Ackerman group, as petitioner claims.



     163
       (...continued)
regarding the distribution of SMHC’s films in connection with its
cable business; (6) a possible acquisition of the Crossroads film
library in 1997; (7) negotiations with Atlas Entertainment in
1997 and 1998 regarding the development of a production capacity
inside of SMHC; (8) a business proposal to establish an African-
American film distribution company with C. O’Neill Brown in 1998;
(9) a possible transaction with Reisher Entertainment in 1998;
(10) a possible acquisition of the feature film library of the
Modern Times Group in 1998; (11) negotiations with Frank Klein,
who was president of PEC Israeli Economic Corp. in 1998; (12)
negotiations regarding the sale of Polygram Filmed Entertainment
in 1998; (13) a possible merger of SMHC with, or acquisition by,
Artisan Entertainment in 1998; (14) a possible business venture
with Regent Entertainment, Inc. in 1998; (15) negotiations for
the purchase of film titles from Silver Screen International and
Aries Entertainment, Inc., in 1999; and (16) a possible film deal
involving Broadcast.com. in 1999. Petitioner also points to
discussions with Alan Cole Ford, formerly of MGM, regarding his
acquisition of Paul Kagan Associates.
                                 -219-

           2.   Relationship Between the Parties

     We are not persuaded that Mr. Jouannet’s interests, and

those of CDR, were necessarily adverse to the interests of the

Ackerman group and SMP, at least insofar as the tax

characterization of the transaction was concerned.     As previously

discussed, Mr. Jouannet’s job was to realize whatever value he

could in the Credit Lyonnais group’s “bad” investments and loans,

as quickly as possible.    Whatever value might be realized from

these “bad” investments and loans depended in large part on

structuring a deal whereby the potential buyer could exploit the

associated tax attributes.    At least to this degree, Mr.

Jouannet’s and Mr. Lerner’s interests coincided.

           3.   Ackerman Group’s Exploitation of Tax Attributes

     The Corona transaction and the sales of receivables to

TroMetro clearly denote the long-term objectives of the Ackerman

group in entering into the transaction with CDR.    The sales of

the receivables to Mr. Lerner’s friend, colleague, and business

associate, Mr. van Merkensteijn, were an essential component to

realizing the built-in losses in the receivables.164   The sales of


     164
        In connection with his purchase of the receivables from
SMP in 1997 and 1998, Mr. van Merkensteijn paid a total amount of
approximately $1 million to SMP, either as cash downpayments or
as principal and interest payments on his notes to SMP. In
connection with his purchase of the $79 million receivable, Mr.
van Merkensteijn paid approximately $400,000 ($120,000 as a cash
down payment and $287,791 as principal and interest on his note).
Besides the sales of the receivables, the Ackerman group had
                                                   (continued...)
                                -220-

the receivables resulted in substantial losses that passed

through from SMP to Somerville S Trust to Mr. Ackerman:    A

$147,486,000 loss on the sale of the $150 million receivable in

1997; a $80,190,418 loss on the sale of the $81 million

receivable in 1998; and a $4,097,577 loss on the sale of the $79

million receivable in 1997.   But these losses were not enough for

the Ackerman group.

     In 1997, Mr. Lerner actively marketed a tax deal to

Imperial, which was searching for tax losses to offset

substantial gains that it expected to realize.   Mr. Lerner was a

director at Imperial and offered Imperial a stake in SMP’s

purported “film business.”    From the beginning, however, Imperial

was interested in one thing only, a piece of the more than $1

billion in built-in losses that SMP possessed.   Mr. Lerner

proposed that Imperial would purchase a 25-percent ownership

interest in SMP; upon disposal of SMP’s high-basis assets,

Imperial would be allocated approximately $400 million in losses.



     164
       (...continued)
other dealings with TroMetro and Mr. van Merkensteijn. For
example, on Dec. 7, 1998, SMP purportedly purchased a 50-percent
interest in Railcar Management Partners, LLC, which Mr. van
Merkensteijn owned, for $1.4 million (approximately the same
amount that Mr. van Merkensteijn paid altogether for his
purchases of the receivables). Given Mr. van Merkensteijn’s
close relationship with Mr. Lerner, evidenced in part by his
sharing office space with Crown Capital, we cannot foreclose the
possibility that SMP funneled back Mr. van Merkensteijn’s
purchase payments or “financed” TroMetro’s purchases of the
receivables in 1997 and 1998.
                               -221-

As part of this deal, Imperial would enter into a tax-sharing

agreement providing for a payment for the benefits attributable

to this loss.

     Although Imperial approved this deal, Mr. Lerner got nervous

and proposed an alternative tax deal in which SMP would form a

new limited liability company, Corona, by contributing the $79

million receivable.   Imperial would purchase a substantial

portion of SMP’s membership interest and would receive a smaller,

but still significant, tax-loss allocation on Corona’s sale of

the high-basis $79 million receivable.   In exchange for the tax

losses, Imperial would “contribute” back to Corona 20 percent of

the tax losses that it received; i.e., $14,595,652.   SMP received

this purported contribution as a fee for the tax losses.165   At

the end of the day, the Ackerman group and Imperial had

effectively duplicated the built-in loss that was inherent in the

$79 million receivable with both the contributor (SMP) and the

transferee partner (Imperial) receiving tax-loss allocations:

SMP realized $62,237,061 and $11,647,367 losses, respectively, on

the sales of portions of its Corona membership interest; Imperial

realized a $74,671,378 loss (and SMP realized a $4,097,577 loss)

on the sale of the $79 million receivable.




     165
        Mr. Lerner testified that SMP would receive “A very large
payment” for the tax losses, roughly “$15 million.”
                                 -222-

     For these reasons, we conclude that the only purpose for the

banks’ participation was to transfer built-in losses to the

Ackerman group taking advantage of the section 704(c) special

allocation rules and to subsequently market those losses to other

“investors” in the Ackerman group’s purported film enterprise.

As a result of the transaction with CDR and the section 704(c)

rules, the Ackerman group acquired $974,296,601 in claimed basis

in the receivables from Generale Bank, $79,912,955 in claimed

basis in the $79 million receivable, and $665 million in the SMHC

stock.

           4.   Congressional Intent

     Petitioner contends that, notwithstanding these

considerations, we should respect the form of the transactions

between the Ackerman group, CDR, Generale Bank, and CLIS.

Petitioner argues that the transfer of tax basis from Generale

Bank and CLIS to Somerville S Trust is contemplated and, in fact,

prescribed under section 704(c).       Petitioner concludes that

section 723 and the partnership basis rules control the outcome

of these cases.

      Petitioner suggests that formalistic compliance with

statutory provisions necessarily entitles the taxpayer to the tax

benefits provided therein.    We disagree.166   Under Gregory v.


     166
        In response to such a contention, the Court of Appeals
for the Second Circuit has stated:
                                                   (continued...)
                               -223-

Helvering, 293 U.S. at 469, “the substance of transactions is to

be determined uniformly in relation to the meaning and

intendment” of the Federal tax laws.     Weller v. Commissioner, 270

F.2d 294, 298 (3d Cir. 1959), affg. 31 T.C. 33 and Emmons v.

Commissioner, 31 T.C. 26 (1958); see also Jacobson v.

Commissioner, 96 T.C. 577, 590 (1991), affd. 963 F.2d 218 (8th

Cir. 1992).

     In enacting subchapter K, Congress adopted an aggregate rule

for contributed property.   In other words, Congress required

partners to divide the gain or loss, depreciation, or depletion

with respect to contributed property among the partners in a

manner which attributes precontribution appreciation or

depreciation in value to the contributor.     H. Conf. Rept. 2543,

83d Cong., 2d Sess., at 58 (1954).     In enacting this aggregate

rule, however, Congress did not envision contributions to a

partnership made solely for the purpose of subsequently



     166
       (...continued)
          Having satisfied the formal requirements of what
     it sees as the applicable rules, SuCrest urges us to
     understand its elaborate machinations as a legitimate
     ploy to hold down taxes and directs us to the maxim
     that a person is entitled to arrange his taxes so as to
     pay only that which is due. But, of course, the
     taxpayer is not permitted to avoid taxes which are due
     and the invocation of the phrase tells us nothing about
     what must ultimately be rendered unto the I.R.S. any
     more than Socrates solved the thorny problems of
     justice by defining it to require that we give every
     person his due. [United States v. Ingredient Tech.
     Corp., 698 F.2d 88, 94 (2d Cir. 1983).]
                               -224-

transferring inside basis to another partner.   Indeed, the

purpose of section 704(c) is to prevent the shifting of tax

consequences among partners with respect to precontribution gain

or loss, sec. 1.704-3(a)(1), Income Tax Regs., and not to

perpetrate a massive shift in basis from transitory “partners” to

other partners as part of a transaction lacking economic

substance.

     The purpose for the CDR transaction was purely and simply to

transfer built-in losses from CDR to the Ackerman group.    CDR

wanted to realize some amount on the banks’ built-in losses.      The

Ackerman group wanted to acquire the built-in losses to exploit

the tax attributes.   To these ends, the parties entered into a

prearranged series of transactions wherein the banks contributed

high-basis assets to SMP in exchange for preferred interests in

that company and then immediately sold their preferred interests

to the Ackerman group.

     Notwithstanding its form, the transaction did not, in

substance, represent contributions of property in exchange for

partnership interests, ingredients obviously contemplated in

sections 704(c) and 723.   The contribution provisions of

subchapter K do not contemplate giving effect to a transitory

partnership “contribution” that has no economic significance

apart from trafficking in tax attributes.   Cf. United States v.

Stafford, 727 F.2d 1043, 1048 (11th Cir. 1984) (stating that the
                                -225-

purpose of the contribution rules is “to facilitate the flow of

property from individuals to partnerships that will use the

property productively.”).

      In Wilkinson v. Commissioner, 49 T.C. 4 (1967), the

taxpayers were obligees on installment notes made by their own

corporation.    They wished to liquidate the corporation.   Doing

so, however, would have caused a deemed disposition of the notes

(because the obligor and obligee on the notes would then be

merged) and would have triggered tax on the deferred gains in the

notes.    In an attempt to avoid this result, the taxpayers hit

upon a scheme:    they would first assign the notes to a

partnership in which they were members; then, after their

corporation was liquidated, the partnership could assign the

notes back to them.    Under section 721, they would recognize no

gain on the transfer to the partnership; under section 731, there

would be no tax on the partership’s reassigning the notes to

them.    In fact, there would never be any tax to anyone:   “the

installment obligations would simply vanish for tax purposes.”

Wilkinson v. Commissioner, supra at 12.    This Court observed:

“We cannot believe that a hurriedly organized tour through

sections 721 and 731 could yield such an absurd result.”     Id.    We

reasoned that “the transparent device of making a formal

assignment * * * to the partnership” was not controlling.     Id. at

10.   Instead, after examining the “realities” of the transaction,
                                 -226-

we concluded that the taxpayer’s assignment of the notes to the

partnership was “not intended to have any economic significance”

and should be disregarded     Id. at 11.

     Similarly, in the instant case, the transaction between the

banks and the Ackerman group carried the seeds of its own

undoing:    it depended upon the banks’ withdrawing from the very

partnership they purported to join.      The banks’ “contributions”

to the partnership were not intended to have any economic

significance apart from transferring built-in tax losses.     The

transaction, if respected, would produce tax results not

contemplated by subchapter K:    staggering capital losses would be

allocated to partners in the absence of any economic losses, to

be used to shelter unrelated income not only for themselves but

also for other taxpayers to whom, for a fee, the Ackerman group

might market the losses.    To paraphrase Wilkinson:    We cannot

believe that a romp down the yellow brick road of subchapter K

can yield these absurd results.

     G.    Conclusion

     We conclude that the transaction whereby the banks purported

to partner with the Ackerman group lacked economic substance.

The Ackerman group and the banks did not intend to partner in a

film distribution business.    Rather, the transaction was designed

to transfer built-in tax losses to the Ackerman group for $10

million.    The economic realities of the transaction align with
                                  -227-

this intent.    Consequently, we disregard Generale Bank’s and

CLIS’s purported contributions to SMP.    Cf. Rice’s Toyota World,

Inc. v. Commissioner, 752 F.2d at 95 (holding that the Tax Court

correctly ignored labels applied by the taxpayers and determined

that a transaction was in substance a fee paid for tax benefits).

IV.   Step Transaction Doctrine

      Respondent contends that the step transaction doctrine

applies to disallow petitioner’s claimed losses.    Whether this

contention is viewed as an alternative argument, or merely as a

particularization of respondent’s substance over form argument,

the results are identical:    We disregard the banks’ purported

contributions to SMP.    Nevertheless, for the sake of

completeness, and because the parties have briefed legal

precedents involving the step transaction doctrine, we address

the parties’ arguments in this regard.

      A.   Legal Principles

      The step transaction doctrine embodies substance over form

principles; it treats a series of formally separate steps as a

single transaction if the steps are in substance integrated,

interdependent, and focused toward a particular result.    Penrod

v. Commissioner, 88 T.C. 1415, 1428 (1987).    “Where an

interrelated series of steps are taken pursuant to a plan to

achieve an intended result, the tax consequences are to be

determined not by viewing each step in isolation, but by
                               -228-

considering all of them as an integrated whole.”    Packard v.

Commissioner, 85 T.C. 397, 420 (1985).

     There is no universally accepted test as to when and how the

step transaction doctrine should be applied to a given set of

facts; however, courts have applied three alternative tests in

deciding whether to invoke the step transaction doctrine in a

particular situation:   the “binding commitment,” the

“interdependence,” and the “end result” tests.     Cal-Maine Foods,

Inc. v. Commissioner, 93 T.C. 181, 198-199 (1989); Penrod v.

Commissioner, supra at 1429-1430.   Respondent relies in the

instant cases on the “end result” and “interdependence” tests.

     Under the “end result” test, the step transaction doctrine

will be invoked if it appears that a series of separate

transactions is made up of prearranged parts of a single

transaction, cast from the outset to achieve the ultimate result.

Greene v. United States, 13 F.3d 577, 583 (2d Cir. 1994);

Associated Wholesale Grocers, Inc. v. United States, 927 F.2d

1517, 1523 (10th Cir. 1991).   The end result test is particularly

pertinent to cases involving a series of transactions designed

and executed as parts of a unitary plan to achieve an intended

result.   Kanawha Gas & Utils. Co. v. Commissioner, 214 F.2d 685,

691 (5th Cir. 1954), revg. 19 T.C. 1017 (1953).    The series of

closely related steps in such a plan is merely the means by which

to carry out the plan, and the steps will not be separated.      Id.
                                  -229-

In the Second Circuit, the prearranged plan need not be legally

binding but must at least constitute an informal agreement or

understanding between the parties.        Greene v. United States,

supra at 583; Blake v. Commissioner, 697 F.2d 473, 478-479 (2d

Cir. 1982), affg. T.C. Memo. 1981-579.

     Under the “interdependence” test, the step transaction

doctrine will be invoked where the steps in a series of

transactions are so interdependent that the legal relations

created by one transaction would have been fruitless without a

completion of the series.      Am. Bantam Car Co. v. Commissioner, 11

T.C. 397, 405 (1948), affd. 177 F.2d 513 (3d Cir. 1949).       We must

determine whether the individual steps had independent

significance or whether they had significance only as part of a

larger transaction.   Greene v. United States, supra at 584;

Penrod v. Commissioner, supra at 1430.       In making this

determination, we rely on a reasonable interpretation of

objective facts.   King Enters., Inc. v. United States, 189 Ct.

Cl. 466, 418 F.2d 511, 516 (1969); Cal-Maine Foods, Inc. v.

Commissioner, 93 T.C. 181, 199 (1989).

     B.   Parties’ Arguments

     Invoking the “end result” test, respondent argues that

Generale Bank’s and CLIS’s contributions of the high-basis, low-

value receivables and SMHC stock to SMP, and Somerville S Trust’s

purchase of Generale Bank’s and CLIS’s preferred interests were
                               -230-

really component parts of a single transaction intended from the

outset to transfer to the Ackerman group the built-in tax losses

in the SMHC receivables and stock.     Invoking the

“interdependence” test, respondent argues that Generale Bank’s

and CLIS’s contributions of the SMHC receivables and stock and

Somerville S Trust’s purchase of Generale Bank’s and CLIS’s

preferred interests were so interdependent that either

transaction alone would have been fruitless without the other.

Respondent argues that these transactions should be recast as a

direct sale of the high-basis, low-value receivables to

Somerville S Trust.

     Petitioner argues that the “end result” test is

inapplicable.   Petitioner argues that Generale Bank’s and CLIS’s

contributions of SMHC receivables and stock and Somerville S

Trust’s purchase of Generale Bank’s and CLIS’s preferred

interests were not merely a series of steps in a single

transaction designed to transfer tax attributes but were instead

designed for SMP to acquire a film library.     Petitioner also

argues that the “interdependence” test is inapplicable.

Petitioner argues that Generale Bank’s and CLIS’s contributions

of SMHC receivables and stock and Somerville S Trust’s purchase

of Generale Bank’s and CLIS’s preferred interests were not so

interdependent that either transaction alone would have been

fruitless without the other.   Petitioner contends that there was
                               -231-

no formal or informal agreement or understanding to carry out a

prearranged sale transaction via SMP.

     C.   Court’s Analysis

     Whether we apply the “end result” test or the

“interdependence” test, we conclude that the step transaction

doctrine applies to Generale Bank’s and CLIS’s contributions of

the SMHC receivables and stock and Somerville S Trust’s purchase

of Generale Bank’s and CLIS’s preferred interests in SMP.    For

the reasons discussed in more detail above, we find that Generale

Bank’s and CLIS’s contributions were made solely for the purpose

of transferring built-in tax losses to the Ackerman group.    The

Ackerman group could not obtain the built-in tax losses through a

direct purchase of the SMHC receivables and stock, but could only

obtain those losses by interposing a partnership and manipulating

the partnership basis rules.   From the beginning, both parties

planned and understood that CLIS would receive a $5 million

advisory fee and that the banks would exercise their put rights

at the earliest possible point (December 31, 1996), exiting the

partnership.   The contributions, the payment of the advisory fee,

and the exercise of the put rights were mutually interdependent

steps taken to dispose of Generale Bank’s and CLIS’s “bad”

investments in the SMHC receivables and stock and to transfer the

built-in tax losses to the Ackerman group.
                               -232-

     Petitioner argues, however, that respondent’s attempted

application of the step transaction doctrine is prohibited under

certain judicial precedents.   Petitioner contends that the step

transaction doctrine cannot be applied to invent steps that did

not occur or replace a taxpayer’s chosen route with the

Commissioner’s preferred route when no steps are eliminated.

Petitioner relies on Greene v. United States, 13 F.3d 577 (2d

Cir. 1994); Redding v. Commissioner, 630 F.2d 1169 (7th Cir.

1980), revg. and remanding 71 T.C. 597 (1979); Grove v.

Commissioner, 490 F.2d 241 (2d Cir. 1973), affg. T.C. Memo. 1972-

98; Turner Broad. Sys., Inc. & Subs. v. Commissioner, 111 T.C.

315 (1998); Esmark, Inc. & Affiliated Cos. v. Commissioner, 90

T.C. 171 (1988), affd. without published opinion 886 F.2d 1318

(7th Cir. 1989).   We conclude that these precedents are legally

and factually distinguishable from the instant cases.

     Greene v. Commissioner, supra, and Grove v. Commissioner,

supra, like Blake v. Commissioner, supra at 478-479, addressed

the application of the step transaction doctrine in situations

where the taxpayer “contributed” a substantially appreciated

asset to a charitable or tax-exempt entity to sell.   In Blake,

the critical inquiry in the court’s step transaction analysis was

whether the transactions were undertaken pursuant to an advance

understanding.   In Blake, because the Court of Appeals for the

Second Circuit determined that the Tax Court’s finding of a
                                -233-

prearranged understanding was not clearly erroneous, it upheld

the Commissioner’s proposed application of the step transaction

doctrine.   The court distinguished Grove, in which the court

declined to apply the step transaction doctrine, as a case where

there was not even an informal agreement among the parties as to

future disposition of the contributed asset.    Id. at 479.   Like

the transaction in Blake, and unlike the transactions in Greene

and Grove, Generale Bank’s and CLIS’s contributions of the high-

basis, low-value receivables and SMHC stock to SMP, and

Somerville S Trust’s purchase of Generale Bank’s and CLIS’s

preferred interests in SMP, occurred as part of a prearranged

understanding between the Ackerman group, CDR, and the banks.

