1 BEFORE THE CALIFORNIA STATE BOARD OF EQUALIZATION 2 5901 GREEN VALLEY CIRCLE 3 CULVER CITY, CALIFORNIA 4 5 6 7 8 REPORTER'S TRANSCRIPT 9 FEBRUARY 22, 2017 10 (Prepared from audio recording) 11 CORPORATE FRANCHISE AND PERSONAL INCOME TAX HEARING 12 APPEAL OF 13 THE SHERWIN-WILLIAMS COMPANY 14 NO. 785285 15 AGAINST PROPOSED ASSESSMENT OF 16 ADDITIONAL INCOME TAX 17 18 19 20 21 22 23 24 25 26 27 Prepared by: Kathleen Skidgel 28 CSR No. 9039 1 1 P R E S E N T 2 For the Board of Equalization: Fiona Ma, CPA 3 Chairwoman 4 Diane L. Harkey Vice Chair 5 Jerome E. Horton 6 Member 7 Sen. George Runner (Ret.) Member 8 (Not present) 9 Yvette Stowers Appearing for Betty T. 10 Yee, State Controller (per Government Code 11 Section 7.9) 12 Joann Richmond Chief 13 Board Proceedings Division 14 David Gau 15 Executive Director 16 For Board of Equalization Staff: Anthony Epolite 17 Tax Counsel IV Legal Department 18 Grant Thompson 19 Tax Counsel IV Legal Department 20 For Franchise Tax Board: Ian Foster 21 Tax Counsel 22 Michael Cornez Tax Counsel 23 Craig Scott 24 Bureau Director 25 For Appellant: Michael T. Cummins Taxpayer 26 Linda E. Carlisle 27 Attorney 28 ---oOo--- 2 1 5901 GREEN VALLEY CIRCLE 2 CULVER CITY, CALIFORNIA 3 FEBRUARY 22, 2017 4 ---oOo--- 5 MS. RICHMOND: Our next item is Item B, 6 Corporate Franchise and Personal Income Tax Appeals 7 Hearings. We will be starting with Item B3, The 8 Sherwin-Williams Company. 9 Please come forward. 10 Board Proceedings has received contribution 11 disclosure forms for today's hearings from the parties, 12 participants and agents. All forms were properly 13 completed and signed, and no disqualifying contributions 14 were disclosed. All parties, participants and agents 15 are on the alpha listings provided to your office. 16 Each person sitting at the table will be asked 17 to introduce themselves and, if necessary, their 18 affiliation with the taxpayer for the record. 19 Ten minutes is allocated for the taxpayer's 20 opening presentation, followed by ten minutes for the 21 Franchise Tax Board or Department's presentation. And 22 five minutes is allocated to the taxpayer for 23 rebuttal. 24 Chairwoman Ma. 25 MS. MA: Okay. Note an additional five minutes 26 has been granted to both sides to present their opening 27 arguments. They will have a total of 15 minutes to make 28 their initial presentations. 3 1 Mr. Thompson, please introduce the issues in 2 this case. 3 MR. THOMPSON: Good morning. Grant Thompson 4 for the Appeals Division. 5 Two issues on this appeal: 6 One, whether appellant's use of a special 7 conversion formula lacked economic substance in a 8 business purpose; 9 And two, whether the noneconomic substance 10 transaction penalty was properly imposed. 11 I'd note we received an exhibit from each party 12 this morning, which the Board Members should have. 13 MS. MA: Okay. Thank you very much. 14 Welcome to the Board of Equalization. You have 15 been granted additional time. You have 15 minutes to 16 make your initial presentation and an additional five 17 minutes on rebuttal. 18 Please introduce yourself for the record, and 19 then you may begin. 20 MS. CARLISLE: Thank you, Chairman Ma. 21 Good morning. I'm Linda Carlisle, counsel to 22 The Sherwin-Williams Company. Accompanying me is Mike 23 Cummins. Mike is Vice President and Director of Taxes 24 for The Sherwin-Williams Company. 25 Sean Hennessey, the Chief Financial Officer of 26 the company, which many of you met with last week, is 27 not able to join us due to an unfortunate family medical 28 emergency. He has, however, prepared a declaration for 4 1 the record, reiterating the points that he made last 2 week. You should have received that yesterday when he 3 determined he was not able to join the hearing. 4 Mike and I are here to explain to you that the 5 company's sales of convertible preferred stock to the 6 Sherwin-Williams ESOP in 2001 and 2003 had economic 7 substance because the sales substantially changed the 8 economic position of both the company and the ESOP and 9 the sales were done in the judgment of the company's 10 management for significant non tax business purposes; 11 this is the two-prong test to determine whether a 12 transaction has economic substance. 