       In Redding v. Commissioner, supra, the Court of Appeals for

the Seventh Circuit held that the step transaction doctrine did

not justify treating the distribution of stock warrants, and the

exercise of those warrants, as steps in a single transaction

involving the distribution solely of stock for purposes of

section 355(a)(1).   In Redding, the corporation had no

prearranged understanding with its shareholders that they would

exercise the stock warrants; during the subscription period the

shareholders had the option of exercising the stock warrants or

not.    Unlike the parties to the transaction in Redding, the

Ackerman group, CDR, and the banks had decided on a predestined

course--the banks would exercise their put rights, effectively
                               -234-

transferring their built-in tax losses to the Ackerman group for

cash.   Although the banks were not legally obligated to exercise

their put rights, there was an understanding that they would do

so.   The banks had every intention of exercising those rights and

no economic incentive to stay in SMP.

      We also find the instant cases distinguishable from Esmark

Inc. & Affiliated Cos. v. Commissioner, supra, and Turner Broad.

Sys., Inc. & Subs. v. Commissioner, supra.   In Esmark Inc., we

determined that a tender offer and redemption were part of an

overall plan and a prearranged understanding between Mobil and

the taxpayer.   Nonetheless, the taxpayer, which was a publicly

held company, could in no way bind its shareholders to an

agreement to sell their shares, and each shareholder

independently decided to sell or retain the taxpayer’s stock.

The shareholders were not a part of the understanding between

Mobil and the taxpayer.   Thus, the existence of the shareholders

gave the individual steps in the multi-step transaction

independent significance; Mobil’s acquisition of the taxpayer’s

shares was not a foregone conclusion.   By contrast, in the

instant cases, there were no independent parties that might upset

the planned transactions.   Pursuant to the side letter agreement,

Rockport Capital was bound to purchase the banks’ preferred

interests on the exercise of their put rights.   Pursuant to the

deposit account agreement, the $5 million put price for the
                               -235-

preferred interests was guaranteed.    Although the banks were not

legally obligated to exercise their put rights, there was an

understanding that they would do so.   The banks had every

intention and economic incentive to do so.

        Unlike the transactions in Turner Broadcasting Sys., Inc.

and Esmark Inc., the transaction with CDR was engaged in solely

to accomplish a reduction in taxes and did not involve the type

of legitimate tax choices that courts have traditionally upheld.

Unlike Turner Broadcasting Sys., Inc. and Esmark Inc., the

instant cases do not involve attempts by the Commissioner to add

steps that did not occur.   Unlike the transactions in Turner

Broadcasting Sys., Inc. and Esmark Inc., the form of the CDR

transaction in the instant cases does not align with its

substance.   Under the circumstances, we find respondent’s

proposed direct-sale recharacterization to be consistent with our

conclusion that the true substance of the transaction between the

Ackerman group and CDR was a transfer of built-in tax losses for

cash.

     Petitioner claims, however, that there were legitimate

business reasons for structuring the transaction as a

contribution to a partnership for preferred interests.

Petitioner claims:   “Viewed from the broader perspective, a

partnership structure was the only arrangement by which the stock

of Santa Monica Holdings Corporation, the obligor on two large
                               -236-

debts, and the debts themselves could be consolidated in the same

hands.”   We might agree that such goals could provide legitimate

reasons for using the partnership form.    But where, as here, the

banks intended to immediately exit the partnership, petitioner’s

argument loses its force.   The interposition of the partnership

contribution was unnecessary to accomplish the Ackerman group’s

acquisition of the SMHC receivables and stock.    Indeed, the

Ackerman group easily could have accomplished this acquisition in

one step, in a direct purchase of the SMHC receivables and stock,

with the same effect (apart from tax consequences).    In these

circumstances, we cannot agree that Turner Broadcasting or Esmark

precludes the application of the step transaction doctrine.     Cf.

W. Coast Mktg. Corp. v. Commissioner, 46 T.C. 32 (1966); Rev.

Rul. 70-140, 1970-1 C.B. 73.

          D.   Conclusion

     We conclude that the step transaction doctrine applies to

Generale Bank’s and CLIS’s contributions of SMHC receivables and

stock to SMP and Somerville S Trust’s purchase of Generale Bank’s

and CLIS’s preferred interests in SMP.    We conclude that those

transactions should be recast as direct sales of the SMHC

receivables and stock from Generale Bank and CLIS to Somerville S

Trust followed by Somerville S Trust’s contribution of the

receivables and stock to SMP for its preferred interests.
                                 -237-

V.   Basis Arguments

     Respondent makes alternative arguments relating to the SMHC

receivables; i.e., the $974 million in receivables from Generale

Bank and the $79 million receivable from CLIS.     In essence,

respondent argues that even if we were to respect the form of the

transaction, the banks’ purported contributions of the SMHC

receivables to SMP should not create basis in SMP, because the

receivables were worthless when the banks made the purported

contributions.   Although this argument, if successful, would

prove fatal to all the built-in losses associated with all the

SMHC receivables, respondent singles out the $79 million

receivable for additional punishment:     Respondent argues that SMP

obtained no basis in the $79 million receivable, because it was

not bona fide debt of SMHC and could not be contributed to SMP.

For the sake of completeness, we address each of these

alternative arguments below.

      A.   Worthlessness Issue

      For the reasons described below, we hold that the SMHC

receivables were worthless when Generale Bank and CLIS

purportedly contributed them to SMP.     Consequently, the

receivables did not constitute a “contribution of property”

within the meaning of section 721 and the partnership basis

rules; SMP obtained no basis in the SMHC receivables pursuant to

section 723.
                                     -238-

            1.    Contribution of Worthless Assets

     Respondent’s threshold legal premise is that a contribution

of worthless debts does not constitute a “contribution of

property” for purposes of section 721 and the partnership basis

rules.      Respondent contends that when worthless assets are

contributed to a partnership “there is no contribution in the

true sense of the word as nothing of value is transferred to it.”

In making this contention, respondent relies on our holding in

Seaboard Commercial Corp. v. Commissioner, 28 T.C. 1034 (1957).

In Seaboard Commercial Corp., we held that a transfer of

worthless stock to a corporation was not a “contribution to

capital” within the meaning of the corporate carryover basis

rules.167    We stated that it would be “a perversion of the

statutory language” to consider a contribution of a worthless

asset as coming within the phrase “contribution to capital”.          Id.

at 1054.      We further stated:    “A contribution of zero would not

really be a contribution”.         Id.

     Petitioner contends that the SMHC receivables constitute

“property” within the meaning of section 721 and the partnership

basis rules, irrespective of whether the receivables were

worthless.       Petitioner cites Crane v. Commissioner, 331 U.S. 1



     167
        Sec. 113(a)(8)(B) of the 1939 Code provided that if
property were acquired by a corporation as paid-in surplus or as
a contribution to capital, then the corporation’s basis would be
the same as it was in the transferor’s hands.
                                 -239-

(1947), for the proposition that the term “property” is to be

construed broadly.   Petitioner contends that the term “property”

encompasses “whatever may be transferred.”      In making his

contentions, petitioner relies on United States v. Stafford, 727

F.2d 1043 (11th Cir. 1984).

     In United States v. Stafford, supra at 1052, the Court of

Appeals for the Eleventh Circuit held that the term “contribution

of property” in section 721 did not contemplate as a prerequisite

the legal enforceability of the rights asserted as “property”.

The Court of Appeals then concluded that a letter of intent that

was contributed to a partnership was a “contribution of property”

within the meaning of section 721.       Id. at 1052.   In doing so,

however, the Court of Appeals assumed arguendo that the

factfinder on remand would determine that the letter of intent

had value.   Id.   The Court of Appeals explained that “If the item

asserted as property is valueless,” then section 721 will not

apply.   Id. at 1052 n.14.

     We hold that a contribution of a worthless debt is not a

“contribution of property” for purposes of section 721 or the

partnership basis rules.     See Hayutin v. Commissioner, T.C. Memo.

1972-127 (suggesting that a contribution of a worthless note to a

partnership would not be a true contribution since nothing of

value was transferred to the partnership), affd. 508 F.2d 462

(10th Cir. 1974); McKee et al., Federal Taxation of Partnerships
                                 -240-

and Partners, par. 4.02[1], at 4-15 (3d ed. 1997) (“Regardless of

how broadly the term ‘property’ is defined under § 721, it is

obvious that § 721 does not apply unless the person receiving the

partnership interest surrenders something of value to the

partnership.”).

           2.   Worthlessness of Debts

     Respondent argues that the $974 million in receivables from

Generale Bank and the $79 million receivable from CLIS were

worthless at the time of Generale Bank’s and CLIS’s contributions

to SMP because the SMHC assets underlying them had no value.    We

agree.

     The parties agree that in determining whether the

receivables (debts from SMHC’s perspective) were worthless when

they were contributed to SMP, the principles of section 166(a)(1)

apply by analogy.168   Under those principles, a debt becomes

worthless when identifiable events clearly mark the futility of

any hope of further recovery.    See James A. Messer Co. v.

Commissioner, 57 T.C. 848, 861 (1972).    A worthless debt lacks

both potential value and current liquid value.    Id.   Whether a

debt has become worthless is a question of fact to be determined

on the basis of objective factors, not on the taxpayer’s

subjective judgment as to the worthlessness of the debt.



     168
        Sec. 166(a)(1) allows a deduction for any debt which
becomes worthless within the taxable year.
                                -241-

LaStaiti v. Commissioner, T.C. Memo. 1980-547.   We examine only

facts and circumstances that were known or reasonably could have

been known at the time of the asserted worthlessness.   See

Halliburton Co. v. Commissioner, 93 T.C. 758, 774 (1989), affd.

946 F.2d 395 (5th Cir. 1991).

     For a debt to be entirely worthless, it must have lost its

“‘last vestige of value.’”   Bodzy v. Commissioner, 321 F.2d 331,

335 (5th Cir. 1963) (quoting Miami Beach Bay Shore Co. v.

Commissioner, 136 F.2d 408, 409 (5th Cir. 1943), revg. and

remanding an unpublished decision of this Court), revg. on

another issue T.C. Memo. 1962-40; Am. Offshore, Inc. v.

Commissioner, 97 T.C. 579, 593 (1991); see also Higginbotham-

Bailey-Logan Co. v. Commissioner, 8 B.T.A. 566, 578-579 (1927).

A debt is not wholly worthless if the collateral securing it has

value.   Jessup v. Commissioner, T.C. Memo. 1977-289.

     As discussed in detail supra, we have found that the EBD

film rights, the Carolco securities, and the NOLs in SMHC had no

material or consequential value as of December 11, 1996, when

Generale Bank and CLIS “contributed” the SMHC receivables to SMP.

Petitioner argues, however, that these assets had some value,

even if speculative, and therefore the receivables were not

entirely worthless.

     Although the term “worthless” in section 166 has been

interpreted strictly to include only debts that are “wholly
                                 -242-

worthless”, see sec. 1.166-5(a)(2), Income Tax Regs., the courts

have not interpreted section 166 so strictly as to include the

recovery of nominal amounts.     For example, in Buchanan v. United

States, 87 F.3d 197, 200 (7th Cir. 1996), the Court of Appeals

for the Seventh Circuit observed that “the recovery of a tiny

amount of a debt, even if fully anticipated rather than

completely unpredictable, will not defeat a finding of

worthlessness”.   Instead, a debt is worthless if on a particular

date the taxpayer has “no reasonable prospect” of recovering “a

significant, though in the sense merely of nontrivial, fraction”

of the debt amount.169   Id.   The Court of Appeals reasoned that

“Recovery of a trivial fraction of the debt would be unlikely to

cover the costs of collection”.     Id.

       Petitioner, however, points to Los Angeles Shipbuilding &

Drydock Corp. v. United States, 289 F.2d 222 (9th Cir. 1961).       In

that case, the Court of Appeals for the Ninth Circuit held that

“Nominal value of the property owned by * * * [the debtor]

compared to the size of its debt * * * does not determine

worthlessness, but rather worthlessness is determined by

comparing the value of the property to a zero figure.”     Id. at

228.    Reading Buchanan and Los Angeles Shipbuilding & Drydock

together, petitioner argues:     “To be considered worthless,



       169
        See Rev. Rul. 71-577, 1971-2 C.B. 129 (recovering one or
two cents on the dollar represents a trivial amount).
                               -243-

property must be worthless in a relative and an absolute sense.”

See Buchanan v. United States, supra at 201.

     Whether we compare the value of the EBD film rights, the

Carolco securities, and the NOLs in SMHC to the size of the

receivables or to a zero figure, we reach the same conclusion.

We conclude that the receivables were worthless both in a

relative and an absolute sense.170   We hold that Generale Bank’s

and CLIS’s purported contributions of the SMHC receivables to SMP

were not a “contribution of property” within the meaning of

section 721 and the partnership basis rules, and that SMP

obtained no basis in those receivables pursuant to section 723.171


     170
        Petitioner also contends that there was “potential value”
in SMHC. Petitioner claims that “Messrs. Ackerman and Lerner
(through Rockport) had expressed an interest in SMHC stock and
had presented a proposal to the Banks which would entail the
continuation and rejuvenation of that company, rather than its
destruction.” For the reasons stated supra, we find that the
Ackerman group, CDR, and the banks did not intend to engage in
any film business. Moreover, SMHC was virtually devoid of
assets, and any recovery in that company would have required an
infusion of new capital.
     171
        Respondent argues, alternatively, that under sec.
1016(b), Generale Bank’s and CLIS’s bases in the SMHC receivables
should have been adjusted to account for worthlessness deductions
that Generale Bank and CLIS could have taken, but did not. Sec.
1016(b) provides that, in the case of substituted basis property,
proper adjustments to basis shall be made in respect of the
period during which the property was held by the transferor,
donor, or grantor. We cannot agree that sec. 1016(b) requires an
adjustment for bad debt deductions that could have been taken,
but were not. None of the specified adjustments in sec. 1016(a)
refers to sec. 166 bad debt deductions. In any event, because we
decide that the receivables were worthless when they were
contributed to SMP, a contribution of those worthless receivables
                                                   (continued...)
                                 -244-

      B.    Bona Fide Indebtedness Issue

      Respondent makes an alternative argument that the $79

million receivable did not arise as part of a bona fide debtor-

creditor relationship.     Respondent cites MGM Group Holdings’

assumption of New MGM’s $79 million in indebtedness as a

condition to the sale of New MGM to Kirk Kerkorian.     Respondent

contends that since the $79 million receivable did not represent

a bona fide debt, it could not have been contributed to SMP on

December 11, 1996, and SMP could not have obtained basis in the

receivable.     Petitioner contends that the $79 million receivable

was bona fide debt of SMHC and arose from a “real loan”

obligation in connection with the 1993 restructuring.

      Generally, to be recognized for Federal tax purposes,

indebtedness must be bona fide and must arise from a valid

debtor-creditor relationship.     See Knetsch v. United States, 364

U.S. at 365-367; Maxwell v. Commissioner, 3 F.3d 591, 595-597 (2d

Cir. 1993), affg. 98 T.C. 594 (1992).      The determinative question

is:   “Was there a genuine intention to create a debt, with a

reasonable expectation of repayment, and did that intention

comport with the economic reality of creating a debtor-creditor

relationship?”     Litton Bus. Sys., Inc. v. Commissioner, 61 T.C.

367, 377 (1973).     In determining whether indebtedness is bona


      171
       (...continued)
would not give rise to any substituted basis under the
partnership basis rules (e.g., sec. 723).
                               -245-

fide, we must look to the substance of the transaction, not the

formalities attending it.   Muserlian v. Commissioner, 932 F.2d

109, 113 (2d Cir. 1991), affg. T.C. Memo. 1989-493.

     In determining whether a debt is bona fide, all the facts

and circumstances are considered, including:    (1) Whether a note

or other evidence of indebtedness exists; (2) whether interest is

charged; (3) whether there is a fixed schedule for repayments;

(4) whether any security or collateral is requested; (5) whether

there is any written loan agreement; (6) whether a demand for

repayment has been made; (7) whether the parties’ records, if

any, reflect the transaction as a loan; (8) whether any

repayments have been made; and (9) whether the borrower was

solvent at the time of the loan.   See, e.g., Goldstein v.

Commissioner, T.C. Memo. 1980-273 (and cases cited therein).

     During the course of its relationship with MGM, the Credit

Lyonnais group had lent or advanced upwards of $2 billion to the

MGM companies.   Before October 10, 1996, there was a realistic

possibility that the Credit Lyonnais group might recover a

substantial portion, or perhaps the entire amount, of their loans

and advances to the MGM companies.172   This possibility hinged on


     172
        Alan Cole Ford, a member of MGM’s management team,
testified that the Credit Lyonnais group had the hope and
expectation of realizing $2 billion on the sale of the MGM
operating company. In considering the disposition of MGM, the
Credit Lyonnais group had prepared a document entitled “Project
Lion, Presentation to Consortium de Realisation”, which recorded
                                                   (continued...)
                                 -246-

the valuable MGM film library.    Any chance of recouping the loans

and advances evaporated, however, when the highest bid in the New

MGM sale was $1.3 billion.   New MGM was still insolvent; it still

owed approximately $79 million to Credit Lyonnais.    Generale Bank

would recover nothing on the approximately $1 billion in debt

obligations that MGM Group Holdings owed Generale Bank.    Stripped

of the potential value in its stock in the MGM operating company,

MGM Group Holdings was left hopelessly insolvent.    Without its

MGM stock and the valuable MGM film library, MGM Group Holdings

was essentially an empty shell, devoid of any assets of value.173

The only assets in MGM Group Holdings at this time were the

Carolco securities and the NOLs.    Carolco had been in bankruptcy

for nearly a year; a first plan of reorganization filed on

September 13, 1996, reflected that holders of the Carolco

preferred stock and subordinated notes would receive nothing on

Carolco’s imminent liquidation.    MGM Group Holdings had NOLs



     172
       (...continued)
a range of values of approximately $1.6 to $2.0 billion for MGM.
     173
        SMHC’s draft financial statements for the period ended
Dec. 10, 1996, paint a very bleak picture of SMHC’s history and
future. The financial statements report that SMHC (i) had
experienced recurring operating losses, (ii) had an accumulated
deficit, and (iii) generated insufficient cashflow to fund its
debt servicing requirements. The financial statements also show
that SMHC had debt held by affiliates of Credit Lyonnais which
was due and payable July 15, 1997, and which was not expected to
be extended and that SMHC’s sole shareholder, CLIS, had not
committed to providing further funding of SMHC’s debt
obligations.
                                 -247-

possibly in excess of $200 million; however, any use of the NOLs

would be severely limited by MGM Group Holdings’ absence of

income and the interest owed on its debts, as well as the NOL

limitations under section 382.    These assets provided no

meaningful basis for repaying the $79 million receivable, even

under the best of estimates.    Despite these infirmities, Credit

Lyonnais released New MGM from its $79 million debt obligation

and caused MGM Group Holdings to assume this amount.

     MGM Group Holdings had a long track record of failing to

repay the loans and advances that the Credit Lyonnais group had

made to it.    Following the 1993 restructuring, MGM Group Holdings

retained approximately $962 million in debt that the MGM

companies owed to the Credit Lyonnais group.    After additional

advances in 1994 and 1995, MGM Group Holdings owed approximately

$975 million in indebtedness to CLBN, including some capitalized

interest.    This amount remained owing as of October 10, 1996.

MGM Group Holdings paid no principal amount of this indebtedness;

there is no evidence that it was ever called upon to make any

repayment.

     For many years, MGM Group Holdings paid no interest on its

debt obligations to the Credit Lyonnais group.    In connection

with the 1993 financial restructuring of MGM, MGM Group Holdings

and CLBN agreed that $800 million of MGM Group Holdings’ debt

obligations would be noninterest bearing.    MGM Group Holdings
                               -248-

paid no interest on the interest-bearing portion of the debt

obligations.174

     With this backdrop in mind, we conclude that Credit Lyonnais

did not expect the $79 million principal amount of the receivable

to be repaid when it released New MGM from, and caused MGM Group

Holdings to assume, that debt obligation.   Cf. Epic Associates

84-III v. Commissioner, T.C. Memo. 2001-64 (“Indebtedness is not

considered genuine, that is, a true loan, if the facts show that

the parties to the loan did not intend the principal amount of

the indebtedness to be repaid in full.”).