13 Sherwin-Williams is in the business of 14 manufacturing and selling paint through its 15 company-owned and operated stores. Each 16 Sherwin-Williams store is owned by the company. It is 17 not franchised. So the employees in the store are 18 employees of The Sherwin-Williams Company. 19 In 2001, the company generated most of its 20 revenue from selling paint to painting contractors who 21 purchased products on a daily or a weekly basis due to 22 strong personal relationships with the sales personnel 23 in those individual franchise -- the non franchise, um, 24 stores. The company's experienced and knowledgeable 25 sales personnel are a key asset of the company. That's 26 what makes it work. 27 To maintain and cultivate this 28 customer/contractor relationship, the company had to 5 1 retain its experienced employees. To that end, the 2 company provided generous employee benefits to its 3 employees, including contributions to the ESOP that 4 matched contributions by the employees. 5 And many of the employees during this time had 6 accumulated substantial balances that were invested 7 primarily in company stock, which is what an ESOP is 8 designed to do. 9 The company's matching contributions to the 10 ESOP, however, were purely discretionary, as they are 11 under the law. So at any point in time the company 12 could stop matching contributions. 13 During the 1990s, individuals and certain 14 governments sued the company for damages arising from 15 the company's historic manufacture of lead-based pigment 16 used in paint even though the company had ceased, 17 decades before, manufacturing lead-based paint. 18 The company was successful defending itself 19 against these lawsuits until 1999 when the State of 20 Rhode Island filed a public nuisance lawsuit against the 21 company and other historic manufacturers of lead-based 22 paint for the remediation of lead paint hazards in the 23 state. 24 The suit for Rhode Island alone estimated 25 damages of approximately $2.4 billion. And the public 26 nuisance argument did not require proof that the lead 27 paint hazards in the state were attributable to the 28 Sherwin-Williams Company. 6 1 The company's market cap at that time was 2 3.5 billion. If Rhode Island was successful, it was 3 thought that other states would bring similar nuisance 4 suits. 5 The company stock clearly suffered as a result. 6 As the Rhode Island case proceeded, negative headlines 7 materially reduced the stock price, and the stock price 8 became very volatile. 9 For example, April 2nd, 2001, a Rhode Island 10 trial court decision was rendered that allowed the case 11 to continue; i.e., a motion to dismiss was denied. In 12 that one day alone the stock price dropped 21 percent. 13 For a public company, that is huge. 14 The impact of the lead paint litigation on the 15 stock price caused many concerns for the company and for 16 the company's management. First, there was a concern 17 that the experienced employees that I said was so very 18 important to the work -- I mean to the company's 19 revenue, um, would leave the company to work for 20 competitors that had no exposure to lead paint and cash 21 out their ESOP accounts, which were invested primarily 22 in company stock. They were concerned that the stock 23 price would go down and they wanted -- they might want 24 to get out before it did. 25 In addition, a low stock price could lead to 26 hostile takeover attempts, and the company was perceived 27 in the market as a likely target. To address both 28 concerns, the company's management decided to prefund 7 1 the company's contributions to the ESOP. Remember, they 2 were discretionary, but not if they were prefunded. And 3 they would do so with convertible preferred stock, with 4 a guaranteed base value to ensure employees that -- of 5 the company's commitment to fund the ESOP and put a 6 significant block of company stock in friendly hands if 7 the stock price declined precipitously and a hostile 8 takeover was attempted. 9 The company's management used its best business 10 judgment to address both the employee retention issue 11 and the threat of a hostile takeover by issuing the 12 convertible preferred stock, selling -- and selling it 13 to the ESOP. 14 The FTB is substituting its judgment for that 15 of the management of the company that has prospered for 16 over 150 years. In my view, that's a leap too far. 17 The market value of the stock sold to the ESOP 18 exceeded the price paid by the -- for the stock by the 19 ESOP as confirmed by Duff & Phelps, an expert valuation 20 firm that the company chose because it had no prior 21 dealings with The Sherwin-Williams Company, and that was 22 retained by the independent ESOP trustee. 23 The sale of the convertible preferred stock 24 irrevocably changed the economic positions of both the 25 company and the ESOP. In the sale, the ESOP acquired 26 the convertible preferred stock and the company was 27 committed to make contributions to the ESOP to enable 28 the ESOP to repay the purchase price of the loan 8 1 incurred by the ESOP to buy the stock over time. 2 In the exhibit that we handed to you, as Tab 1 3 shows, the economic position of the company and the ESOP 4 changed because the company had irrevocably committed, 5 just that one slide, committed to make contributions to 6 the ESOP equal to the purchase price of the stock. 7 As shown on the next page in that exhibit, this 8 ensured that the purchase loan, purchase price loan, 9 would be repaid, that stock appreciation would be 10 allocated to the ESOP participants. And if the stock 11 price declined precipitously in value, the convertible 12 preferred stock could be converted into a substantial 13 amount of common stock to deter a hostile takeover 14 attempt. 15 In the 2003 transaction, just as an example, 16 the value of the convertible preferred stock sold to the 17 ESOP included the three -- repayment of the $350 million 18 loan, $212 million in stock appreciation and an 85 -- 19 $85 million base amount. That exceeded the purchase 20 price of the stock to the ESOP. 21 The company exercised its business judgment to 22 prefund the ESOP with convertible preferred stock rather 23 than common stock because, as shown in Tab 2 of the 24 exhibits that I -- we handed to you, a base value could 25 be ensured. Could not do that with common stock. 26 Dividends could be set to match interest due on 27 the loan. Wouldn't be able to do that with common 28 stock. And the convertible preferred stock would have a 9 1 preference over common stock in bankruptcy. Remember 2 what I just said, we were at a point in time, the 3 company was at a point in time where, unfortunately, 4 bankruptcy could have been an issue. 5 Most importantly, the base value guaranteed 6 that the ESOP could obtain a substantial additional 7 block of company stock if a hostile takeover was 8 attempted as a result of a precipitously, precipitous 9 decline in the company's stock due to the lead paint 10 litigation. 11 If you flip to Tab 3, if the value of the 12 convertible -- I mean of the common stock dropped to $1, 13 the ESOP could convert the convertible preferred shares 14 for 85 million shares of common stock and own almost 48 15 percent of the company. 16 This would enable the ESOP to prevent a hostile 17 takeover. Generally an ESOP is deemed to be friendly 18 hands, no control by the company, but they would own 48 19 percent. 20 This would give the participants a 21 substantial -- very substantial share of the company. 22 Again, the FTB is substituting its judgment for that of 23 the judgment of the management of The Sherwin-Williams 24 Company. 25 The ESOP sold -- told the ESOP participants in 26 letters about the prefunding, but did not go into 27 details regarding the contingency plans for a major 28 stock drop to avoid further frightening employees about 10 1 the lead paint litigation and emboldening other 2 litigants to sue. The independent trustee, however, 3 knew absolutely everything about the conversion formula. 4 The company made contributions to the ESOP by 5 forgiving the principal of the ESOP's purchase price -- 6 or purchase money loan over time, and deducted such 7 contributions as permitted by Internal Revenue Code 8 section 404(a)(9). That amount did not exceed the fair 9 market value of the stock at the time it was sold as 10 determined by Duff & Phelps. 