     Certain other factors point to the absence of a genuine

debtor-creditor relationship between Credit Lyonnais and MGM

Group Holdings.   First, MGM Group Holdings (or SMHC) never

executed a note for its assumption of the $79 million debt.

There is no indication that the Credit Lyonnais group and MGM

Group Holdings established any fixed repayment schedule for the

$79 million debt.   There is no indication that the Credit



     174
        In the Forms 5472, “Information Return of a 25% Foreign-
Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S.
Trade or Business”, included in its consolidated income tax
returns for the periods ended Dec. 31, 1991, Dec. 31, 1992, Dec.
31, 1993, Dec. 31, 1994, Dec. 31, 1995, and Oct. 8, 1996, MGM
Holdings (and its subsidiaries) reported that no interest was
paid on amounts owed by MGM Holdings and its subsidiaries to
Credit Lyonnais and CLBN. In the Form 5472 for its consolidated
income tax return for the period ended Dec. 31, 1996, MGM Group
Holdings (and its subsidiaries) reported that no interest was
paid on the $1,051,031,234 reported as owed by MGM Group Holdings
and its subsidiaries to Credit Lyonnais and Generale Bank.
                               -249-

Lyonnais group ever intended to enforce the collection of the $79

million debt or interest on that debt.175   Cf. Estate of Flandreau

v. Commissioner, 994 F.2d 91, 93 (2d Cir. 1993) (stating that

there must be a real expectation of repayment and an intent to

enforce collection at the time of the debt transaction), affg.

T.C. Memo. 1992-173.

     Credit Lyonnais, CLIS, MGM Group Holdings, and New MGM were

wholly owned entities in the Credit Lyonnais group.    Cf. Estate

of Van Anda v. Commissioner, 12 T.C. 1158, 1162 (1949) (stating

that debt transactions involving related parties are subject to

“rigid scrutiny”), affd. 192 F.2d 391 (2d Cir. 1951); see also

Hardman v. United States, 827 F.2d 1409, 1412 (9th Cir. 1987);

Hoyt v. Commissioner, 145 F.2d 634, 636 (2d Cir. 1944), affg. an

unpublished decision of this Court.    It is clear that MGM Group

Holdings assumed New MGM’s debt at Credit Lyonnais’s direction as

a convenient way of moving the $79 million debt out of New MGM to

effectuate its sale to Mr. Kerkorian.   Although MGM Group

Holdings assumed New MGM’s obligations on the $79 million debt,

this assumption merely created the illusion of a real debt in MGM

Group Holdings.   Unlike New MGM, MGM Group Holdings did not have

the assets to back up the $79 million receivable; it already owed

approximately $974 million in receivables to Generale Bank.    It


     175
        There is no indication that Credit Lyonnais or CLIS
charged any interest, or that MGM Group Holdings (or SMHC) paid
any interest, on the $79 million receivable.
                               -250-

had no reasonable prospect of generating any revenue to pay back

any meaningful part of the $79 million receivable or, for that

matter, the $974 million in receivables that Generale Bank held.

For these reasons, we conclude that the $79 million receivable

does not represent a bona fide indebtedness and did not arise

from a genuine debtor-creditor relationship.

     Petitioner contends, however, that the $79 million

receivable originated in December 1993 when New MGM was created.

Petitioner contends that under the original loan documents

executed in 1993, MGM Group Holdings guaranteed the line of

credit that gave rise to the $79 million receivable.   Petitioner

contends that the debt was bona fide when made and the guaranty

was enforceable against SMHC after the $79 million balance was

not paid by the proceeds of New MGM’s sale.    Petitioner contends

that MGM Group Holdings’ assumption of the unpaid $79 million

obligation simply reaffirmed its preexisting obligation under the

1993 guaranty.

     Petitioner is correct that the $79 million in debt

obligations emanated from the 1993 working capital agreement

between Credit Lyonnais and New MGM.   Pursuant to that agreement,

Credit Lyonnais agreed to make certain credit facilities

available to New MGM to fund its cashflow requirements consistent

with its business plan.   MGM Group Holdings irrevocably and

unconditionally guaranteed the full and timely payment of the
                              -251-

principal of (and interest on) the loans and advances to New MGM

under the working credit agreement.   We cannot agree, however,

that MGM Group Holdings’ assumption of the $79 million receivable

was part and parcel of its 1993 guaranty.

     First, under applicable State law, a guaranty is a secondary

or collateral liability, not a primary obligation.    See Gen.

Phoenix Corp. v. Cabot, 89 N.E.2d 238, 243 (N.Y. 1949).176     A

guarantor’s obligation matures “when there is a default on the

separate and independent contract or agreement.”     Columbia Hosp.

v. Hraska, 338 N.Y.S.2d 527, 529 (Civ. Ct. 1972); see 63 N.Y.

Jur. 2d, Guaranty & Suretyship sec. 113 (1987).    Although it

appears that New MGM failed to make proper payment on the loans

and advances under the working capital agreement, there is no

indication that Credit Lyonnais ever demanded payment or treated

New MGM’s failure as a default under that agreement.    More

importantly, there is no indication that Credit Lyonnais ever

called on MGM Group Holdings to make payment under its guaranty

or that the guaranty was otherwise triggered.

     Second, the debt assumption and agreement fundamentally

changed the relationships of the various parties and resulted,

critically, in a new debt obligation.   Cf. Banco Portugues do


     176
        The working capital agreement, MGM Group Holdings’
guaranty, and the debt release and assumption agreement each
recite that the terms of the agreement shall be construed in
accordance with and governed by the laws of the State of New
York.
                                 -252-

Atlantico v. Asland, 745 F. Supp. 962, 967 (S.D.N.Y. 1990) (“It

is well settled that ‘[w]hen the terms of the contract guaranteed

have been changed or the contract, as finally made, is not the

one upon which the surety agreed to become bound, he will be

released.’” (quoting Smith v. Molleson, 42 N.E. 669 (N.Y. 1896);

Lincoln Sav. Bank v. Murphy's Deluxe Limousine Serv., Inc., 556

N.Y.S.2d 102, 103 (App. Div. 1990))); Bier Pension Plan Trust v.

Estate of Schneierson, 74 N.Y.2d 312, 315 (Ct. App. 1989).       After

Mr. Kerkorian made his $1.3 billion bid for New MGM, there was a

$79 million shortfall in the amounts available to pay off Credit

Lyonnais.     As part of the stock purchase agreement, Mr. Kerkorian

required, as a condition precedent to closing on the sale of New

MGM, that this remaining debt amount be satisfied, canceled, or

extinguished at or before the closing.     To effectuate the sale of

New MGM, Credit Lyonnais agreed to release New MGM entirely from

this liability and, in turn, caused MGM Group Holdings to assume

that debt amount.177    This assumption did not occur as a result of

MGM Group Holdings’ guaranty obligations.     Instead, MGM Group


     177
           The debt release and assumption agreement provides:

          The Parent [MGM Group Holdings] hereby assumes
     principal of the Loans under the Credit Agreement in
     the amount of $79,912,955.34 effective as of the date
     hereof, immediately prior to the sale of Stock pursuant
     to the Stock Purchase Agreement and for all purposes of
     the Credit Agreement shall be treated as a Borrower, as
     such term is defined under the Credit Agreement and all
     references to Borrower shall be deemed to refer to and
     include MGM Parent.
                               -253-

Holdings ostensibly became the full-fledged obligor on the $79

million receivable without any of the typical rights that a

guarantor might have, such as, importantly, a right of

subrogation against a revitalized New MGM.178   Cf. Putnam v.

Commissioner, 352 U.S. 82, 89 (1956); In re Enron Corp., 307

Bankr. 372, 379 (S.D.N.Y. 2004); Restatement (Third) of

Suretyship and Guaranty, sec. 27 (1996).

     Petitioner suggests that the Credit Lyonnais group’s

subjective judgment that MGM Group Holdings would have value was

reasonable and well-founded.   Petitioner contends that the Court

should not, with the benefit of hindsight, substitute its

judgment for that of the Credit Lyonnais group.

     We have no basis in the record for concluding that the

Credit Lyonnais group made a determination that MGM Group

Holdings would have value.   Instead, the evidence points in the

opposite direction.   For many years, the Credit Lyonnais group

had struggled to keep MGM afloat; to that end, it had lent

enormous sums to MGM.   In 1993, the Credit Lyonnais group caused

MGM to be restructured into two companies with nearly $1 billion

in debt being funneled into MGM Group Holdings.    The only

realistic chance of recovering on that debt was a lucrative sale


     178
        Pursuant to its guaranty under the working capital
agreement, MGM Group Holdings was entitled to “all rights of
subrogation otherwise provided by law in respect of any payment
it may make or be obligated to make under this Guaranty”.
Exhibit 72-J, J000071.
                                 -254-

of the MGM operating company.    Once the MGM operating company was

sold, however, any hope of recovering the debts disappeared.

Without its MGM stock and a major cash or asset infusion, it

seems clear that MGM Group Holdings would have no meaningful

prospective value.   Looking beyond the formality of MGM Group

Holdings’ assumption of the $79 million debt, Credit Lyonnais’s

intentions here point to the absence of a genuine debtor-creditor

relationship and bona fide indebtedness.    See Muserlian v.

Commissioner, supra at 113; A.R. Lantz Co. v. United States, 424

F.2d 1330, 1333-1334 (9th Cir. 1970).

      We conclude that MGM Group Holdings’ assumption of New MGM’s

$79 million debt obligation did not establish a valid debtor-

creditor relationship with the Credit Lyonnais group and did not

create a bona fide indebtedness for Federal tax purposes.

Because the $79 million receivable did not represent a bona fide

indebtedness, no basis was established in that receivable, and no

basis carried over to SMP on CLIS’s purported contribution of

that receivable.

VI.   Corona Transaction

      Respondent argues that Mr. Lerner structured the Corona

transaction for the sole purpose of duplicating the built-in loss

in the $79 million receivable.    Respondent contends that there

was no business purpose for the Corona transaction and that Mr.

Lerner structured the transaction for the sole purpose of
                               -255-

duplicating tax benefits.   Respondent contends that Imperial

never intended to enter into a film finance business through

Corona.   Petitioner contends that SMP and Imperial entered into

the Corona transaction with the bona fide business purpose of

film financing.

     For the reasons discussed in more detail above, we conclude

that SMP had no basis in the $79 million receivable when it

contributed that receivable to Corona for a membership interest.

Consequently, SMP’s adjusted basis in its membership interest was

limited to its $250,000 cash contribution to Corona.    Also, since

SMP had no basis in the $79 million receivable on its

contribution, Corona did not obtain any basis in that receivable

under section 723 when the receivable was contributed.    Because

SMP did not receive a substituted basis in its membership

interest equal to the purported basis that it claimed in the $79

million receivable and because Corona did not receive any

carryover basis in the $79 million receivable, SMP is not

entitled to the substantial losses that it claimed from the sales

of its Corona membership interests to Imperial, and Corona is not

entitled to the substantial loss that it claimed from the sale of

the $79 million receivable to TroMetro.   This analysis

effectively disposes of the issues relating to the Corona

transaction; however, for sake of completeness, we shall briefly
                                 -256-

address the parties’ contentions with respect to this

transaction.

     We conclude that the Corona transaction and the subsequent

sale of the $79 million receivable were part of a general scheme

to obtain and exploit tax attributes in that receivable using the

partnership tax rules.    Mr. Lerner effectively duplicated the

built-in loss that existed in the contributed $79 million

receivable.    SMP also received approximately $15 million from

Imperial as a fee for the loss that Imperial realized on the sale

of the receivable to TroMetro.

     We cannot agree that the parties entered into the

transaction with any intention of engaging in a film finance

business.   Indeed, Imperial’s CEO, Wayne Snavely, testified that

tax losses were driving the Corona transaction and were the

primary reason in 1997 for Imperial’s investing in the Corona

transaction.    He further testified that his analysis leading up

to the Corona transaction was directed primarily to the

transaction’s tax aspects and that to that end he directed

Imperial’s chief financial officer, Kevin Villani, to get

together with Imperial’s accountants to see whether the Corona

transactions and its tax advantages worked for Imperial.

     Mr. Snavely acknowledged that he had a personal interest in

the film finance business; however, his testimony indicated

clearly that film finance was not considered as a reason for
                               -257-

Imperial’s engaging in the Corona transaction.   Indeed, although

Imperial held substantial membership interests in Corona after

its purchases of SMP’s membership interests, Mr. Snavely did not

know whether Corona ever financed or acquired any films, did not

know of any specific business transactions in which Corona

engaged, and did not recall seeing any written business plan for

Corona.   We conclude that the Corona transaction was undertaken

for the sole purpose of duplicating the built-in loss in the $79

million receivable through a sale of SMP’s membership interests

in Corona to Imperial and Corona’s sale of the $79 million

receivable to TroMetro.   The evidence in the record establishes

that Mr. Lerner orchestrated this plan from the beginning and was

responsible for its implementation.    We conclude that the Corona

transaction, similar to the transaction involving CDR, was devoid

of business purpose and economic substance and therefore cannot

be respected for Federal tax purposes.

VII. Sales of Receivables to TroMetro

     Respondent also argues that substance over form principles

apply to recast the sales of the $150 million, $81 million, and

$79 million receivables to TroMetro as sales by SMP to TroMetro

of an option to receive an equity interest in SMHC or its

successor.   In support of this argument, respondent relies on the

facts that: (1) Mr. van Merkensteijn wanted SMHC stock and not

the SMHC receivables; (2) Messrs. Lerner and van Merkensteijn had
                              -258-

discussions regarding TroMetro as a vehicle for purchasing the

receivables; (3) Mr. van Merkensteijn never expected to be paid

any principal or interest on those receivables; (4) the sales

were not conducted in an ordinary manner inasmuch as Mr. van

Merkensteijn relied upon the Sage Entertainment appraisal; and

(5) the transaction had no business purpose because Mr. van

Merkensteijn did not want the receivables but wanted the stock.

     Although we question Mr. van Merkensteijn’s motivations for

purchasing the SMHC receivables in 1997 and 1998, we are not

persuaded that the facts that respondent highlights establish his

proposed application of substance over form principles.

Respondent appears to rely on the March 1, 1999, capital

contribution agreement between SMHC and TroMetro.   Pursuant to

this agreement, TroMetro contributed, assigned, transferred, and

conveyed to SMHC all the interests that TroMetro owned and held

in the SMHC receivables in exchange for the right to receive 20

percent of all classes of stock of SMHC (or its successor),

exercisable by TroMetro any time after March 1, 2001.

Respondent, however, fails to establish the necessary link

between Mr. van Merkensteijn’s purchase of the receivables in

1997 and 1998, and his receipt of the stock option in 1999.

These transactions took place over several years, and, in the

absence of some additional evidence, we are not persuaded that
                               -259-

respondent has met his burden of proof on this issue.179   Because

we decide, on alternative grounds, that SMP obtained no bases in

the SMHC receivables, this conclusion does not ultimately affect

our decision.

VIII. Summary of Conclusions So Far

     We conclude that the banks’ contribution of the SMHC

receivables to SMP lacked economic substance and cannot be

respected for Federal tax purposes.    We also conclude that SMP

obtained no basis in the SMHC receivables under section 723

(because the receivables were worthless) or in the $79 million

receivable (because that debt did not represent bona fide

indebtedness when it was assumed by MGM Group Holdings).    In

addition, we conclude that the Corona transaction lacked economic

substance and likewise cannot be respected for Federal tax

purposes.   For these reasons, we conclude:   (1) SMP had no basis

in the $150 million receivable and the $81 million receivable

when those receivables were sold to TroMetro in 1997 and 1998;

(2) SMP had no basis in the $79 million receivable when it

contributed that receivable to Corona in 1997, and SMP’s basis in

its Corona membership interest under section 722 was limited to

the $250,000 cash contribution that it made to Corona; and (3)

Corona obtained no basis from SMP under section 723 in the $79


     179
        Respondent’s argument was raised as new matter in the
amendment to answer. Consequently, respondent bears the burden
of proof as to this issue. Rule 142(a).
                               -260-

million receivable on its contribution and had no basis in that

receivable when it was sold to TroMetro in 1997.180   Consequently,

we hold:   (1) SMP is not entitled to a $147,486,000 capital loss

on its sale to TroMetro of the $150 million receivable in 1997;

(2) SMP is not entitled to capital losses of $11,647,367 and

$62,237,061 on its sales to Imperial of portions of its Corona

membership interest in 1997; (3) SMP is not entitled to a

$80,190,418 capital loss on its sale to TroMetro of the $81

million receivable in 1998; and (4) Corona is not entitled to a

capital loss on its sale to TroMetro of the $79 million

receivable in 1997.181




     180
        We also conclude that the step transaction doctrine
applies to recast the banks’ contributions of the SMHC
receivables and stock as direct sales of those properties from
the banks to Somerville S Trust, followed by Somerville S Trust’s
contributions of the SMHC receivables and stock to SMP in
exchange for preferred interests in SMP. Presumably, Somerville
S Trust would be entitled to a cost basis totaling $10 million in
the SMHC receivables and stock, which would carry over to SMP
under sec. 723. The parties have not addressed the manner in
which the $10 million basis amount would be divided among the
receivables and stock; because we decide on alternative grounds
that SMP received a zero basis in the SMHC receivables, we need
not decide this issue.
     181
        Corona claimed a $78,768,955 capital loss on this
transaction. We do not have jurisdiction over the $74,671,378
portion of the loss that Corona claimed on its 1997 return. See
supra note 7. As a practical matter, the effect of our holding
is to disallow the $4,097,577 portion of the claimed loss that
flowed through to SMP.
                                  -261-

IX.   At-Risk and Passive Activity Loss Rules

      Respondent argues, alternatively, that to the extent the

losses SMP and Corona reported on their partnership tax returns

are allowed, certain partnership-level determinations relating to

the at-risk and passive activity loss rules must be made in this

proceeding.182    Petitioner argues that we do not have jurisdiction

over at-risk and passive activity loss determinations in a

partnership-level proceeding, and that these issues must be

resolved only in an affected-item proceeding at the partner

level.      Because our decision in these cases results in a

disallowance of the losses that SMP and Corona claimed on their




      182
        Under sec. 465, respondent argues that to the extent the
losses SMP reported on its sales of the $150 million and $81
million receivables are allowed, those losses arose from a film
activity that was a separate activity from its other investment
activities for purposes of applying the at-risk limitation rules.
Respondent argues that to the extent the loss Corona reported on
its sale of the $79 million receivable is allowed, that loss
arose from a film activity that was a separate activity from its
portfolio investment activities for purposes of applying the at-
risk limitation rules.

     Additionally, under sec. 469, respondent argues that to the
extent the losses SMP reported on its sales of the $150 million
and $81 million receivables and the portions of its Corona
membership interests, and any flow-through losses from Corona,
are allowed, those losses arose from a film trade or business
that cannot be combined with other trade or business activities
in SMP. Respondent argues that to the extent the loss Corona
reported on its sale of the $79 million receivable is allowed,
that loss arose from a film trade or business that cannot be
combined with other trade or business activities in SMP.
                                  -262-

partnership tax returns,183 we do not decide respondent’s at-risk

and passive activity loss arguments.

X.   SMP’s Basis in SMHC Stock

      On its Forms 1065, U.S. Partnership Return of Income, for

1997 and 1998, SMP reported that it had an adjusted basis of $665

million in its SMHC stock.184    In an amendment to his answer,

respondent proposes adjusting SMP’s reported tax basis in its

SMHC stock for these years to zero.

     Petitioner agrees that this item is a partnership item but

challenges its relevance to the issues in this case.     Petitioner

points to the fact that “SMP did not dispose of any stock during

the years before the Court or claim a loss from the sale of SMHC

stock.”      Respondent’s position, however, appears more pointed--

respondent challenges SMP’s reporting of its SMHC stock basis

rather than its impact on the loss adjustments in the FPAA.

     Section 6226(f) provides with respect to the scope of our

judicial review that we shall have jurisdiction--

     to determine all partnership items of the partnership
     for the partnership taxable year to which the notice of
     final partnership administrative adjustment relates,
     the proper allocation of such items among the partners,
     and the applicability of any penalty, addition to tax,
     or additional amount which relates to an adjustment to
     a partnership item.


      183
            See supra note 6.
      184
        SMP’s adjusted basis in its SMHC stock is reported on
statements accompanying Schedules L, Balance Sheets per Books, of
its partnership returns.
                                -263-


The Treasury regulation interpreting this section provides:

     A court reviewing a notice of final partnership
     administrative adjustment has jurisdiction to determine
     all partnership items for the taxable year to which the
     notice relates and the proper allocation of such items
     among the partners. Thus, the review is not limited to
     the items adjusted in the notice. [Sec. 301.6226(f)-
     1T(a), Temporary Proced. & Admin. Regs., 52 Fed. Reg.
     6779-01 (Mar. 5, 1987).185]

     On the basis of section 6226(f) and the applicable

regulation, we could construe our jurisdiction over petitioner’s

1997 and 1998 taxable years to encompass SMP’s reporting of its

basis in SMHC stock.    Nonetheless, if we were to exercise

jurisdiction over this item, and if we were to decide, as

respondent contends, that SMP’s basis in SMHC is zero, our

decision would result in no real tax adjustments at either the

partnership or partner level for the partnership taxable years at

issue.186   Conceivably, our decision might influence SMP’s

reporting for subsequent taxable years, but beyond this “in

terrorem” effect, it is unclear what impact such a decision would


     185
        A final regulation under sec. 6226 was promulgated
effective for partnership taxable years beginning on or after
Oct. 4, 2001. Sec. 301.6226(f)-1(c), Proced. & Admin. Regs.
     186
        Unlike River City Ranches #1 Ltd. v. Commissioner, 401
F.3d 1136 (9th Cir. 2005), affg. in part, revg. in part, and
remanding T.C. Memo. 2003-150, this is not a case where our
findings with respect to this matter are alleged to have any
bearing on penalty-interest under sec. 6621 or on any other
penalties. For instance, respondent has not alleged that an
adjustment to SMP’s reported basis in SMHC stock would give rise
to any underpayment for purposes of sec. 6662 accuracy-related
penalties.
                                -264-

have on taxable years that are not before us in this proceeding.

For this reason, we cannot agree that Congress contemplated our

exercising jurisdiction over this type of adjustment.    Cf. sec.

301.6226(f)-1T(b), Temporary Proced. & Admin. Regs., 52 Fed. Reg.

6788 (Mar. 5, 1987) (indicating that the reviewing court has

jurisdiction to determine an issue raised by a partner relating

to partnership’s treatment of certain costs).

      We hold that we do not have jurisdiction to determine issues

related to SMP’s reporting of its basis in SMHC stock for its

1997 and 1998 taxable years.

XI.   Accuracy-Related Penalties

      Respondent determined that section 6662 accuracy-related

penalties apply with respect to the partnership adjustments for

SMP and Corona.187   In particular, with respect to SMP, respondent

determined that the section 6662(h) 40-percent penalty for gross

valuation misstatements applies to the underpayments that result

from adjustments to the tax bases that SMP reported on its 1997


      187
        In the Taxpayer Relief Act of 1997, Pub. L. 105-34, sec.
1238(a), 111 Stat. 1026, Congress amended sec. 6221 to include,
as an item to be determined at the partnership level, the
applicability of any penalty, addition to tax, or additional
amount which relates to an adjustment to a partnership item,
effective for partnership taxable years ending after Aug. 5,
1997. Consequently, we have jurisdiction in this partnership-
level proceeding to decide issues relating to the sec. 6662
penalties that respondent determined. Partner-level defenses,
however, must be asserted in a separate refund action following
assessment and payment. See sec. 6230(c)(1)(C), (4); cf. sec.
301.6221-1(d), Proced. & Admin. Regs. (effective for partnership
taxable years beginning on or after Oct. 4, 2001).
                                 -265-

and 1998 partnership tax returns in the $974 million in

receivables, the $79 million receivable, and SMP’s membership

interest in Corona.   In the alternative, respondent determined

that the section 6662(a) 20-percent penalty for negligence,

disregard of rules or regulations, or    substantial understatement

applies to the underpayments that result from these adjustments.

     With respect to Corona, respondent argues that the section

6662(h) 40-percent accuracy-related penalty for gross valuation

misstatements applies to the underpayment that results from an

adjustment to the tax basis that Corona reported on its 1997

partnership tax return in the $79 million receivable.   In the

alternative, respondent argues that the section 6662(a) 20-

percent accuracy-related penalty for negligence, disregard of

rules or regulations, or substantial understatement applies to

the underpayment that results from this adjustment.

     A.   Burden of Production

     Section 7491(c) provides that the Commissioner shall have

the burden of production in any court proceeding with respect to

the liability of any “individual” for any penalty, addition to

tax, or additional amount imposed by the Code.   Presumably on the

basis of this provision, petitioner argues that “Respondent bears

the burden of showing that Petitioners are liable for any

penalties.”   We disagree.
                              -266-

     Section 7491(c), if applicable, imposes upon the

Commissioner only the burden of production with respect to

penalties, and not the burden of proof as petitioner suggests.188

See Higbee v. Commissioner, 116 T.C. 438, 446 (2001).    Moreover,

by its terms, section 7491(c) applies only with respect to the

liability for penalties of any “individual”.   By contrast,

section 7491(a), which provides the general rule for shifting the

burden of proof to the Commissioner in certain circumstances,

applies in ascertaining the liability of a “taxpayer”.   Plainly,

by using the different terms “individual” and “taxpayer”,

Congress intended to distinguish the two terms.   See sec.

7701(a)(14) (defining the term “taxpayer” to mean any person

subject to any internal revenue tax) and (a)(1) (defining the

term “person” to mean and include an individual, a trust, estate,

partnership, association, company, or corporation); see also sec.

7491(b) (limiting its application to an “individual taxpayer”);

cf. Elec. Arts, Inc. v. Commissioner, 118 T.C. 226, 258 (2002)

(“Ordinarily, in statutes and other legal documents, it is

presumed that if the drafter * * * varies the terminology, then

the drafter intends that the meaning also varies.”).


     188
        This burden of production, if applicable, requires the
Commissioner to “initially come forward with evidence that it is
appropriate to apply a particular penalty to the taxpayer”. H.
Conf. Rept. 105-599, at 241 (1998), 1998-3 C.B. 747, 995. This
provision is not intended, however, to require the Commissioner
to introduce evidence regarding reasonable cause, substantial
authority, or similar provisions. Id.
                               -267-

     In any event, we conclude that respondent has satisfied any

burden of production he might have under section 7491(c) with

respect to the appropriateness of applying accuracy-related

penalties in the instant cases.    Consequently, petitioner must

come forward with evidence sufficient to persuade the Court that

respondent’s penalty determinations are incorrect.     Higbee v.

Commissioner, supra at 447.

     B.   Gross Valuation Misstatements

     A 20-percent accuracy-related penalty applies to the extent

that any portion of an underpayment is attributable to any

“substantial valuation misstatement”.     Sec. 6662(a) and (b)(3).

There is a “substantial valuation misstatement” if “the value of

any property (or the adjusted basis of any property) claimed on

any return of tax imposed * * * is 200 percent or more of the

amount determined to be the correct amount of such valuation or

adjusted basis (as the case may be)”.     Sec. 6662(e)(1)(A).   In

the case of a “gross valuation misstatement”, the penalty

increases from 20 to 40 percent.    There is a “gross valuation

misstatement” if the value of any property (or the adjusted basis

of any property) claimed on any return of tax imposed is 400

percent or more of the amount determined to be the correct amount

of such valuation or adjusted basis (as the case may be).       Sec.

6662(e)(1) and (h)(2).   In the case of multiple valuation

misstatements, the determination of whether there is a
                                  -268-

substantial or gross valuation misstatement on a return is made

on a property-by-property basis.      Sec. 1.6662-5(f)(1), Income Tax

Regs.      There is no disclosure exception to this penalty.   Sec.

1.6662-5(a), Income Tax Regs.189

     On its 1997 partnership tax return, SMP reported a $150

million basis in the $150 million receivable that it purportedly

sold to TroMetro.      As a result of this basis reporting, SMP

claimed a $147,486,000 loss ($2,514,000 sale price minus $150

million adjusted basis).      SMP reported a $63,489,061 basis in the

79.2-percent Corona membership interest that it sold to Imperial.

As a result of this basis reporting, SMP claimed a $62,237,061

loss ($1,252,000 sale price minus $63,489,061 adjusted basis).

SMP reported a $11,864,117 basis in the additional 14.65-percent

Corona membership interest that it sold to Imperial.      As a result

of this basis reporting, SMP claimed an $11,647,367 loss

($216,750 sale price minus $11,864,117 adjusted basis).

     We have concluded on alternative grounds that SMP obtained a

zero basis in the $974 million in receivables from Generale Bank

and the $79 million receivable from CLIS.      Because the $79


     189
         The substantial or gross valuation misstatement penalty
applies only if the portion of the underpayment for the taxable
year attributable to substantial valuation misstatements exceeds
$5,000 ($10,000 in the case of a corporation other than an S
corporation or a personal holding company). Sec. 6662(e)(2). In
the case of a partnership, this dollar limitation is applied at
the partner level. Sec. 1.6662-5(h)(1), Income Tax Regs.
Consequently, we do not decide whether the dollar limitation
applies in these partnership-level proceedings.
                               -269-

million receivable had a zero basis in SMP’s hands, SMP received

no carryover basis under section 722 in its Corona membership

interest on the contribution of that receivable to Corona.

Corona received no carryover basis under section 723 in the

contributed $79 million receivable.    Consequently, SMP’s and

Corona’s basis reporting for the receivables was infinitely more

than 400 percent of the amount that we determined to be the

correct basis in the receivables.190   See sec. 1.6662-5(g), Income

Tax Regs. (“The value or adjusted basis claimed on a return of

any property with a correct value or adjusted basis of zero is

considered to be 400 percent or more of the correct amount.

There is a gross valuation misstatement with respect to such

property, therefore, and the applicable penalty rate is 40

percent.”); see also Rybak v. Commissioner, 91 T.C. 524, 566-567

(1988).



     190
        As an alternative holding, we have concluded that the
step transaction doctrine applies to recast Generale Bank’s and
CLIS’s contributions of the receivables and Somerville S Trust’s
purchases of Generale Bank’s and CLIS’s preferred interests in
SMP as direct sales of the SMHC receivables and stock from
Generale Bank and CLIS to Somerville S Trust followed by
Somerville S Trust’s contributions of those items for preferred
interests in SMP. Pursuant to this holding, Somerville S Trust
seemingly would receive a $10 million cost basis in the SMHC
receivables and stock which would carry over to SMP. The parties
have not addressed this issue, but presumably this $10 million
cost basis would be divided among the SMHC receivables and stock
on a proportional basis. The basis amounts that SMP reported on
its 1997 and 1998 partnership tax returns and Corona reported on
its 1997 partnership tax return would still exceed by far more
than 400 percent any $10 million cost basis in the receivables.
                                 -270-

     Petitioner argues that the section 6662(h) gross valuation

misstatement penalty is inapplicable to the adjustments in these

cases.    Petitioner contends that section 6662(h) has limited

application and applies only where the misstatement of adjusted

basis is attributable to an overvaluation of property. Petitioner

contends that the misstatements of basis in these cases are not

attributable to any overvaluation but instead are attributable to

the operation of the partnership basis rules.     Stated

differently, petitioner’s position essentially is that section

6662(e) and (h) cannot apply where the alleged gross valuation

misstatement penalty is not directly attributable to an erroneous

overvaluation.    We disagree.

     Section 6662(e) and (h) refers to an underpayment that is

attributable to a “valuation misstatement”.     The statute defines

“valuation misstatement” to include overstatements of “adjusted

basis”.    Specifically, a substantial or gross valuation

misstatement occurs where “the value of any property (or the

adjusted basis of any property)” claimed on any tax return is at

least 200 percent (for a substantial valuation misstatement or

400 percent (for a gross valuation misstatement) of “the amount

determined to be the correct amount of such valuation or adjusted

basis (as the case may be)”.     Sec. 6662(e)(1)(A) (emphasis

added).    Consequently, Congress did not limit the definition of a

“valuation misstatement” to instances involving inflated
                                 -271-

valuations but included within that definition instances

involving inflated adjusted bases.       See sec. 1.6662-5(h)(2),

Example, Income Tax Regs. (“Partnership P * * * claims a $40,000

basis in a depreciable asset which, in fact, has a basis of

$15,000.   The determination that there is a substantial valuation

misstatement is made solely with reference to P by comparing the

$40,000 basis claimed by P with P’s correct basis of $15,000.”);

cf. Garrett v. Commissioner, T.C. Memo. 1997-231.       On the basis

of the statutory definition, we cannot agree with petitioner that

an overvaluation is essential to the application of the section

6662(e) and (h) penalty.

     Petitioner contends:   “Outside of the Second Circuit, case

law covering the scope of the ‘valuation’ element of the

accuracy-related penalty has always emphasized that it is

applicable only to situations where the increased tax liability

is attributable to an actual misstatement of a valuation.”

Petitioner relies on Gainer v. Commissioner, 893 F.2d 225

(9th Cir. 1990), affg. T.C. Memo. 1988-416, and Todd v.

Commissioner, 862 F.2d 540 (5th Cir. 1988), affg. 89 T.C. 912

(1987).    Gainer and Todd focused on the phrase “attributable to a

valuation overstatement” in former section 6659(a), the precursor

to section 6662(e) and (h).191   Pursuant to the holdings in those


     191
        In the Omnibus Reconciliation Act of 1989, Pub. L. 101-
239, sec. 7721, 103 Stat. 2395, Congress repealed former sec.
                                                   (continued...)
                              -272-

cases, the portion of a tax underpayment that is attributable to

a valuation overstatement is to be determined after taking into

account any other proper adjustments to tax liability.    See

Gainer v. Commissioner, supra at 228; Todd v. Commissioner, 89

T.C. 912, 916 (1987), affd. 862 F.2d 540 (5th Cir. 1988).    Thus,

to the extent the taxpayer’s claimed tax benefits are disallowed

on grounds separate and independent from alleged valuation

overstatements, the resulting underpayments of tax are not

regarded as “attributable to valuation overstatements”.    See

Krause v. Commissioner, 99 T.C. 132, 178 (1992), affd. sub nom.

Hildebrand v. Commissioner, 28 F.3d 1024 (10th Cir. 1994).

Neither Gainer nor Todd dealt with the definition of a “valuation

overstatement” or the application of the penalty to the reporting

of inflated adjusted bases in properties.192

     In Gainer and Todd, the taxpayers made valuation

overstatements of certain property and claimed depreciation


     191
       (...continued)
6659 and consolidated the various accuracy-related penalties into
sec. 6662, carrying over the same essential language as sec.
6659. In the Omnibus Reconciliation Act of 1990, Pub. L. 101-
508, sec. 11312, 104 Stat. 1388-454 to 1388-455, Congress amended
sec. 6662, changing, inter alia, the phrase “valuation
overstatement” to refer to “valuation misstatement”.
     192
        Former sec. 6659(c), similar to current sec. 6662(e) and
(h), provided: “there is a valuation overstatement if the value
of any property, or the adjusted basis of any property, claimed
on any return is 150 percent or more of the amount determined to
be the correct amount of such valuation or adjusted basis (as the
case may be).”
                                -273-

deductions and investment tax credits on the basis of these

valuations.    This Court and the Courts of Appeals determined,

however, that the properties had not been placed in service;

therefore, the taxpayers’ claimed deductions were disallowed on

that ground and not because of any valuation overstatement.

Thus, in Gainer and Todd, this Court and the Courts of Appeals

disallowed the taxpayers’ tax benefits on grounds separate and

apart from the alleged valuation overstatements.    In the instant

cases, however, each of our alternative holdings goes directly to

SMP’s and Corona’s correct adjusted bases in the contributed SMHC

receivables.

     In Gilman v. Commissioner, 933 F.2d 143 (2d Cir. 1991),

affg. T.C. Memo. 1990-205, the Court of Appeals for the Second

Circuit applied the valuation overstatement penalty under former

section 6659 to an underpayment of taxes derived from a

transaction that was disregarded for lack of economic substance.

Because the taxpayer was deemed to have a zero basis, the

taxpayer’s claimed basis was infinitely larger than the amount

determined to be the correct basis (as would be any amount of

claimed basis, compared to zero).    Acknowledging that applying

the valuation overstatement penalty “somewhat strains the natural

reading of the statutory phrase ‘valuation overstatement’”, the

court nevertheless held, consistent with other judicial

precedents applying the valuation overstatement penalty in the
                                  -274-

context of tax shelter transactions, that the penalty was

applicable.    Id. at 151.   The Court of Appeals observed:

“application of the section 6659 penalty surely reenforces the

Congressional objective of lessening tax shelter abuse.”        Id.

     The Court of Appeals in Gilman acknowledged that former

section 6659 might require some nexus with an overvaluation but

determined:    “A transaction that lacks economic substance

generally reflects an arrangement in which the basis of the

property was misvalued in the context of the transaction.”        Id.

at 152.    The Court of Appeals determined that the lack of

economic substance in that case was due in part to a valuation

overstatement, relying on the absence of any reasonable

expectation of profit and the lack of value in the property that

the taxpayer purchased.      Id. at 151; see also Massengill v.

Commissioner, 876 F.2d 616 (8th Cir. 1989), affg. T.C. Memo.

1988-427.

     As in Gilman, valuation issues form a critical part of these

cases.    For example, we have found that the absence of value in

the properties that Generale Bank and CLIS “contributed” under

the guise of the partnership rules indicates a lack of economic

substance in the transaction.     We have also found that the

absence of value in these properties suggests a lack of economic

benefit in the transaction from the Ackerman group’s perspective

and indicates that the Ackerman group pursued the transaction
                               -275-

with CDR, Generale Bank, and CLIS solely for tax purposes.

Moreover, in determining that the SMHC receivables were worthless

when they were contributed to SMP, we have relied on an extensive

examination of the values of the assets in SMHC.    Consequently,

to whatever extent Gilman may require an indirect nexus to an

overvaluation of property, we conclude that such a nexus exists

in these cases.

     We conclude that SMP’s 1997 and 1998 partnership tax return

and Corona’s 1997 partnership tax return contain gross valuation

misstatements for purposes of section 6662(e) and (h).

     C.   20-Percent Accuracy-Related Penalties

     Respondent determined, alternatively, that 20-percent

accuracy-related penalties apply under section 6662(a) with

respect to the adjustments to SMP’s 1997 and 1998 partnership tax

return and Corona’s 1997 partnership tax return.    Respondent

asserts two grounds for imposing these penalties:    negligence and

substantial understatement of income tax.    We address each of

these grounds below.

          1.   Negligence

     Section 6662(a)(1) imposes a 20-percent accuracy-related

penalty on any portion of an underpayment of tax required to be

shown on a return which is attributable to negligence or

disregard of rules or regulations.     For purposes of section 6662,

the term “negligence” includes any failure to make a reasonable
                                  -276-

attempt to comply with Code provisions.     Sec. 6662(c).

“Negligence is lack of due care or failure to do what a

reasonable and ordinarily prudent person would do under the

circumstances.”      Marcello v. Commissioner, 380 F.2d 499, 506 (5th

Cir. 1967), affg. in part and remanding in part 43 T.C. 168

(1964) and T.C. Memo. 1964-299; see Neely v. Commissioner, 85

T.C. 934, 947 (1985).     For purposes of section 6662, the term

“disregard” includes any careless, reckless, or intentional

disregard.193    Sec. 6662(c).

     A return position that has a reasonable basis is not

attributable to negligence.      Sec. 1.6662-3(a), Income Tax Regs.

A reasonable basis connotes significantly more than not being

frivolous or patently improper.     Sec. 1.6662-3(b)(3), Income Tax

Regs.      The reasonable basis standard is not satisfied by a return

position that is merely arguable or that is merely a colorable

claim.     Id.




     193
        The term “rules or regulations” includes the provisions
of the Code, temporary or final regulations issued under the
Code, and revenue rulings or notices issued by the Internal
Revenue Service. Sec. 1.6662-3(b)(2), Income Tax Regs. A
disregard of rules or regulations is “careless” if the taxpayer
does not exercise reasonable diligence to determine the
correctness of a return position that is contrary to the rule or
regulation. Id. A disregard is “reckless” if the taxpayer makes
little or no effort to determine whether a rule or regulation
exists, under circumstances which demonstrate a substantial
deviation from the standard of conduct that a reasonable person
would observe. Id. A disregard is “intentional” if the taxpayer
knows of the rule or regulation that is disregarded. Id.
                              -277-

     Mr. Lerner is a highly educated, sophisticated tax attorney.