11 The IRS audited both the 2001 and 2003 12 transactions and no adjustments were made to the 13 company's deductions for the 2003 or 2004 tax years, 14 years at issue here. 15 The IRS and the company agreed to a settlement 16 with respect to the 2006 and 2008 tax years. The 17 company amended its state tax returns, including 18 California, to reflect the IRS settlement and pay any 19 taxes due. 20 The FTB is now disputing the 2003 and 2004 tax 21 years despite this determination by the IRS, despite the 22 other states' acceptance of the IRS determination, and 23 despite the California statute requiring conformity with 24 IRS determinations. 25 The DOL audited the 2003 transaction for 26 compliance with ERISA, not tax law. The company reached 27 a settlement with the Department of Labor regarding 28 ERISA compliance by paying $80 million to its employees, 11 1 not to the government. The company agreed to this 2 settlement with the DOL because it benefited the 3 company's employees who had stayed with the company 4 during the trying times of the lead paint litigation, 5 and because the lead paint litigation risk had largely 6 diminished, making it unnecessary to continue the 7 leveraged ESOP. 8 In conclusion, the sale of the convertible 9 preferred stock to The Sherwin-Williams Company ESOP in 10 2001 and 2003 had economic substance because such sales 11 were substantially, first, changed the position of both 12 the ESOP and the company, and in the business judgment 13 of management, the convertible preferred stock was sold 14 to the ESOP for significant non tax business purposes. 15 We thank you very much for your consideration 16 of our appeal. 17 MS. MA: Okay, thank you. 18 To the Franchise Tax Board, please introduce 19 yourself for the record, and you may commence 15 minutes 20 for your presentation. 21 MR. FOSTER: Thank you, and good morning, 22 Chairwoman Ma and Members. I'm Ian Foster representing 23 FTB. And with me is Michael Cornez. 24 In some respects a lot has been made about this 25 being a complicated case, and I respectfully disagree 26 with that. There certainly has been a lot of briefing, 27 a lot of exhibits, a lot of arguments. However, when 28 you really break this case down -- break this case down 12 1 to its bare bones, its essence, I actually think it's 2 one of the more simple and clear economic substance 3 cases I've seen. 4 This all comes down to one thing: a conversion 5 formula that always strips value from the original 6 purchase price while ensuring that the large artificial 7 tax deduction stays in place. 8 Of the $600 million that the ESOP supposedly 9 paid for the preferred stock in the transactions at 10 issue, only 330 million was actually allocated to 11 employees' accounts. The remaining 270 million was 12 nothing more than a circular cash flow that had no 13 economic effect on appellant, no economic effect on the 14 ESOP, and provided no benefit for the employees. 15 That's $270 million of fuel for what FTB 16 believes is an artificial tax deduction. This happened 17 because appellant used a conversion formula designed to 18 make it happen. 19 The conversion formula mathematically 20 guaranteed, in every possible scenario, that the 21 employees would always be allocated less value than what 22 was fully paid for, and that appellant would always take 23 a larger deduction than the allocation to the employees. 24 That central fact, that result of the conversion formula 25 is not in dispute. It's a mathematical certainty. 26 I hope you'll indulge me as I clarify again 27 what FTB is not arguing. We are not arguing that 28 leveraged prefunded ESOPs lack economic substance 13 1 generally. We do not argue that ESOPs have no business 2 purpose. They have a number of valid business purposes. 3 And we did not deny all of appellant's claimed ESOP 4 deductions. But we don't see appellant's case as a 5 normal ESOP case. 6 In a typical ESOP case, there might be a block 7 of shares set aside, say a hundred shares. The company 8 loans the money to the ESOP to purchase those shares. 9 As the ESOP pays down the loan, the shares are released 10 from suspense and allocated to the employees. 11 Here, instead of a number of shares being 12 allocated to the participants, it's a specific value 13 that is allocated to the participants. 14 The ESOP's purchase may start out with a number 15 of shares of a special preferred stock, but through the 16 conversion formula it's converted into a specific value 17 of common stock. And that conversion formula always 18 strips the value down before the shares are allocated. 19 I brought in a few visual aids today if you 20 wouldn't mind taking a look. In my first example we 21 have what we consider more of a typical or normal ESOP. 22 So we have a company that earmarks a hundred shares, 23 say, of common stock for the ESOP. We can say those 24 shares are worth a hundred dollars for sake of argument. 25 The company loans the hundred dollars to the ESOP. As 26 the ESOP pays down the loan, the shares are released 27 from suspense and those hundred shares go to the 28 employees. 14 1 Now here, there's a transfer of real economic 2 value, the company takes a hundred dollar tax deduction, 3 there's somewhere in the range of a hundred dollars 4 allocated to the employees, depending on specific share 5 price. FTB has no problem with this transaction. We 6 would allow the full $100 deduction. 7 In my second example on the next page, now 8 instead of releasing a number of shares we're going to 9 release a specific value to the employees. So, this has 10 legitimate reasons for doing it, reasons appellant has 11 pointed out. 12 So here we're protecting the employees from a 13 drop in share price so they don't receive less value 14 than what the ESOP originally paid. In a sense it 15 protects the company from a spike in share price. 16 And so here we start with a hundred shares of 17 the preferred stock, worth a hundred dollars. And then 18 when the allocation to the employees happens, that 19 preferred stock is converted to common stock. 20 Now here, you could call it there's no 21 conversion formula, or if you like you could say there's 22 a conversion formula, but it's one-to-one, $1 equals $1. 23 So as the stock is released from suspense, it's 24 converted into an identical value of common stock. 25 Now, on the top line there, if the stock price 26 stays roughly the same, the employees get a hundred 27 shares and they get a hundred dollars in value. If the 28 stock price were to drop to 50 cents, the employees 15 1 would get 200 shares. So they get more shares as 2 appellant has pointed out, but they still get the 3 hundred dollars in value that's protecting the 4 employees. 5 If the shares were to go up to $2, then the 6 employees only get 50 shares, but they're still getting 7 the $100 in value. So the company takes a hundred 8 dollar tax deduction, and the employees get a hundred 9 dollars in value. The tax deduction reflects the 10 economics of the transaction. FTB has no problem with 11 this. We would allow the entire $100 deduction. 12 We believe appellant's case is more like the 13 example number three, on the third page of my exhibits. 14 So here, instead of a $1 to $1 conversion formula, $1 of 15 the preferred is converted into 60 cents of common 16 stock. 17 Now, appellant's conversion formula is a little 18 bit more complicated in that, with a number of terms, 19 and we can look at that in a little bit. But its effect 20 is the same. It always comes out to less than 100 21 percent. And my 60-cent example is a little bit 22 generous. It was, on average, more like 55 percent in 23 this case. 24 So here, they get a hundred -- they purchase a 25 hundred dollars of preferred stock, a hundred shares 26 worth a hundred dollars. If the share price stays 27 roughly the same, the employees get their $60 value, 28 they get 60 shares worth, $60. But then we have $40 16 1 worth of nothing other than circular cash flow that FTB 2 argues has no economic effect on anybody if the only 3 purpose of that $40 is to inflate the tax deduction. 4 Again, if the share price drops, the employees 5 are protected here. Now they get 120 shares, but it's 6 still only $60 worth. And there's still $40 of excess 7 circular cash flow of value that does not go to anybody. 8 Again, if the share price increases, now the 9 employees get fewer shares, they only get 30, but they 10 still get their $60 in value and we still have $40 of 11 excess circular cash flow. 12 Now, of the company's deduction, there is $60 13 worth of real economic value here. That's the deduction 14 FTB would allow. FTB has no problem with that 15 deduction. 