He worked for many years at O’Melveny & Myers; at one point, he

established and ran the firm’s London office.    Mr. Lerner also

worked as a clerk/attorney-advisor with the U.S. Tax Court and as

an attorney advisor for the U.S. Treasury Department.

     Mr. Lerner personally engineered a plan to transfer the

built-in losses in the defunct MGM Group Holdings from Generale

Bank and CLIS to the Ackerman group.    This transaction had no

economic substance for Federal tax purposes.    Instead, the

transaction was the equivalent of a sale of approximately $1.7

billion in tax attributes from Generale Bank and CLIS to

Somerville S Trust for $10 million.    To exploit these tax

attributes, Mr. Lerner devised a second plan whereby SMP

purportedly sold portions of the receivables from Generale Bank

to TroMetro, which was owned by his friend, colleague, and

business associate, Mr. van Merkensteijn.    Mr. Lerner also

devised a third plan whereby SMP transferred the $79 million

receivable to Corona for a membership interest, sold portions of

its Corona membership interest to Imperial, and caused Corona to

sell the $79 million receivable to TroMetro, effectively

duplicating the built-in losses in that receivable.    In the

course of these various transactions, SMP reaped approximately

$300 million in tax losses and Corona reaped $79 million.      SMP

also received a $14.5 million fee from Corona for the latter’s
                               -278-

tax losses in the Corona transaction.    Under the circumstances,

we believe that a reasonable and prudent person would recognize

that these tax losses were “‘too good to be true’”, especially

given that neither SMP, Corona, Somerville S Trust, nor Imperial

bore the economic loss associated with these tax losses.    See

sec. 1.6662-3(b)(ii), Income Tax Regs.

     Petitioner seeks to hide behind formal compliance with the

partnership tax rules.   As an experienced tax attorney, Mr.

Lerner should have known that mere formal compliance with

statutory provisions would not sustain transactions that have no

economic substance and that are mere contrivances designed solely

to exploit tax benefits.   Under the circumstances, we conclude

that reasonably prudent persons with Mr. Lerner’s tax experience

would not have conducted themselves as he did in reporting the

bases in the SMHC receivables and the substantial losses from the

transactions involving TroMetro and Imperial.   Consequently, we

sustain respondent’s alternative determination that negligence

penalties are appropriate in these cases.194


     194
        Petitioner argues that negligence penalties do not apply
because the instant cases involve issues of first impression.
The accuracy-related penalty is inappropriate where an issue to
be resolved by the Court is one of first impression involving
unclear statutory language. Bunney v. Commissioner, 114 T.C.
259, 266 (2000); see Braddock v. Commissioner, 95 T.C. 639, 645
(1990) (holding penalties inapplicable where the issue has never
before been considered by any court, and the answer is not
entirely clear from the statutory language). Petitioner does not
point to the issues which he considers to be issues of first
                                                   (continued...)
                                 -279-

           2.   Substantial Understatement of Income Tax

     Section 6662(a)(2) imposes a 20-percent accuracy-related

penalty on any portion of an underpayment of tax required to be

shown on a return which is attributable to any substantial

understatement of income tax.     Sec. 6662(b)(1) and (2).

     There is a “substantial understatement of income tax” for

any taxable year if the amount of the understatement of the

taxable year exceeds the greater of 10 percent of the tax

required to be shown on the return for the taxable year, or

$5,000.    Sec. 6662(d)(1).   For this purpose, the term

“understatement” generally means the excess of the amount of the


     194
       (...continued)
impression. The only issue that we decide against petitioner,
which might be construed as an issue of first impression, is
whether a contribution of worthless debts to a partnership
constitutes a “contribution of property” for purposes of sec. 721
and the partnership basis rules. This issue arises in our
holding sustaining respondent’s alternative argument regarding
basis; this issue is not directly implicated in our primary
holding that the transaction in question lacked economic
substance or in our alternative holding involving the application
of the step transaction doctrine. Moreover, this Court
previously decided that a contribution of worthless stock to a
corporation was not a “contribution” for purposes of the
analogous corporate carryover basis rules. See Seaboard
Commercial Corp. v. Commissioner, 28 T.C. 1034, 1054 (1957). The
Court of Appeals for the Eleventh Circuit in United States v.
Stafford, 727 F.2d 1043, 1052 n.14 (11th Cir. 1984), has also
considered whether a contribution of valueless property
represents a contribution of property for purposes of sec. 721 of
the partnership rules, concluding that it did not. Moreover, we
do not find the language of sec. 721 or the partnership basis
rules unclear. On the contrary, we find it to be quite obvious
from those Code sections that a contribution of worthless debt is
not a contribution of property. Consequently, petitioner cannot
avoid the negligence penalty on this basis.
                                  -280-

tax required to be shown on the return for the taxable year, over

the amount of the tax imposed which is shown on the return.      Sec.

6662(d)(2)(A).195     The amount of the understatement is reduced by

that portion of the understatement that is attributable to the

tax treatment of any item by the taxpayer for which there is or

was substantial authority, if the relevant facts affecting the

item’s tax treatment are adequately disclosed in the return or in

a statement attached to the return and there is a reasonable

basis for the tax treatment of such item by the taxpayer.      Sec.

6662(d)(2)(B).      Petitioner relies on the substantial authority

standard as a defense to the application of the understatement

penalty.196

     The substantial authority standard is an objective standard

involving an analysis of the law and application of the law to



     195
        In a partnership-level proceeding, we do not calculate
the understatement or determine whether it is substantial for
purposes of sec. 6662. Because the penalties apply at the
partner level, the understatement must be calculated on the basis
of the partner’s return and is the subject of a computational
adjustment. A partner may file a claim for refund on the ground
that the Secretary erroneously imposed any penalty which relates
to an adjustment to a partnership item. Sec. 6230(c)(1)(C), (4);
see sec. 301.6221-1(c) and (d), Proced. & Admin. Regs.
(applicable to partnership taxable years beginning on or after
Oct. 4, 2001).
     196
        Even if sec. 7491(c) is applicable, respondent is not
required to introduce evidence as to substantial authority.
Petitioner bears both the burden of production and the burden of
proof as to these issues. See Higbee v. Commissioner, 116 T.C.
438, 446-447 (2001); H. Conf. Rept. 105-599, at 241 (1998), 1998-
3 C.B. 747, 995.
                               -281-

relevant facts.   Sec. 1.6662-4(d)(2), Income Tax Regs.   There is

substantial authority for a position if the weight of the

authorities supporting the treatment is substantial in relation

to the weight of authorities supporting contrary treatment.      Sec.

1.6662-4(d)(3)(i), Income Tax Regs.    Because the substantial

authority standard is an objective standard, the taxpayer’s

belief that there is substantial authority for the tax treatment

of an item is not relevant in determining whether there is

substantial authority for that treatment.    Id.   Relevant

authorities for this purpose are limited to materials such as

applicable provisions of the Code, regulations, revenue rulings

and revenue procedures, court cases, and legislative history.

Sec. 1.6662-4(d)(3)(iii), Income Tax Regs.197

     Petitioner has cited no substantial authority that might

provide a basis for reducing any understatement of income tax.

In the first place, the transaction between the Ackerman group

and CDR, Generale Bank, and CLIS, had no economic purpose.    The

transaction’s sole purpose was to transfer approximately $1.7

billion in built-in tax losses from the banks to Somerville S

Trust in exchange for a $10 million cash payment.    Although these



     197
        Conclusions reached in legal opinions or opinions
rendered by tax professionals are not authority; however, the
authorities underlying such expressions of opinion where
applicable to the facts of a particular case may give rise to
substantial authority. Sec. 1.6662-4(d)(3)(iii), Income Tax
Regs.
                                -282-

transfers were accomplished using the partnership basis rules, it

seems evident that Congress did not envision these rules’ being

used merely as a vehicle to transfer built-in losses from a tax-

indifferent party to an interested purchaser pursuant to a

prearranged plan.   As relevant to these circumstances, the

authorities are clear and firmly established:   a transaction that

lacks economic substance is not recognized for Federal tax

purposes.   See, e.g., Ferguson v. Commissioner, 29 F.3d at 101.

     Special rules apply in the case of a “tax shelter”, which

means a partnership or other entity, any investment plan or

arrangement, or any other plan or arrangement, if a significant

purpose of such partnership, entity, plan, or arrangement is the

avoidance or evasion of Federal income tax.   Sec.

6662(d)(2)(C)(iii).   In the case of any item of a taxpayer (other

than a corporation) which is attributable to a tax shelter, an

understatement shall not be reduced on the basis of substantial

authority unless the taxpayer reasonably believed that his tax

treatment of the item was more likely than not proper.   Sec.

6662(d)(2)(C)(i)(I) and (II).

     We have concluded that the transaction between the Ackerman

group and the Credit Lyonnais group had no economic substance,

its only purpose being to transfer built-in tax losses in

exchange for a $10 million cash payment.   Consequently, this

arrangement is considered a “tax shelter” for purposes of section
                                -283-

6662(d)(2)(C)(iii), and petitioner must demonstrate a reasonable

belief that SMP’s and Corona’s tax treatment of the transactions

in question was more likely than not the proper treatment.      Given

Mr. Lerner’s education, sophistication, and tax experience, as

well as the particular circumstances of these cases, we do not

believe that there was such a reasonable belief.

       A taxpayer is considered reasonably to believe that the tax

treatment of an item is more likely than not the proper tax

treatment if the taxpayer reasonably relies in good faith on the

opinion of a professional tax adviser; and if the opinion is

based on the tax adviser’s analysis of the pertinent facts and

authorities and unambiguously states that the tax adviser

concludes that there is a greater than 50-percent likelihood that

the tax treatment of the item will be upheld if challenged by the

IRS.    Sec. 1.6662-4(g)(4)(B), Income Tax Regs.   None of the tax

opinions that petitioner purportedly relied upon in preparing

SMP’s and Corona’s partnership tax returns unambiguously state

that there is a greater than 50-percent likelihood that the tax

treatment of the transactions at issue in these cases would be

upheld if challenged by the IRS.    Moreover, for the reasons

discussed below, we conclude that Mr. Lerner did not reasonably

rely on those opinions.    We conclude that petitioner did not have

substantial authority for his tax treatment of the transactions

at issue.
                                 -284-

     D.    Reasonable Cause

     No penalty shall be imposed under section 6662 with respect

to any portion of an underpayment if it is shown that there was a

reasonable cause for such portion and that the taxpayer acted in

good faith with respect to such portion.    Sec. 6664(c)(1).198   The

determination whether a taxpayer acted with reasonable cause and

in good faith is made on a case-by-case basis, taking into

account all pertinent facts and circumstances.    Sec. 1.6664-

4(b)(1), Income Tax Regs.     Generally, the most important factor

is the extent of the taxpayer’s effort to assess his proper tax

liability.    Id.   Circumstances that may indicate reasonable cause

and good faith include an honest misunderstanding of fact or law

that is reasonable in light of all of the facts and

circumstances, including the experience, knowledge, and education

of the taxpayer.199   Id.




     198
        The determination of whether a taxpayer acted with
reasonable cause and in good faith with respect to an
underpayment that is related to an item reflected on the return
of a pass-through entity is made on the basis of all pertinent
facts and circumstances, including the taxpayer’s own actions, as
well as the actions of the pass-through entity. Sec. 1.6664-
4(d), Income Tax Regs.
     199
        Petitioner bears the burden of production and burden of
proof with respect to the reasonable cause exception. Higbee v.
Commissioner, 116 T.C. at 446-447; H. Conf. Rept. 105-599, supra
at 241, 1998-3 C.B. at 995.
                                -285-

       In arguing that the reasonable cause exception applies,

petitioner points to his efforts to verify the factual

underpinnings of the contributed assets.

       Petitioner points first to the memorandum that Kaye Scholer

prepared in the course of Safari’s failed effort to acquire New

MGM.    We cannot agree that Kaye Scholer’s memorandum establishes

reasonable cause for SMP’s and Corona’s reporting positions.

Although Kaye Scholer’s legal due diligence provided Mr. Lerner

with a detailed picture of the relationships between the Credit

Lyonnais group and the MGM companies and the various tax

attributes that the Credit Lyonnais group possessed, that legal

due diligence occurred in the context of a proposed acquisition

of New MGM.    It did not involve the transactions at issue in the

instant cases.    In addition, the Kaye Scholer investigation

occurred in or about May 1996, before the sale of New MGM and MGM

Holdings’s dissolution, events which might have profoundly

affected any of the conclusions that Kaye Scholer reached

regarding the various tax attributes.200

       Petitioner points next to what he characterizes as an

extensive due diligence process involving his attorney, James


       200
        Petitioner contends that a major focus of this
investigation was establishing the amount of the NOLs, which
petitioner contends was an important aspect of the subsequent
transaction involving CDR. We cannot agree. Although Kaye
Scholer documented the NOLs in the various MGM companies, the
NOLs in MGM Group Holdings were by no means a “major focus” of
its investigation.
                                -286-

Rhodes.    Mr. Rhodes’s due diligence process, however, was

directed toward documenting the banks’ historical bases in the

SMHC receivables and stock and obtaining representations that the

banks did not write down the receivables or stock for accounting

or tax purposes or otherwise claim the tax attributes that the

Ackerman group sought to obtain.    See Exhibit 183-P (document

entitled “Basis Chronology”).    Mr. Rhodes conducted no due

diligence on the more germane issues of whether SMP received a

carryover basis in the SMHC receivables and stock, whether the

transaction had any substance for Federal tax purposes, whether

the assets underlying the SMHC receivables and stock had any

value, or whether the $79 million receivable represented bona

fide indebtedness.201

     Petitioner also points to his reliance on the

representations that Generale Bank and CLIS made with respect to

their tax bases in the contributed SMHC receivables.    In the

exchange and contribution agreement, CDR, Generale Bank, and CLIS

represented that they had received no payment of principal on the

SMHC receivables and had not written down their loans for

accounting or tax purposes.    Like Mr. Rhodes’s due diligence

investigation, the banks’ representations do not extend to the


     201
        On May 12, 1997, Mr. Rhodes asked for and received a
confirmation from White & Case that neither CDR, Generale Bank,
nor CLIS derived any U.S. tax benefit from the contribution of
the SMHC receivables and stock or the subsequent disposition by
Generale Bank and CLIS of their preferred interests in SMP.
                                -287-

particulars of the transaction between the Ackerman group and CDR

or otherwise indicate that the banks had the tax bases that Mr.

Lerner later claimed for the SMHC receivables.

      In trying to meet the reasonable cause exception,

petitioner focuses principally on his purported reliance on

“outside” professional tax advice.      Reliance on the advice of a

professional tax adviser constitutes reasonable cause and good

faith if, under all the circumstances, the reliance was

reasonable and the taxpayer acted in good faith.      Sec. 1.6664-

4(b)(1), Income Tax Regs.; cf. United States v. Boyle, 469 U.S.

241 (1985).   All facts and circumstances must be taken into

account in determining whether a taxpayer has reasonably relied

in good faith on the opinion of a professional tax adviser as to

the treatment of the taxpayer (or any entity, plan, or

arrangement) under Federal tax law.     Sec. 1.6664-4(c)(1), Income

Tax Regs.   The advice must be based upon all pertinent facts and

circumstances and the law as it relates to those facts and

circumstances.   Sec. 1.6664-4(c)(1)(i), Income Tax Regs.     For

example, the advice must take into account the taxpayer’s

purposes (and the relative weight of such purposes) for entering

into a transaction and for structuring a transaction in a

particular manner.   Id.   In addition, the taxpayer cannot

establish reasonable reliance if he fails to disclose a fact that
                               -288-

he knows, or should know, to be relevant to the proper tax

treatment of an item.   Id.

     The advice must not be based on unreasonable factual or

legal assumptions (including assumptions as to future events) and

must not unreasonably rely on the representations, statements,

findings, or agreements of the taxpayer or any other person.

Sec. 1.6664-4(c)(1)(ii), Income Tax Regs.   For example, the

advice must not be based upon a representation or assumption

which the taxpayer knows, or has reason to know, is unlikely to

be true, such as an inaccurate representation or assumption as to

the taxpayer’s purposes for entering into a transaction or for

structuring a transaction in a particular manner.   Id.

     Petitioner points to the following items that he claims he

relied upon:   (1) An August 27, 1996, memorandum from Gerald

Rokoff and Alvin Knott of Shearman & Sterling to Mr. Lerner; (2)

an August 30, 1996, memorandum from Messrs. Rokoff and Knott of

Shearman & Sterling to Mr. Lerner; (3) a February 21, 1997, draft

memorandum from Robert Feinberg and Jeffrey N. Bilskie of Ernst &

Young, LLP, to James Rhodes; (4) a May 12, 1997, memorandum of

Messrs. Rokoff and Knott of Shearman & Sterling to Messrs. Lerner

and Rhodes; (5) an October 10, 1997, memorandum from Messrs.

Rokoff and Knott of Shearman & Sterling to Mr. Lerner and Cynthia

Beerbower; (6) a February 26, 1998, memorandum from Mr. Knott of

Shearman & Sterling to Mr. Lerner; (7) a May 1, 1998, memorandum
                                 -289-

prepared by Howard Levinton of Grant Thornton, LLP; and (8) a

December 11, 1998, letter of opinion prepared by Joseph R.

Valentino of Chamberlain, Hrdlicka, White, Williams & Martin.202

We evaluate petitioner’s reliance on these purported opinions in

turn.203

           1.   August 1996 Memoranda From Shearman & Sterling

     Sometime before August 27, 1996, Mr. Lerner hired the law

firm of Shearman & Sterling, LLP, in New York City, to assist the

Ackerman group in the CDR transaction.     Mr. Lerner testified:



     202
        Petitioner also offered into evidence a Jan. 3, 1997,
memorandum from Messrs. Rokoff and Knott of Shearman & Sterling.
The memorandum discusses a proposed transaction involving SMP’s
transfer of high-basis assets to an existing corporation as part
of a sec. 351 contribution. The memorandum does not analyze or
discuss the transaction between the Ackerman group and CDR. In
fact, the memorandum states that “P’s current members acquired a
substantial portion of their interests in transactions unrelated
to that described in” the memorandum. Although the memorandum
analyzes whether an “ownership change” would occur under the sec.
382 rules, it does so in the context of the built-in loss rules
(not the rules regarding NOL carryovers). The proposed
transaction apparently did not occur, and we cannot agree that
any reasonable person, let alone a sophisticated tax attorney
like Mr. Lerner, would place any reliance on it in determining
the proper treatment of the CDR transaction. In any event, Mr.
Lerner testified that he relied on this memorandum in preparing
SMHC’s corporate tax return and not in preparing SMP’s and
Corona’s 1997 and 1998 partnership tax returns.
     203
        Petitioner listed James Rhodes, Howard Levinton, Gerald
Rokoff, and Alvin Knott as witnesses in his pretrial memorandum.
Petitioner called none of these witnesses to testify at trial.
Instead, petitioner relies solely on his own testimony and the
various documents to establish his reasonable cause position.
The law firm of Chamberlain, Hrdlicka, White, Williams & Martin
represented petitioner in these cases. Joseph R. Valentino did
not testify.
                               -290-

“When our conversation began with Rene Claude about acquiring MGM

Holdings, I already knew from the due diligence exercise before

that there were, I would say, complex tax issues arising from the

acquisition of that company”, including tax basis and NOL issues.

He testified that he asked Shearman & Sterling to give him “an

analysis of the ways in which a transaction could be organized

involving MGM Holdings so that any tax attributes that might have

existed could be preserved.”