16 There's $40 of what FTB would call an 17 artificial or fictional deduction. That's the $40 of 18 circular cash flow that never goes to the employees, for 19 a total hundred dollar deduction. FTB would deny that 20 extra $40, while allowing the 60, because the $60 is the 21 only value that can ever get to the employees. 22 Now, there's a legitimate argument, an 23 objection here might be, well, what if, for any number 24 of legitimate reasons, they only wanted to get $60 to 25 the employees? Now, that's fine, too. 26 So if you look at example Number 4 on the 4th 27 page, so just purchase $60 worth of value up front and 28 have no conversion formula. Just do a one-to-one. And 17 1 then here you take a $60 deduction for $60 of value, and 2 you've still protected your employees in the same way 3 from the fluctuations in the stock price. 4 Our problem is not that they are converting to 5 value. Our problem is not that they are protecting the 6 employees from fluctuations in share price. Our problem 7 is with the inflated tax deduction. 8 In my example where they purchased the hundred 9 dollars worth and only 60 can ever go to the employees, 10 you have an extra $40 that can never go to the employees 11 because of the conversion formula. No matter what 12 happens to the share price, that extra $40 can never go 13 to the employees. It's the mathematics of the formula. 14 It's a circular cash flow that has no economic effect on 15 anybody. 16 So you might ask, I mean why would the 17 taxpayer, if they only wanted the $60 to go to the 18 employees, why would they purchase the hundred dollars 19 up front and then install that conversion formula to 20 ensure that the value gets stripped down while leaving 21 the large tax deduction in place? I mean you can guess 22 what FTB's answer to that is. 23 But they've advanced a couple of business 24 purposes here: Employee retention and protection from a 25 hostile takeover. So I'll take those one at a time. 26 To get the evidentiary part of this out of the 27 way first, there are no documents where appellant ever 28 recorded employee retention as a purpose for the 18 1 conversion formula that strips value. Literally, not 2 one. 3 Appellant has cited certain letters to its 4 employees in 2001 and 2003. They don't mention the 5 conversion formula. The letters even say that the ESOP 6 purchased a certain block of stock that was earmarked 7 for allocation of the employees. I would argue that's 8 not true. The preferred stock could never be allocated 9 to the employees and not even its full value could be 10 allocated to the employees. 11 I argue there are good reasons they didn't tell 12 the employees about this. And it actually came up in 13 the declaration that was submitted last night. 14 The former CFO submitted the declaration last 15 night. And in paragraph 13, on page 6, he states that 16 if the employees had known about the conversion formula, 17 it would have, quote, caused panic and confusion. 18 That's why they didn't tell the employees. That's in 19 his own words. And honestly, I think perhaps he made my 20 case more succinctly than I could have. 21 I also want to address the supposed floor value 22 they talk about as a possible reason the employees might 23 like the conversion formula. But let's be clear about 24 what this floor value is and is not. It does not 25 prevent the employees' accounts from ever going below a 26 certain amount or even to zero, not if they're full of 27 stock. 28 Once the common stock has been allocated, 19 1 should its value crash in the market, that drop will be 2 reflected in the employees' accounts that hold common 3 stock. The only thing the floor value does is ensure 4 that at the moment of conversion and allocation, that 5 the employees are getting something greater than zero at 6 that moment. 7 But the -- the conversion formula still ensures 8 that value is stripped from the full value before the 9 allocation is made and that the large tax deduction is 10 left in place. So this so-called floor value, which 11 does not actually place a floor on the value of 12 anybody's account, essentially just takes what I would 13 call a guaranteed losing proposition and says, well, 14 you're still going to lose something in it; you're just 15 not going to lose everything in the conversion. 