     Shearman & Sterling prepared two memoranda summarizing the

anticipated U.S. tax consequences of certain hypothetical

transactions involving MGM Holdings.    Neither memorandum analyzes

the transaction that actually occurred between the Ackerman group

and CDR.   Notably, the memoranda propose a section 351 corporate

transaction involving MGM Holdings:    “In general, the most

favorable tax treatment would result if a section 351 transaction

took place in 1996, and the transactions triggering both the loss

and the gain took place in subsequent years.”204   The memoranda


     204
        In the first memorandum dated Aug. 27, 1996, Shearman &
Sterling analyzed two alternative transactions. In the first
alternative, the “Section 351 Transaction”, Acquirer, a U.S.
corporation, transfers property to a new or existing subsidiary
(“Sub”) in exchange for stock of Sub, and, concurrently, CDR
transfers all the stock of MGM Holdings to Sub in exchange for
cash and stock of Sub. After these transfers, Acquirer owns 80
percent of the vote and value of Sub. In the second alternative,
the “B Reorganization”, Acquirer acquires all the stock of MGM
Holdings from CDR in exchange for Acquirer’s publicly traded
voting common stock or voting preferred stock redeemable in 5
years.
                                                   (continued...)
                                -291-

provide no analysis of the partnership basis rules (specifically

section 704(c)) but instead focus on the recognition or

nonrecognition of gain or loss under section 351, the

consolidated loss disallowance and separate return limitation

year rules under section 1502, the built-in loss limitations of

section 382, the section 384(a) pre-acquisition loss rules, and

the section 269(a)(2) disallowance rules for tax-motivated

corporate acquisitions.    The memoranda propound a series of

hypothetical transactions, none of which appear to have actually

occurred, and do not rely on, or analyze, the relevant facts of

the CDR transaction.205   Consequently, we cannot agree that these

memoranda establish reasonable cause.



     204
       (...continued)
     In the second memorandum dated Aug. 30, 1996, Shearman &
Sterling also analyzed two alternative transactions. In the
first alternative, the “Section 351 Transaction”, Acquirer, a
U.S. corporation (“GCo”), transfers property to a new or existing
subsidiary (“DCo”) in exchange for stock of DCo, and,
concurrently, CDR transfers all the stock of MGM Holdings to DCo
in exchange for cash and stock of DCo. Immediately after these
transfers, GCo owns at least 80 percent of the vote and value of
DCo. In the second alternative, the “B Reorganization”, GCo
acquires all the stock of MGM Holdings from CDR in exchange for
GCo’s publicly traded voting common stock or voting preferred
stock redeemable in 5 years.
     205
        The memoranda were prepared before the closing date of
the New MGM transaction and MGM Holdings’s dissolution. Although
the memoranda acknowledge the New MGM sale and the existence of
tax attributes in MGM Holdings, the memoranda are framed in terms
of CDR’s “expected” basis in MGM Holdings’s stock following the
sale. The memoranda do not analyze these expectations or provide
any insight regarding CDR’s basis in MGM Group Holdings or the
effect of a dissolution of MGM Holdings.
                                 -292-

           2.   Ernst & Young Memorandum

     On February 21, 1997, Robert Feinberg and Jeffrey N. Bilsky

of Ernst & Young, LLP, prepared a draft memorandum which it sent

to Mr. Rhodes.    The draft memorandum is not an opinion letter and

is entitled “DRAFT”.    It purports to address SMP’s claimed tax

basis in the SMHC receivables and stock; however, it repeatedly

emphasizes that the scope of its review is limited, incomplete,

and cannot be relied on except for internal purposes.206   For

example, the draft memorandum begins:

     As you know, we have not been asked to perform a
     comprehensive tax basis study with respect to the
     subject assets. Consequently, the scope of our
     services and related procedures have been limited to
     reviewing the available materials and commenting as to
     their relevance and reasonableness for use in
     determining the tax basis of the assets. To the extent
     that additional documents and information become
     available, we will need to review our analysis since it
     could be materially affected.

     Our analysis may be used by current management of Santa
     Monica solely for internal purposes and may not be
     disclosed to third parties. When we are fully informed
     of the intended use of the information, including
     review of all related materials expected to be issued,
     we can further review whether disclosure to any third
     parties will be acceptable.




     206
        With respect to the SMHC receivables, Ernst & Young
reached a rather ambivalent conclusion: “We have seen nothing
inconsistent in the materials made available to date with the
view that the outstanding balance of the receivable in the hands
of Santa Monica could be as high as the amount reflected on the
contribution agreement”.
                                 -293-

The draft memorandum ends with the following statement:

     Given the limited scope of our review, and your desire
     for us to emphasize a quantitative as opposed to a
     qualitative review, please appreciate that more
     detailed procedures, analysis and review would be
     necessary before any reliance should be placed on our
     analysis for tax return or other tax filing purposes.
     We will be pleased to further discuss the opportunity
     for Ernst & Young LLP to become engaged to provide a
     more detailed analysis of tax basis.

We believe that the draft memorandum speaks for itself--any

reliance on that memorandum in preparing tax returns would be

plainly unreasonable.

           3.   May 12, 1997, Shearman & Sterling Memorandum

     On May 12, 1997, Gerald Rokoff and Alvin Knott of Shearman &

Sterling prepared a memorandum addressed to Messrs. Lerner and

Rhodes discussing certain issues relating to the CDR transaction

and SMP’s bases in the SMHC receivables and stock.    Mr. Lerner

testified that this memorandum was prepared in connection with a

possible merger transaction in which SMP’s stock and debt

interests in SMHC would be contributed to SMHC or another holding

company.    In connection with this proposed transaction, Mr.

Lerner testified that he sought and received the advice of

Shearman & Sterling as to whether the $79 million receivable and

the $974 million in receivables should be treated as worthless or
                                -294-

partially worthless, and whether the SMHC stock should be treated

as worthless.207

     The May 12, 1997, memorandum appears to have been prepared

as part of an effort to secure an outside opinion letter or

advice with respect to the CDR transaction.    Indeed, the letter

begins by stating:   “At your request, we have prepared the

following responses to the requests for additional background

materials set forth in Donald Alexander’s memorandum to you,

dated April 9, 1997.”208   In this regard, the May 12, 1997,

memorandum from Shearman & Sterling has a distinct quality of

advocating Mr. Lerner’s position rather than providing advice

that might reasonably be relied upon in preparing SMP’s and

Corona’s 1997 and 1998 partnership tax returns.

     The opinion itself deals primarily with the worthlessness

issue and concludes that the SMHC receivables and stock were not



     207
        Gerald Rokoff and Alvin Knott do not appear to have been
independent, “outside”, professional tax advisers, as petitioner
claims. Messrs. Rokoff and Knott represented the Ackerman group
in the CDR transaction and assisted Mr. Lerner in structuring the
partnership transactions at issue. Messrs. Rokoff and Knott
appear to have been actively involved in structuring transactions
for the Ackerman group’s subsequent exploitation of the acquired
built-in loss tax attributes, including as we explain below, the
“marketing” of the tax attributes to an outside “investor”.
     208
        Petitioner did not offer Donald Alexander’s memorandum
into evidence, and we have no basis for ascertaining its context.
There is no indication that Mr. Alexander (a former IRS
Commissioner) ever provided any favorable advice to petitioner
with respect to the proposed transaction or the issues discussed
in Shearman & Sterling’s memorandum.
                              -295-

worthless when those assets were contributed to SMP.   In

addressing that issue, Shearman & Sterling discusses Los Angeles

Shipbuilding & Drydock Corp. v. United States, 289 F.2d 222 (9th

Cir. 1961) and Higgenbotham-Bailey-Logan Co. v. Commissioner, 8

B.T.A. 566 (1927), cases which we have discussed supra in the

context of the worthlessness issue.   In concluding that the SMHC

receivables were not worthless under those cases, Shearman &

Sterling relied on the faulty factual assumption that the EBD

film rights and Carolco securities had considerable value.209   The

memorandum provided the following analysis:

          Debt of a corporation, such as * * * [SMHC], which
     has valuable assets that could be sold or exploited to
     pay off a portion of the debt is certainly not
     worthless. * * * [SMHC] has retained extensive films
     rights and properties which had been acquired by Credit
     Lyonnais in connection with its lending activities.
     Those rights include distribution rights to
     approximately sixty-five films, sequel rights and film
     development rights. In addition, * * * [SMHC] also
     owns approximately $60 million (face value) of the
     securities of Carolco, Inc., which is engaged in
     bankruptcy proceedings. The Company [SMP] is actively
     exploiting * * * [SMHC’s] film rights and the Company
     has commenced discussions with a number of parties to
     acquire additional film libraries. The Company is also
     pursuing its rights to maximize its recovery of its
     investment in Carolco.

          We understand that * * * [SMHC’s] rights in the
     Carolco investment have been valued at approximately
     $11 million. The projected income stream from the next
     cycle of * * * [SMHC’s] film rights has been estimated
     to have a present value of approximately $29 million
     and a future value in excess of $35 million. This


     209
        The Shearman & Sterling memorandum does not discuss
whether the NOLs in SMHC had any value.
                               -296-

     estimate does not include sequel rights, development
     projects, residual values or the proceeds of subsequent
     distribution cycles. The members of the Company
     believe that the going concern value of * * * [SMHC]
     should be based on a market multiple of * * * [SMHC’s]
     anticipated earnings. This valuation should take into
     account the contribution to be made by the joint
     ventures under consideration and the exploitation of
     * * * [SMHC’s] additional rights. The valuation
     currently given for comparable companies is in the
     range of 8 to 15 times earnings.

     When this memorandum was prepared it would have been clear,

at least to Mr. Lerner, that SMP was not “pursuing its rights to

maximize its recovery of its investment in Carolco.”   The record

contains no indication of any such efforts; indeed, as of April

3, 1997, the bankruptcy court had confirmed the fourth amended

plan of reorganization and also had confirmed that SMHC would

receive nothing for the Carolco securities.

     Shearman & Sterling’s conclusions were also based, in part,

on the dubious Sage Entertainment appraisal of the EBD film

rights and the Harch Capital Management report regarding the

Carolco securities.   For the reasons discussed supra, we do not

believe that Mr. Lerner reasonably relied on those purported

appraisals.   Moreover, although the memorandum was dated May 12,

1997, Mr. Lerner claims that he relied on it in October 1998 and

October 1999, when SMP’s and Corona’s partnership tax returns

were prepared and filed.   Clearly, by this time, on the basis of

Troy & Gould’s conclusions, Mr. Lerner should have recognized

that Mr. Kutner’s conclusions could not be relied upon.
                              -297-

     The memorandum also provides some discussion of the

transaction with CDR, describing it as follows:

     The Rockport Members interest in * * * [SMHC] did not
     originate with a desire to obtain a favorable tax
     attribute that could be used as a tax shelter. Rather,
     their interest originated in a desire to acquire all
     the assets of MGM and, when it became clear that they
     would not be able to acquire all such assets, to
     acquire certain valuable assets that remained. * * *

          The Rockport Members then decided to acquire an
     interest in * * * [SMHC]. GB and CLIS wanted to retain
     some interest in * * * [SMHC]. In this context, the
     Rockport Members, GB and CLIS, each for their own valid
     business reasons, became members of the Company in a
     way that made it possible to preserve a favorable tax
     attribute, namely the basis of the MGM Debt and the MGM
     Stock.

On this basis, Shearman & Sterling concluded:

          No transaction involving the Company should be
     recharacterized under substance over form principles.
     GB, CLIS and the Rockport Members became members by
     contributing property to the Company. At the time GB
     and CLIS transferred the MGM Debt and the MGM Stock to
     the Company, they were under no obligation to transfer
     any portion of their interest in the Company to any
     person. Thereafter, the Somerville S Trust purchased
     interests from GB and CLIS. GB and CLIS should not be
     treated as selling the MGM Debt and the MGM Stock to
     the Rockport Members who then contributed such property
     to the Company. Although courts have been willing to
     step transactions together, they have generally been
     reluctant to reverse the order of steps. [Discussing
     Esmark & Affiliated Cos. v. Commissioner, 90 T.C. 171
     (1988).]

     Shearman & Sterling’s description of the CDR transaction and

its conclusion are based on faulty factual assumptions regarding

the Ackerman group’s purposes for entering into the transaction

with CDR, Generale Bank, and CLIS.    To wit, we have concluded
                                 -298-

that the Ackerman group entered into the transaction solely to

exploit the banks’ built-in losses using section 704(c).      The

parties did not intend to partner in any film business; the

parties had a prearranged understanding that the banks would

exercise their put rights and immediately exit the partnership.

Petitioner cannot rely on Shearman & Sterling’s “advice”, which

unreasonably assumes a different purpose for the transaction and

its structure.    Sec. 1.6664-4(c)(1)(ii), Income Tax Regs.

     Shearman & Sterling’s May 12, 1997, memorandum was not

prepared in connection with the filing of SMP’s and Corona’s 1997

or 1998 partnership tax returns.    Further, Mr. Lerner testified

only that he relied on that memorandum in preparing SMHC’s 1997

corporate tax return.    He did not testify that he relied on the

memorandum to prepare SMP’s and Corona’s returns.     In any event,

we conclude that any such reliance would have been unreasonable.

           4.   October 10, 1997, Shearman & Sterling Memorandum

     Gerald Rokoff and Alvin Knott of Shearman & Sterling

prepared another memorandum dated October 10, 1997.     The

memorandum purports to summarize the anticipated tax consequences

of a proposed joint venture between the Ackerman group and “GCo”,

a U.S. corporation.210   The memorandum proposes two hypothetical

structures for this joint venture, a corporate structure and a


     210
        The memorandum does not identify “GCo” but acknowledges
that Crown Capital might deliver the memorandum to “GCo” in the
course of discussions.
                               -299-

partnership structure, and outlines the anticipated tax

consequences to the parties.   It states:   “In each proposed

structure, we believe that neither party should recognize current

gain or loss and that GCo, through the entity conducting the

joint venture, should effectively receive a carryover tax basis

in the assets of the joint venture.”

     The memorandum begins with a short “BACKGROUND” section that

describes the New MGM transaction and the transaction with CDR.

Shearman & Sterling reiterates its erroneous factual assumptions

(almost verbatim) from its May 12, 1997, memorandum; i.e., that

SMHC retained extensive film rights and properties, including the

65 EBD film titles, which had a present value of $29 million and

a future value in excess of $35 million and that SMP was actively

pursuing its rights to maximize its recovery of its investment in

the Carolco securities, which had been valued at approximately

$11 million.

     The memorandum proposes a section 351 transaction similar to

the transactions hypothesized in Shearman & Sterling’s August

1996 memoranda.   The memorandum discusses similar legal issues

and reaches similar conclusions as in the other memoranda.      The

memorandum also proposes a partnership transaction in which GCo

acquires 45 percent of the preferred interests and 45 percent of

the common interests in the partnership from the Ackerman group

for cash.   Under the proposed transaction, GCo would receive an
                               -300-

allocation of 45 percent of the built-in loss with respect to the

SMHC receivables and stock.   Shearman & Sterling then provided

the following legal analysis with respect to the transaction:

          The Proposed Partnership Transaction should not be
     recharacterized under the partnership anti-abuse
     regulation because:

          (a) Subchapter K, specifically section 704(c) and
     the regulations promulgated thereunder, contemplates
     and indeed mandates, the tax results set forth above;
     and

          (b) Although the parties will structure the
     Proposed Partnership Transaction to maximize their
     after-tax yield, GCo and the Rockport Members will
     engage in the joint venture for bona fide commercial
     purposes, namely to jointly develop the existing assets
     of the Company and GCo, and to invest together on a
     continuing basis through the Company.

The memorandum provides no further legal discussion; for example,

there is no discussion as to whether the transaction passes

muster under the economic substance doctrine or the step

transaction doctrine.   Moreover, the hypothetical transaction

described in the memorandum differs fundamentally from the

transaction involving the Ackerman group, CDR, Generale Bank, and

CLIS.   For instance, the proposed transaction does not

contemplate that any of the partners will exit the partnership,

and it assumes that the joint venture will be for bona fide

commercial purposes.

     Shearman & Sterling’s October 10, 1997, memorandum was not

prepared in connection with the filing of SMP’s and Corona’s 1997

or 1998 partnership tax returns.   It did not relate to a
                                 -301-

transaction that actually occurred involving SMP, Corona, or the

Ackerman group, and Mr. Lerner did not testify that he

specifically relied upon it in preparing SMP’s and Corona’s

returns.    We conclude that any reliance on the memorandum would

have been unreasonable.

           5.   February 26, 1998, Shearman & Sterling Memorandum

     Alvin Knott of Shearman & Sterling prepared another

memorandum dated February 26, 1998, regarding the criteria for

recharacterizing debt as equity.    Mr. Lerner testified that at

some point in early 1998, he was considering whether SMP should

capitalize the SMHC receivables.    He testified:   “It’s fair to

say that the debt was not performing at that time”, and he sought

and received the advice of Shearman & Sterling on the debt versus

equity issue.211

     Respondent does not argue that the SMHC receivables should

be recharacterized as equity.    Nonetheless, the Shearman &

Sterling memorandum addresses certain points that might be

relevant to our decision that the $79 million receivable did not

arise from a bona-fide debtor-creditor relationship.     Shearman &

Sterling indicates:    “Of the total amount loaned to MGM pursuant



     211
        Shearman & Sterling’s Feb. 26, 1998, memorandum again
relies on the same faulty factual assumptions: that SMHC held
valuable film rights estimated to have a present value of
approximately $29 million and a future value in excess of $35
million, and that SMHC was also pursuing its rights to maximize
the recovery of its investment in Carolco.
                               -302-

to * * * [working capital agreement], $298,835,633.58, or 79% of

the loan, was repaid.   As late as mid-1996, and for all periods

prior thereto, there was a clear expectation that the Holdings-

CLIS Debt would be paid.”

     Shearman & Sterling concluded that the $79 million

receivable represented a valid debt interest when issued because,

inter alia, the parties were unrelated, the terms of the debt

were largely based on terms negotiated at arm’s length when the

parties were unrelated, and MGM Group Holdings had the capacity

to pay at least some of the debt from its assets.   Shearman &

Sterling did not analyze whether MGM Group Holdings’ assumption

of the $79 million receivable represented a new debt and whether

that assumption established a valid debtor-creditor relationship.

Insofar as we have concluded that the $79 million represented new

debt, Shearman & Sterling’s conclusions are erroneous.    Credit

Lyonnais, the creditor with respect to the $79 million

receivable, was the parent company of CLIS.   CLIS, in turn, was

the sole shareholder of MGM Group Holdings when that entity

assumed New MGM’s $79 million debt obligation to Credit Lyonnais.

MGM Group Holdings, in turn, was the sole shareholder of New MGM.

All the parties were related, with Credit Lyonnais pulling the

strings.   The assumption of the $79 million debt was not

negotiated at arm’s length.   After New MGM was sold, MGM Group
                                  -303-

Holdings lacked the capacity to repay the debt from its assets--

it had no assets of any discernible value.

     Shearman & Sterling’s memorandum is limited to the debt

versus equity issue.     It does not discuss any other relevant

issues.    The memorandum was not prepared in connection with the

filing of SMP’s and Corona’s 1997 and 1998 partnership tax

returns.    It was offered into evidence only for the purpose of

showing that Mr. Lerner relied on it in characterizing the SMHC

receivables as debt on SMP’s 1998 partnership tax return.     We

conclude that this memorandum does not provide reasonable cause

for SMP’s or Corona’s tax treatment with respect to the relevant

issues in these cases.

           6.    Grant Thornton Memorandum

     The Ackerman group hired the accounting firm of Grant

Thornton, LLP, as its accountants for SMP and SMHC.     Howard

Levinton, who was a tax partner at Grant Thornton, was assigned

to SMP and SMHC.     In connection with the preparation of SMP’s and

SMHC’s tax returns, Mr. Levinton prepared a memorandum dated

May 1, 1998, concerning the tax issues regarding SMP.     Mr. Lerner

testified:      “I was particularly interested in his analysis of the

fact that Credit Lyonnais unexpectedly put the interest to us

easily a year ahead of what I expected it.     Not that I expected

it at all.      I thought that was very relevant in the preparation

of the return because it affected any number of issues.”     Mr.
                                -304-

Lerner testified that he relied on this memorandum with respect

to SMP’s 1997 partnership tax return.

     Initially, we question whether Mr. Lerner ever received the

memorandum that Mr. Levinton prepared, let alone whether he

relied upon it with respect to SMP’s 1997 return.     The memorandum

is not addressed to Mr. Lerner but is addressed to “File” and is

entitled “Inter Office Memorandum”.     The memorandum is not an

opinion letter, and there is no indication that Mr. Levinton

prepared the memorandum intending that Mr. Lerner rely on it with

respect to SMP’s 1997 return.   Although petitioner listed Mr.

Levinton as a potential witness in his pretrial memorandum,

petitioner did not call Mr. Levinton to testify.