16 Personally, I don't think that's much of an 17 incentive for the employees. 18 Moreover, regardless of the mechanics of the 19 conversion formula, regardless of the floor value, 20 regardless of any purposes they might have had, 21 documented or not, the undisputed fact is that appellant 22 never told the employees about the conversion formula. 23 Appellants admit this; it was in the declaration last 24 night. 25 As the CEO testified, telling the employees 26 would have caused panic and confusion. And regardless 27 of the reason they didn't tell their employees, it's a 28 logical axiom that the conversion formula cannot be an 20 1 incentive for the employees if they don't know about it. 2 So let's took at hostile takeover protection. 3 Again, there is no evidence where they say a conversion 4 formula that strips value was a reason to protect them 5 from hostile takeover protection. There's no 6 contemporaneous documentation that talks about that. 7 The presentations to the ESOP trustee, to appellants 8 Board of Directors, make no mention of any such purpose. 9 And, in my view, there's a reason they didn't 10 talk about it, because stripping value doesn't make a 11 lot of sense as hostile takeover protection. 12 Now, as appellant pointed out, if the value did 13 crash by converting something, you know, a number of 14 shares to value, instead of shares to shares, you 15 protect the ESOP from that drop in value. So as value 16 drops, you get more shares into the ESOP. But that 17 value is stripped before the conversion, before the 18 allocation takes place. 19 So if they purchase the hundred dollars up 20 front, it's stripped down, in my example, to $60. In 21 real life it was stripped down further than that. And 22 then the employees can only ever get the $60 in value. 23 No matter what happens to the share price, 24 mathematically they can never get the full value that 25 was paid up front. 26 So yeah, they'll get more than they would have 27 if it were converted to 60 shares, but they're still 28 only getting the $60 value on the hundred dollars that 21 1 was paid. And they could have just paid the $60 up 2 front to get the $60 value and had a one-to-one formula. 3 But they wanted to pay the full hundred dollars up front 4 because that gets you the large artificial tax 5 deduction. 6 Now, regarding the IRS audit, ultimately under 7 the settlement and how the IRS does things, they do 8 things for a lot of their own business reasons. I don't 9 know why they didn't issue assessments for earlier years 10 and did it later only. It may have been statute of 11 limitations issues. It may have been a business 12 decision. 13 But we're talking here about substantially 14 identical ESOP transactions. They all worked the same. 15 They all had the same mechanics. They just differed in 16 the precise numbers involved. And the IRS did say, for 17 the later years, appellants should not be deducting the 18 excess amount that was not allocated to employees. And 19 that is exactly what appellant agreed to stop doing in 20 the settlement. And appellant filed amended returns for 21 the later years where they stopped deducting the excess 22 amount. We are only trying to reach the same result in 23 the earlier years that appellant agreed to reach for the 24 later years on an identical transaction. 25 We do typically follow RAR adjustments from the 26 IRS even though we're not bound by them. But if it's a 27 closing agreement that reflects the settlement the IRS 28 made for its own reasons, a settlement that may just be 22 1 an acceptable number for the parties, and if we have our 2 own independent audit and analysis, then no, in that 3 case we would not follow the IRS. 4 And here, again, we're just trying to reach the 5 same result that was reached in later years, the same 6 result appellant actually agreed to reach in the later 7 years on the identical transaction. It's the same 8 conversion formula that always stripped value and left 9 the large artificial tax deduction in place. 10 MS. RICHMOND: Time's expired. 11 MR. FOSTER: Thank you. 12 MS. MA: Okay, thank you. 13 Okay. To the appellants, you have five minutes 14 on rebuttal. 