     In reaching his conclusions, Mr. Levinton relies on a number

of assumptions, including:   (1) SMP was formed to exploit the

remaining film libraries owned directly by CLIS; (2) Generale

Bank and CLIS demanded the side letter agreement because of the

absence of a clearly defined exit strategy; and (3) after

Generale Bank and CLIS joined SMP as partners, the French

government, exercising its rights to regulate its banking

industry, determined that Generale Bank and CLIS should cease

their involvement in the movie business.     Petitioner failed to

establish that any of these assumptions are accurate.     The

evidence in the record indicates that SMP was formed to

facilitate the transfer of $1.7 billion of built-in losses from
                               -305-

Generale Bank and CLIS to the Ackerman group and that the banks

demanded the side letter agreement because they full intended and

planned to exit SMP as expeditiously as possible.   There is no

evidence that the banks exited SMP as a result of the French

government’s intervention.

     Mr. Levinton examined the operation of the partnership tax

rules, including sections 721, 722, 723, and 704(c), as well as

the regulations thereunder.   He concluded that “assuming the form

of the transaction is respected, Rockport would succeed to the

position of CLIS and GB with respect to the built in loss

attributable to their contributed property.”

     Mr. Levinton referred to Shearman & Sterling’s May 12, 1997,

memorandum, agreeing:   “The debt will not be worthless.”   Mr.

Levinton pointed out that upon the formation of SMP, the

contributed stock and debt were “valued” at $5 million in the

aggregate and that this might present an argument as to whether

the debts were nominal or “de minimis”; however, he concludes

that $5 million is not nominal or “de minimis” compared to $0.

Mr. Levinton did not discuss the value of the assets underlying

the debts and stock and assumed, without any explanation, that

the stock and debt had a value of $5 million.

     Mr. Levinton alluded to Generale Bank’s and CLIS’s put

rights in the side letter agreement and observed:

     Cast in its most unfavorable light, it could be argued
     that, at the same time CLIS and GB were negotiating to
                                 -306-

     enter the LLC; they were negotiating to exit the LLC.
     The ultimate fact to be drawn from that unfavorable
     assumption is that CLIS and GB never intended to be,
     and never in fact were, true partners. If the
     participation of CLIS and GB as partners in the
     transaction is ignored, then Rockport would be deemed
     to have purchased the stock and debt from GB and CLIS
     on December 31 rather than the Preferred Interests, and
     such stock and debt would then be considered to have
     been contributed to the LLC at a basis equal to the
     purchase price to Rockport paid to CLIS and GB rather
     than the $1.7 billion. In other words, CLIS’s and GB’s
     transitory ownership of LLC member interests would be
     disregarded.

Mr. Levinton then examined whether the partnership antiabuse

regulation or the step transaction doctrine would apply to

disregard Generale Bank’s and CLIS’s contributions to SMP and

recast the transactions as a direct sale of the high-basis

receivables and SMHC stock.     Mr. Levinton concluded that these

legal theories would not apply because:     (1) Generale Bank and

CLIS intended to become members of SMP and to remain participants

in a film venture; (2) it was only an extraneous and unforeseen

circumstance that caused Generale Bank and CLIS to exercise their

put rights; (3) Generale Bank and CLIS had no immediate intention

to sell their preferred interests to Rockport or anyone else; and

(4) the relationships created through the contributions of debt

and stock were bona fide and not undertaken in a manner designed

to shift a tax loss to, or create a tax loss for, a U.S.

taxpayer.212


     212
           Mr. Levinton examined, in great detail, Esmark &
                                                      (continued...)
                                 -307-

     For the reasons discussed in great detail in this opinion,

Mr. Levinton’s assumptions about Generale Bank’s and CLIS’s

intentions to partner in a film venture with the Ackerman group

are erroneous and contrary to what we have found to be Mr.

Lerner’s understanding of the CDR transaction.      Consequently, we

cannot agree that Mr. Lerner reasonably relied on Mr. Levinton’s

memorandum in filing SMP’s 1997 partnership tax return.

           7.   Opinion From Chamberlain Hrdlicka

     In 1998, Mr. Lerner sought and received the advice of

Chamberlain, Hrdlicka, White, Williams & Martin (Chamberlain

Hrdlicka) concerning the tax issues regarding SMP.     Joseph R.

Valentino of Chamberlain Hrdlicka prepared a memorandum to Mr.

Lerner dated December 11, 1998, regarding the adjusted basis for

Federal income tax purposes that SMP had in the SMHC receivables

and stock.

     The Chamberlain Hrdlicka memorandum consists of 19 pages.

Eleven of the 19 pages are dedicated to a statement of facts.



     212
       (...continued)
Affiliated Cos. v. Commissioner, 90 T.C. 171 (1988). Mr.
Levinton posited that “the pivotal factual issue that makes
Esmark persuasive, if not controlling, is that GB and CLIS
entered the LLC with the intention of remaining participants in
it, and with no immediate intention to sell to Rockport or anyone
else”. Mr. Levinton cautioned, however, that the Generale Bank’s
and CLIS’s contributions to SMP in exchange for preferred
interests might be viewed as a meaningless step under Esmark, if
neither Generale Bank nor CLIS ever intended to become members of
SMP and did so only as an intermediate and meaningless step in
disposing of the stock and receivables.
                               -308-

These facts are for the most part undisputed and relate primarily

to the history of MGM and the SMHC receivables and stock.   Of the

remaining eight pages in the memorandum, six are dedicated to

“QUALIFICATIONS AND LIMITATIONS” to the opinion.   This section of

the opinion states, among other things, that “our understanding

is based upon certain assumptions [42 in toto] that you have

allowed us to make, the accuracy of which we have not

independently investigated.”   These assumptions include, among

many others:

          33. At the time of the Exchange Agreement, CLIS,
     GBN, and Consortium [CDR] intended for CLIS and GBN to
     join together with Lerner, Rockport, and Somerville in
     the present conduct of an enterprise to form a valid
     partnership and to share in the profits and losses
     therefrom under the terms of the LLC Agreement.

          34. At the time of the Exchange Agreement, none
     of CLIS, GBN, and Consortium intended for CLIS and GBN
     to acquire its interest in the Company solely to
     receive a specific return on its investment independent
     of the Company’s performance and success.

          35. The payments made to CLIS under the * * *
     [advisory fee agreement] were not intended to reimburse
     either CLIS, GBN, or Consortium for their expenses
     associated with acquiring an interest in the Company.

          36. The income and loss allocations provisions
     and the distribution provisions in the LLC Agreement,
     including its amendments, gave both CLIS and GBN a true
     economic interest in the Company’s profits and losses
     and were not merely artifices to pay CLIS and GBN a
     specified return on its interest in the Company.

          37. Each of Rockport, Lerner, Somerville, CLIS,
     and GBN formed the Company with the intent to develop
     and promote the remaining entertainment assets held by
     CL following the MGM Sale, the Carolco Notes, and the
                                -309-

     Carolco Stock with a view towards making an economic
     profit apart from tax consequences.

          42. The Third Amendment was duly executed by the
     Company’s Manager so that the Company and each of its
     Members are bound by the provisions of the Third
     Amendment under applicable local laws.

     For the reasons discussed in this opinion, we conclude that

CDR, Generale Bank and CLIS did intend for the banks to exercise

their put rights and to exit SMP as expeditiously as possible,

that Mr. Lerner had this same understanding, and that the

interests of all parties were directed towards the banks’

transferring their built-in losses to the Ackerman group for a

$10 million cash payment.   Because the Chamberlain Hrdlicka

opinion is grounded on erroneous factual assumptions that Mr.

Lerner knew were untrue, we cannot agree that he reasonably

relied on that opinion in preparing SMP’s and Corona’s 1997 and

1998 partnership tax returns.

     The last section of the opinion, which contains Chamberlain

Hrdlicka’s legal conclusions, is two pages long.    Chamberlain

Hrdlicka concludes that SMP had a $551,600,856 basis in the SMHC

stock, a $79,912,955.34 basis in the $79 million receivable that

CLIS contributed, and a $975,494,909.84 basis in the $974 million

in receivables that Generale Bank contributed.    Chamberlain

Hrdlicka reaches these conclusions without any legal analysis or

citation to the Code, the regulations, or caselaw.    Instead,

Chamberlain Hrdlicka states simply:     “In reaching our opinions,
                                -310-

we have considered the business and tax purposes for the

Transactions and have analyzed the Tax Laws (as defined below) as

they relate to the facts and circumstances described in this

letter associated with the Transactions in the manner described

in, and required by, Treas. Reg. §§ 1.6662-4(d)(3) and 1.6664-

4(c).”    It defines the term “Tax Laws” as “existing provisions of

the Code, the Treasury Department regulations promulgated

thereunder (final, temporary, and proposed), published revenue

rulings and revenue procedures of the Internal Revenue Service *

* *, reports, and statements of congressional committees and

members, and judicial decisions”.    Chamberlain Hrdlicka, however,

does not cite the particular items that it purportedly relied

upon.    In fact the only citation in the opinion is to section

1.6662-4(d)(3) and 1.6664-4(c), Income Tax Regs., relating to

substantial authority and reasonable cause.    Under these

circumstances, we cannot agree that the Chamberlain Hrdlicka

opinion provides any basis for reliance.

     Chamberlain Hrdlicka’s opinion concludes by stating:

          A number of issues raised by the matters addressed
     in this letter, including matters upon which we have
     stated our opinions, are complex and have not been
     definitively resolved by the Tax Laws. The opinions
     that we state in this letter are based upon our
     interpretation of existing law and our belief regarding
     what a court should conclude if presented with the
     relevant issues properly framed. But we can give no
     assurances that our interpretations will prevail if the
     issues become the subject of judicial or administrative
     proceedings. Realizing the tax consequences set forth
     in this letter is subject to the risk that the IRS may
                               -311-

     challenge the tax treatment and that a court could
     sustain the challenge. Because the Company would bear
     the burden of proof required to support items
     challenged by the IRS, in rendering our opinions, we
     have assumed that the Company, or other appropriate
     taxpayer, will undertake the effort and expense to
     present fully the case in support of any matter that
     the IRS challenges.

We conclude that Mr. Lerner did not reasonably rely on the

Chamberlain Hrdlicka opinion in preparing SMP’s and Corona’s 1997

and 1998 partnership tax returns.213

           8.   Conclusion

     We conclude that the advice that petitioner claims he relied

upon in preparing SMP’s and Corona’s 1997 and 1998 partnership

tax returns does not satisfy the reasonable cause exception and

does not provide a basis for avoiding the accuracy-related

penalties.




     213
        The Chamberlain Hrdlicka opinion was issued after Mr.
Lerner prepared and filed SMP’s and Corona’s 1997 partnership tax
returns. Mr. Lerner claims, however, that he had discussions
with Mr. Valentino prior to filing the 1997 returns and that Mr.
Valentino’s oral advice closely tracked the written advice, as
well as Mr. Levinton’s conclusions. Mr. Lerner did not call Mr.
Valentino as a witness, and, with the exception of Mr. Lerner’s
self-serving testimony, we have no basis for determining the true
nature of Mr. Lerner’s discussions with Mr. Valentino or any way
to gauge his reliance on any advice Mr. Valentino might have
given. In any event, if the advice was consistent with the
Chamberlain Hrdlicka opinion letter, Mr. Lerner could not have
reasonably relied upon it.
                               -312-

XII. Evidentiary Matters

     A.   Daubert Issues

     The parties have submitted expert opinions (in addition to

those previously discussed) that they assert are relevant.

Petitioner submitted the expert report and testimony of Todd

Crawford of Deloitte & Touche, LLP, Houston, Texas.   Respondent

submitted the expert reports and testimonies of Louise Nemschoff

and Alan C. Shapiro.   Before trial, the parties filed respective

motions in limine to the expert opinions of Mr. Crawford, Ms.

Nemschoff, and Mr. Shapiro.   At trial, we conditionally admitted

the expert reports and testimonies of these witnesses and took

the parties’ objections under advisement, affording the parties

an opportunity to brief their objections in relation to the

issues in these cases.

     Under rule 702 of the Federal Rules of Evidence:

          If scientific, technical, or other specialized
     knowledge will assist the trier of fact to understand
     the evidence or to determine a fact in issue, a witness
     qualified as an expert by knowledge, skill, experience,
     training, or education, may testify thereto in the form
     of an opinion or otherwise, if (1) the testimony is
     based on sufficient facts or data, (2) the testimony is
     the product of reliable principles and methods, and (3)
     the witness has applied the principles and methods
     reliably to the facts of the case.

In Daubert v. Merrell Dow Pharms., Inc., 509 U.S. 579, 597

(1993), the U.S. Supreme Court held that, under the Federal Rules

of Evidence, the trial judge must ensure as a precondition to

admissibility that any and all scientific testimony rests on a
                                 -313-

reliable foundation and is relevant.     In Kumho Tire Co. v.

Carmichael, 526 U.S. 137, 149 (1999), the Supreme Court extended

this requirement to all expert matters described in Rule 702,

Fed. R. Evid.214   Under Daubert and Kumho Tire Co., a trial court

bears a “special gatekeeping obligation” to ensure that any and

all expert testimony is relevant and reliable.     Caracci v.

Commissioner, 118 T.C. 379, 393 (2002).     In exercising this

function, trial judges have “considerable leeway in deciding in a

particular case how to go about determining whether particular

expert testimony is reliable.”     Kumho Tire Co. v. Carmichael,

supra at 152; see also Haarhuis v. Kunnan Enters., Ltd., 177 F.3d

1007, 1014-1015 (D.C. Cir. 1999).

           1.   Mr. Crawford

     Mr. Crawford is a certified public accountant and a lead tax

services partner at Deloitte & Touche.    He has 20 years’ tax

experience relating to acquisitions, mergers, reorganizations,

and other complex corporate/entity transactions.    From 1990 to

2002, Mr. Crawford served as a member of Arthur Andersen’s

National Mergers and Acquisitions and Subchapter C Team.




     214
        Although Daubert and Kumho Tire Co. provide a hurdle for
the admissibility of expert testimony, the Federal Rules of
Evidence continue to provide a liberal standard for the
admissibility of expert testimony. See Daubert v. Merrell Dow
Pharms., Inc., 509 U.S. 579, 588 (1993); United States v.
Dukagjini, 326 F.3d 45, 57 (2d Cir. 2003).
                                 -314-

     Mr. Crawford’s expert report addresses two questions:     (1)

Whether unused NOLs of a target company are taken into account in

determining its value to a hypothetical willing buyer and

hypothetical willing seller; and (2) whether unused NOLs of SMHC

(totaling $260,098,293) had potential value to that company and

the amount of that value as of December 11, 1996.    Mr. Crawford

concluded that based on his research and experience:    (1) Unused

NOLs of a target company are taken into account in determining

the value of a target to an acquirer; and (2) NOLs of SMHC would

have had value to a hypothetical willing buyer and hypothetical

willing seller of that company prior to the transactions that

occurred on December 11, 1996.    He concluded that the NOLs in

SMHC would have had a value in the range of $620,000 to

$1,245,000.   In arriving at this range, Mr. Crawford first

propounded a reasonable, projected utilization of NOLs by a

hypothetical acquirer; second, he applied a present value

analysis to the projected utilization of NOLs back to December

11, 1996, using a rate (10 percent) that estimated the weighted

average cost of capital during that period; and third, he applied

a 98- to 99-percent risk-related discount to that result.215




     215
        In calculating the present value of the NOLs, Mr.
Crawford discounted one year too many, causing his calculations
to be off by one year. Although this error would serve to
increase the range of values that Mr. Crawford determined, it
leads us to question the reliability of his valuation as a whole.
                               -315-

     At trial, respondent essentially conceded that NOLs might

have some potential, but speculative, value to an acquirer if the

acquisition were properly structured within the strictures of

section 382.   We extrapolate from respondent’s concession that

the NOLs in SMHC likewise might have had some potential, but

speculative, value to an acquirer.     The parties dispute, however,

Mr. Crawford’s valuation of the NOLs in SMHC.

     In making his valuation conclusions, Mr. Crawford relied

exclusively upon his experience in corporate NOL transactions.

Mr. Crawford, however, has no specific background in valuation;

nothing in his testimony or report indicates that he is qualified

to value the NOLs in SMHC.   Indeed, it appears that critical

elements of Mr. Crawford’s valuation, including his income

projections, his weighted average cost of capital, and his

discount rate, were lifted from Mr. Wagner’s expert report.

Further, although Mr. Crawford testified that his experience in

corporate NOL transactions involves valuations of NOLs, he failed

to explain whether he personally makes or reviews, or has any

substantial role in making or reviewing, those valuations.    He

also failed to correlate his valuation methodology to his

purported experience in valuing NOLs and to explain whether he

makes, reviews, or relies upon valuations similar to the

valuation in his expert report.   Although Mr. Crawford states

that he selected a 98- to 99-percent risk-related discount rate
                                -316-

“in the interest of determining a conservative value”, he

admitted that his selection was inherently subjective and that

the value he arrived at reflects a speculative value.

     Ultimately, we are led to the conclusion that Mr. Crawford’s

expert testimony lacks a sufficiently reliable basis upon which

to reach an opinion as to the value of the NOLs in SMHC.     See

United States v. Fredette, 315 F.3d 1235, 1240 (10th Cir. 2003)

(“a witness ‘relying solely or primarily on experience’ must

‘explain how that experience leads to the conclusion reached, why

that experience is a sufficient basis for the opinion, and how

that experience is reliably applied to the facts.’” (quoting Fed.

R. Evid. 702, Adv. Comm. Note.)).   Accordingly, we exclude Mr.

Crawford’s expert report and testimony.216

           2.   Ms. Nemschoff

     Ms. Nemschoff is an entertainment attorney who has

represented a wide variety of institutional and individual

clients in both domestic and international transactions in film,

television, the visual arts, publishing, music, and multimedia.

She has been in practice for more than 25 years.   She has

published a number of articles and spoken extensively in the U.S.


     216
        Even if we were to admit Mr. Crawford’s report and
testimony into evidence, his valuation analysis would not
materially affect our decisions in these cases. Given the
speculative nature of Mr. Crawford’s conclusions and the
complexity of making any predetermination of whether the NOLs
might survive the gauntlet of sec. 382, we would give little
weight to his valuation analysis.
                                -317-

and Europe on various aspects of copyright, trademark, and

entertainment law, including the transfer of film rights and

chain-of-title issues.217   She serves on the arbitration panel and

the legal committee of the International Film & Television

Alliance (IFTA), formerly known as the American Film Marketing

Association.218

              a.   Ms. Nemschoff’s Expert Opinion

     Ms. Nemschoff submitted her report and testimony on the

following matters:

          (1) the contractual terms, legal documentation of
     ownership and pre-closing research that would be
     reasonably and customarily expected in connection with
     the acquisition of rights in motion pictures;

          (2) the steps customarily taken by a transferee of
     film rights to protect its ownership in the acquired
     rights;

          (3) any deficiencies and discrepancies in the
     legal documentation obtained and research undertaken by
     SMP in connection with its acquisition of the “U.S.
     Video Film Rights” in 65 film titles and 26 development
     projects purportedly owned by SMHC, including
     discrepancies in the ownership of rights as disclosed
     by U.S. Copyright Office records; and

          (4) any deficiencies and discrepancies in the
     steps taken by SMP to protect its rights in these
     assets.



     217
        At one time, Ms. Nemschoff served as general counsel and
vice president of business affairs at Concorde-New Horizons
Corp., a motion picture production and distribution company.
     218
        The legal committee of the International Film &
Television Alliance addresses the transfer of film rights, chain-
of-title issues, and copyright issues.
                                 -318-

     Ms. Nemschoff concluded that the steps taken by SMP and SMHC

contrast sharply with those that would normally be expected from

a party undertaking such a transaction in a number of key areas,

including identification of the film titles and the rights being

acquired, warranties and representations regarding ownership,

chain of title, delivery materials, and recordation of the

transaction.    She opined that the acquisition was conducted in a

manner that strongly suggests a lack of concern on SMP’s part

with respect to its ownership of the film titles or its ability

to exploit them.    Instead, she observed that SMP apparently

adopted the relatively risky strategy of acquiring the film

titles with only minimal information as to the film titles

themselves, the rights being acquired, and the availability of

the physical materials necessary for their exploitation.    Ms.

Nemschoff’s conclusions were based primarily, if not solely, on

her experience as an entertainment attorney.

               b.   Petitioner’s Arguments

     In his motion in limine and on brief, petitioner argues that

we should exclude Ms. Nemschoff’s expert report and testimony

under Daubert v. Merrell Dow Pharms., Inc., 509 U.S. 579 (1993),

and Kumho Tire Co. v. Carmichael, 526 U.S. 137 (1993).     First,

petitioner argues that Ms. Nemschoff’s report is unreliable

because it broadly asserts what is typical and customary with

respect to film-transfer transactions but fails to support that
                                -319-

assertion with a survey, proper sampling of the industry, or any

other type of study among companies acquiring rights, or with any

outside reliable source such as a treatise, contract form book,

practice guide, or material she may have published.    Relying upon

Daubert and Kumho Tire, petitioner contends that Ms. Nemschoff’s

legal practice and experience are insufficient to establish the

requisite degree of reliability under rule 702, Federal Rules of

Evidence.    Petitioner contends that there is an insurmountable

analytical gap between Ms. Nemschoff’s opinions as to what are

typical and customary steps in transferring film rights and her

conclusion that a failure to take such steps in the transaction

with CDR indicates SMP’s lack of interest in acquiring and

exploiting film rights.    Finally, petitioner claims that certain

flaws in Ms. Nemschoff’s legal practice and experience undermine

her ability to comment on what is typical and customary in

transfers of film rights.    Notably, petitioner contends that Ms.

Nemschoff has not identified how many times she has drafted or

reviewed a contract or worked on matters involving films or film

libraries.

              c.   Court’s Analysis

     Personal experience and knowledge can be a reliable and

valid basis for expert testimony in many cases.    See Kumho Tire

Co. v. Carmichael, supra at 150; United States v. Fredette, supra

at 1239-1240; Groobert v. President of Georgetown Coll., 219 F.
                                -320-

Supp. 2d 1, 7 (D.D.C. 2002).    Ms. Nemschoff has more than 25

years of relevant legal experience in the entertainment industry.

As an entertainment attorney, Ms. Nemschoff deals primarily with

film and television rights.    She has been involved in the sale

and purchase of media libraries (including individual media

rights), in the licensing of media rights, and in copyright

registration, renewal, and restoration of media rights.    She has

negotiated, drafted, and reviewed a large number of distribution

agreements.    As a member of IFTA’s legal committee, Ms. Nemschoff

has participated in developing and updating model agreements or

form agreements for distribution.    She has also given advice on

chain-of-title issues to filmmakers and others seeking production

financing.    She has mediated disputes involving media rights and,

in that context, has seen a number of single-picture and multi-

picture distribution agreements and the kinds of disputes that

arise from those agreements.    Ms. Nemschoff has been involved in

qualifying distributors for errors and omissions insurance, which

requires opining that the chain of title on a film is clear and

that there have been no violations of copyrights or defamation

problems.     In some cases, this process required creating

agreements to establish the chain of title for a film.

     We conclude that Ms. Nemschoff’s experience in the

entertainment industry provides a reliable basis for commenting

on what is typical and customary in the transfer of film rights
                               -321-

and for analyzing the deficiencies and discrepancies in the

transfer of the EBD film library from CLIS to SMHC.   With respect

to petitioner’s specific concerns regarding Ms. Nemschoff’s

experience in drafting contracts and working on film or film

library transfers, we believe those concerns go more to the

weight to which her opinion is entitled than to its admissibility

under Daubert v. Merrell Dow Pharms., Inc., supra, and Kumho Tire

Co. v. Carmichael, supra.219

     Although we conclude that Ms. Nemschoff’s opinion is

admissible into evidence, we do not need to rely on her opinion

to reach our conclusions in these cases.   For the reasons

discussed in more detail above, we find ample evidence in the

record to show that the Ackerman group’s investigation of SMHC’s



     219
        In preparing her report, Ms. Nemschoff retained the
services of the law offices of Dennis Angel to search the records
of the U.S. Copyright Office with respect to the film titles in
the EBD film library. Ms. Nemschoff represents that it is
customary for entertainment lawyers to rely on copyright searches
and reports by professionals such as Mr. Angel and his staff and
that she has been retaining his services and relying on his
copyright searches and reports for at least 15 years.

     Under Fed. R. Evid. 702 and 703, experts are permitted to
rely on evidence outside the trial record, which may include
hearsay that is otherwise inadmissible. RLC Indus. Co. & Subs.
v. Commissioner, 98 T.C. 457, 499 (1992), affd. 58 F.3d 413 (9th
Cir. 1995); H Group Holding, Inc. v. Commissioner, T.C. Memo.
1999-334. The information that Mr. Angel relayed to Ms.
Nemschoff is admitted to understand or explain the basis of her
expert opinion; however, we do not rely on that information or
consider it for the truth of the matters asserted therein. See
Engebretsen v. Fairchild Aircraft, Corp., 21 F.3d 721, 728-729
(6th Cir. 1994); H Group Holding, Inc. v. Commissioner, supra.
                                  -322-

film rights before the CDR transaction was not only deficient but

essentially nonexistent.      We reach our conclusions primarily on

the basis of that evidence.      We refer to Ms. Nemschoff’s report

and testimony only as additional support for our conclusions.

           3.   Mr. Shapiro

     Mr. Shapiro has a Ph.D. in economics and is a professor of

banking and finance at the Marshall School of Business,

University of Southern California.        Mr. Shapiro has held a number

of professorial positions and has taught banking, finance, and

economics at a number of institutions in the U.S. and abroad.

Mr. Shapiro has authored numerous articles and books on banking,

finance, and economics, and he has testified in a number of court

proceedings.

                a.   Mr. Shapiro’s Expert Opinion220

     Mr. Shapiro submitted his report and testimony on the

following matters:

          (i) the value of the SMHC stock that CLIS
     contributed to SMP at the time it was contributed;

          (ii) the value of the $79,912,955 of indebtedness
     that MGM Group Holdings owed to CLIS and the
     $974,296,600 of indebtedness that MGM Group Holdings
     owed to Generale Bank at the time those items were
     contributed to SMP; and




     220
        Mr. Shapiro also submitted a rebuttal report to Mr.
Crawford’s expert opinion, which we received into evidence
without objection.
                                -323-

          (iii) the value of SMHC’s interest in the Carolco
     securities at the time the SMHC stock was contributed
     to SMP.

Mr. Shapiro concluded:

          (i) the stock that CLIS contributed to SMP had no
     value at the time it was contributed;

          (ii) the $79,912,955 of indebtedness that SMHC
     owed to CLIS and the $974,296,600 of indebtedness that
     SMHC owed to Generale Bank had no value at the time
     those items were contributed to SMP; and

          (iii) the Carolco securities that SMHC owned had
     no value at the time the SMHC stock was contributed to
     SMP.

In reaching his conclusions, Mr. Shapiro conducted an economic

analysis of the CDR transaction and the events leading up to that

transaction.

     Mr. Shapiro first observed that as of October 10, 1996, the

only asset in SMHC was the Carolco securities, which he

determined were worthless.221   In Mr. Shapiro’s opinion, because

there was no value in any underlying assets in SMHC, the SMHC

stock and the approximately $1 billion in indebtedness were also

worthless as of October 10, 1996.


     221
        Relying on the information contained in the bankruptcy
plans of reorganization, including the various scenarios
discussed in the disclosure statements, Mr. Shapiro observed that
the total estimated amount of asserted claims that had a higher
priority than SMHC’s Carolco securities was $557,482,968. Thus,
for SMHC to receive anything, the net proceeds from Carolco’s
liquidation would have to exceed $557,482,968. The net proceeds
were projected to be far less, however--between $66,491,040 and
$93,027,900. On the basis of this and other information, Mr.
Shapiro concluded that there was no reasonable expectation of
receiving anything on the Carolco securities as of Dec. 11, 1996.
                               -324-

     Second, Mr. Shapiro opined that it would not be rational for

CLIS to contribute the EBD film library to SMHC in its capacity

as an equity holder of SMHC because:   (1) The face amount of

SMHC’s debt was greater than the value of its assets as of

December 10, 1996; and (2) SMHC’s creditors with priority claims

would capture the value of any contribution.222   Moreover,

although debt holders may generally have an incentive to make

additional investments to a company in proportion to their

claims, he observed that it would not be rational for one of the

debt holders on its own to undertake an investment that would

benefit it in an amount less than the cost of the investment.

Thus, because Generale Bank held a more significant debt claim in

SMHC, he opined that it would not be rational for CLIS to

contribute the EBD film library in its capacity as a debt holder

of SMHC.   Mr. Shapiro concluded that “the true economic reality

of this transaction is that CLIS contributed the Film Rights to

SMP and not to SMHC.”223



     222
        Mr. Shapiro describes this phenomenon as the
“underinvestment problem”; i.e., debtholders will appropriate
value created by a new equity infusion, and, therefore, such
equity infusions do not occur. Mr. Shapiro assumed that Generale
Bank and CLIS were unrelated for purposes of his analysis.
     223
        Mr. Shapiro also observed that the $5 million advisory
fee exactly equaled SMP’s “cost basis” in the EBD film library.
On this basis, without elaboration, Mr. Shapiro concluded: “It
appears that CLIS was paid separately for its Film Rights in the
guise of an advisory fee, instead of being paid for the Film
Rights as part of the price paid for SMHC’s debt.”
                               -325-

     Third, because the Carolco securities had no value and the

contribution of film rights was in economic reality to SMP and

not SMHC, Mr. Shapiro concluded that there were no assets of

value supporting the contributed debts, and, therefore, those

debts were worthless.

             b.   Court’s Analysis

     Under Rule 702, Fed. R. Evid., expert testimony is

admissible where it assists the Court to understand the evidence

or to determine a fact in issue.     ASAT, Inc. v. Commissioner, 108

T.C. 147, 168 (1997).   Expert testimony that expresses a legal

conclusion does not assist the Court and is not admissible.

Alumax, Inc. v. Commissioner, 109 T.C. 133, 171 (1997), affd. 165

F.3d 822 (11th Cir. 1999); Hosp. Corp. of Am. & Subs. v.

Commissioner, 109 T.C. 21, 59 (1997); FPL Group, Inc. & Subs. v.

Commissioner, T.C. Memo. 2002-92.    Moreover, an expert who is

merely an advocate of a party’s position does not assist the

Court to understand the evidence or to determine a fact in issue.

Sunoco, Inc. & Subs. v. Commissioner, 118 T.C. 181, 183 (2002);

Snap-Drape, Inc. v. Commissioner, 105 T.C. 16, 20 (1995), affd.

98 F.3d 194 (5th Cir. 1996).   Determining whether expert

testimony is helpful is a matter within the sound discretion of

the Court.   See Laureys v. Commissioner, 92 T.C. 101, 127 (1989).

After reviewing Mr. Shapiro’s report and testimony, we are not
                               -326-

persuaded that it is helpful to the Court in understanding the

evidence or determining a fact in issue.

     In the first instance, we question the relevance and

reliability of Mr. Shapiro’s “economic reality” analysis in

evaluating CLIS’s contribution of film rights to SMHC.    Mr.

Shapiro concluded, with little elaboration, that CLIS contributed

the film rights to SMP instead of SMHC.    Because the film rights

were contributed to SMP, Mr. Shapiro concluded that SMHC had no

value in those assets as of December 11, 1996.   In reaching these

conclusions, Mr. Shapiro superimposes his view of “economic

reality” to a level that wholly ignores the legal effect (apart

from tax considerations) of CLIS’s contribution to SMHC and

SMHC’s existence as a separate corporate entity from SMP.    SMHC,

as opposed to SMP, was the legal owner of whatever film rights

CLIS contributed to it and continued to hold those rights until

its merger with Troma.   Presumably, since the film rights resided

in SMHC after the CLIS contribution, debtholders would be

entitled to whatever value those film rights had, if any.    Mr.

Shapiro concludes, however, that because the film rights were in

SMP, SMHC had no assets of value and therefore the receivables

from Generale Bank and CLIS were worthless.   Under the

circumstances, Mr. Shapiro’s views of “economic reality” are

largely academic, disregard elements of CLIS’s contribution, and

cannot form the basis for determining the facts in issue.    Those
                                 -327-

views are not helpful to the Court in understanding any evidence

or determining a fact in issue.224

     In Mr. Shapiro’s expert report, he indicates that he was

asked to provide an expert opinion on the value of SMHC stock,

the value of the receivables that Generale Bank and CLIS

contributed to SMP, and the value of SMHC’s interest in the

Carolco securities.   After reviewing Mr. Shapiro’s report and

testimony, however, we find that Mr. Shapiro has gone well beyond

the scope of his engagement, reaching conclusions on the

substance over form issues that this Court must decide.

     In his expert report, Mr. Shapiro analyzed the possibility

that the $5 million put purchase price and the $5 million

advisory fee were paid as arm’s-length consideration for Generale

Bank’s and CLIS’s receivables.    In scattershot fashion, he

concludes, without any elaboration, that SMP paid the $5 million

advisory fee for the EBD film rights and not the receivables;

that there is a question whether the $5 million put purchase

price and $5 million advisory fee were paid as consideration for

Generale Bank’s and CLIS’s contributions of the receivables; but

that “Considering that SMP received the Film Rights, as well as


     224
        Although respondent seeks to capitalize on certain
gratuitous statements in Mr. Shapiro’s expert report and
testimony, we do not construe respondent’s position to
contemplate CLIS’s contribution of the EBD film rights to SMP.
Inasmuch as CLIS’s contribution of the film rights to SMHC is not
a fact in issue, we question the relevance of Mr. Shapiro’s
economic analysis.
                               -328-

tax benefits from the transaction with a potential value in the

hundreds of million of dollars, it is very unlikely that the

$10,000,000 figure represents the fair market value of the debt.”

Mr. Shapiro’s expert report provides no basis for reaching these

conclusions other than speculation.    He did not identify the tax

benefits that he alluded to and, indeed, testified that he based

his conclusions on a discussion with respondent’s counsel

regarding SMP’s “trying to take a writeoff on this debt”.

Similar to other portions of Mr. Shapiro’s report, these

statements have the distinct quality of advocacy.

     For the reasons stated above, we conclude that Mr. Shapiro’s

expert report and testimony are not admissible into evidence.   We

shall grant petitioner’s motion in limine as it relates to that

expert report and testimony.

     B.   Mr. Jouannet’s Response

     At trial, we admitted a letter from Mr. Lerner dated

November 21, 1997, requesting a confirmation from Mr. Jouannet:

     In order to respond to a question asked by our
     auditors, we would appreciate receiving a letter from
     you confirming that, to the best of your recollection:
     (i) when GB and CLIS entered into the Santa Monica
     Pictures LLC agreement, they intended at the time to be
     partners with Rockport Capital Inc. and (ii) their
     decision to dispose of their interests was made
     subsequent to the date of that agreement (December 11,
     1996). I recall that the interests were transferred at
     the end of 1996.
                               -329-

In connection with that letter, petitioner offered a second

letter, which petitioner alleges was Mr. Jouannet’s response to

Mr. Lerner.   The exhibit reads:

          Pursuant to your letter of November 21, 1997,
     relating to the transactions that I negotiated with you
     during the last quarter of 1996, my recollection is as
     follows:

     1/   Generale Bank Nederland NV (GB) and Credit
          Lyonnais International Services SA (CLIS) under
          the instructions of their affiliate Consortium de
          Realisation (CDR) entered into an Exchange and
          Contribution Agreement with Rockport Capital
          Incorporated whereby they contributed stock of
          Santa Monica Holding Corp (SMH) and indebtedness
          owing by SMH to GB and CLIS in exchange for
          preferred interests in Santa Monica Pictures LLC.
          That agreement was passed on December 11, 1996.

     2/   Subsequent to entering into the LLC agreement CDR
          (and consequently GB and CLIS) opted, as I
          understand it for reasons in relation to its 1996
          year end accounts, to dispose of their preferred
          interests in the LLC at the end of their financial
          year pursuant to the right granted to them by a
          Letter Agreement entered with Rockport
          simultaneously with the Exchange and Contribution
          Agreement.

          To the best of my recollection notice of such
          decision to assign, was given to Rockport in the
          second half of December 1996 and the transfer
          became effective on December 31st 1996.

Respondent objected to this response on hearsay grounds.    The

Court sustained respondent’s objection.   On brief, petitioner

seeks to have the Court reconsider its ruling.

      Because Mr. Jouannet is deceased and unavailable to

testify, petitioner offered this exhibit under rule 807, Federal

Rules of Evidence, as an exception to the hearsay rule.    Rule
                              -330-

807, Federal Rules of Evidence, provides that a statement not

specifically covered by the hearsay exceptions of rules 803 or

804, Federal Rules of Evidence, but having equivalent

circumstantial guarantees of trustworthiness, is not excluded by

the hearsay rule, if the Court determines: (a) The statement is

offered as evidence of a material fact; (b) the statement is more

probative on the point for which it is offered than any other

evidence which the proponent can procure through reasonable

efforts; and (c) the general purposes of the Federal Rules of

Evidence and the interests of justice will best be served by

admission of the statement into evidence.225   To ensure that this

“residual exception” to the hearsay rule does not emasculate the

body of law underlying the Federal Rules of Evidence, it is to be

used very rarely and only in exceptional circumstances.

Goldsmith v. Commissioner, 86 T.C. 1134, 1140 (1986); Gaw v.

Commissioner, T.C. Memo. 1995-531.

     We are not persuaded that Mr. Jouannet’s response to Mr.

Lerner’s letter has circumstantial guarantees of trustworthiness

equivalent to those in the other hearsay exceptions.    Mr.

Jouannet’s response was made to Mr. Lerner’s inquiry regarding

CDR’s intentions in its transaction with the Ackerman group.    The

response appears to have been written as an accommodation to Mr.


     225
        Petitioner, as the proponent of this evidence, must show
that each of these requirements is met. See Little v.
Commissioner, T.C. Memo. 1996-270.
                                -331-

Lerner; there is no guarantee that the accommodation did not

extend to the substance of the response.    We are not convinced

that Mr. Jouannet gave his response as a “disinterested” party.

Moreover, Mr. Jouannet’s response is not contemporaneous with

CDR’s transaction with the Ackerman group.

     We also are not persuaded that Mr. Jouannet’s response is

more probative on the point for which it is offered than any

other evidence that petitioner could have procured through

reasonable efforts.226   Although the record reflects that Mr.

Jouannet was the principal negotiator on the CDR side of the

transaction, we are not convinced that other individuals at CDR,

Generale Bank, or CLIS could not have testified regarding the

intentions of the banks.

     Finally, petitioner points to the fact that Mr. Jouannet is

deceased and is unavailable to testify as a basis for admitting

the response.   We are not persuaded that rule 807 of the Federal

Rules of Evidence contemplates admitting hearsay evidence solely

on the basis that the declarant is deceased.    See Estate of

Temple v. Commissioner, 65 T.C. 776 (1976).    We are not persuaded

that the general purposes of the Federal Rules of Evidence and


     226
        The requirement that “the statement is more probative on
the point for which it is offered than any other evidence which
the proponent can procure through reasonable efforts” requires a
consideration of two factors: (1) The availability of other
evidence on a particular point; and (2) whether such other
evidence can be procured through reasonable efforts. Goldsmith
v. Commissioner, 86 T.C. 1134, 1141 (1986).
                              -332-

the interests of justice will best be served by admitting Mr.

Jouannet’s response.227

     In light of the foregoing,


                                      An appropriate order will

                              be issued granting respondent’s

                              motion in limine to exclude the

                              expert report and testimony of Todd

                              Crawford, denying petitioner’s

                              motion in limine to exclude the

                              expert report and testimony of

                              Louise Nemschoff, and granting

                              petitioner’s motion in limine to

                              exclude the expert report and

                              testimony of Alan C. Shapiro, at

                              docket No.    6163-03 a decision will

                              be entered for respondent and at

                              docket No. 6164-03 an appropriate

                              order of dismissal will be entered.



     227
        Even if Mr. Jouannet’s response were admitted into
evidence, it would not change our decisions in these cases. For
the reasons discussed above, we would attach little weight to Mr.
Jouannet’s response, which is filled with equivocations that beg
the question posed to him. We are not persuaded that Mr.
Jouannet was adverse to petitioner’s interests. Moreover, the
response itself is contradicted by the salient testimony of Mr.
Geary, who acted as CDR’s counsel in the transaction with the
Ackerman group.