15 MS. CARLISLE: Thank you so much, Chairman Ma. 16 Two -- two things in particular that I would 17 like to reiterate. Number one, the FTB has said that 18 this is an economic substance case. Economic substance 19 is proven by a substantial change in the economics of 20 the parties and by a business purpose for the 21 transaction. I think we've clearly shown that both of 22 those agree. 23 The second thing I would note is that the FTB 24 is saying that the management of The Sherwin-Williams 25 Company was wrong in deciding how to fund the ESOP with 26 convertible preferred shares. 27 As the FTB stated, they should have done it 28 differently. They should have used common stock. Or 23 1 they should have not had a conversion formula. 2 They have also said that the IRS was wrong in 3 agreeing not to assess for 2003 and 2004, because they 4 were wrong. 5 Those things stand out to me. 6 The other thing that stands out to me is the 7 concept that we were stripping value. I think if I had 8 a nickel for every time that was said in the last 15 9 minutes, I would have a lot of money. Okay. 10 The convertible preferred stock, according to 11 Duff & Phelps, an independent valuation firm, was worth 12 more than the purchase price. The reason for that is 13 because its value included the amounts that the company 14 would contribute to repay the purchase money loan, and 15 it included all appreciation on the stock during the 16 period of time when the stock was held by the ESOP. And 17 it included a guaranteed floor on the value of the 18 stock. 19 That is not an insubstantial amount. In fact, 20 for the 2003 transaction, that would have been, at a 21 minimum, 350, plus 212, so $572 million worth of value. 22 The company was not issuing something that stripped 23 value away from the participants. The participants 24 received both the repayment of the loan value, plus the 25 appreciation, plus the 85 million. 26 I think the FTB is very much dismissing the 27 issue of a precipitous drop in the stock price. When 28 you look at that chart, I don't see how you can not 24 1 understand that $85 million, a guaranteed conversion 2 ratio -- so I have $85 million that will wind up with 85 3 million more common shares -- is not substantial value. 4 We did not -- the company chose not, management 5 chose not, to go into the details of that conversion 6 formula with the participants simply because it: A) Did 7 not want to fuel more fear; B) Did not want to fuel more 8 litigation. 9 The ESOP's independent trustee who entered into 10 the transaction on behalf of the ESOP and had fiduciary 11 obligations with respect to the ESOP was fully aware of 12 the conversion formula. Was fully aware of the 13 valuation by the independent trust -- by the independent 14 appraisal firm. 15 We -- we disagree that this transaction in any 16 way, shape, or form hurt the employees of The 17 Sherwin-Williams Company. And, in fact, want to make 18 the point once again that in the business judgment of 19 management, this was necessary at that time to retain 20 our employees and to make sure if a hostile takeover was 21 attempted, we would be okay, that the company would 22 continue, and the employees would have a substantial 23 piece of the rock. 24 Thank you. 25 MS. MA: Okay. All right. Questions. 26 Ms. Harkey. 27 MS. HARKEY: I will lead. I will lead off. 28 I have spent a substantial amount of time on 25 1 this. I've even gotten stock price history and done the 2 whole thing here. 3 So I do have an example here that may -- 4 because I was -- I remember back in the day, leverage 5 buy-outs. 6 MS. CARLISLE: Mm-hmm. 7 MS. HARKEY: Leverage buy-outs were -- 8 Any of you people remember the movie Pretty 9 Woman? 10 MS. CARLISLE: Definitely. 11 MS. HARKEY: Okay. That's a very popular LBO 12 movie. That's what it's about. It had the -- the shark 13 buying out the companies and selling it for parts and 14 getting rid of all of the employees. 15 And the way that you did that was that the 16 company had to have value. It's happening now, too. 17 It's happening now a lot in the -- in the medical 18 industry, in the pharmaceutical. 19 You all heard about Valeant. 20 MS. CARLISLE: Yes. 21 MS. HARKEY: They were doing LBOs constantly 22 and just selling off the product, taking the money that 23 was in fact held for research and development. That's 24 always a -- a cool cash cow to acquire. Allergan had to 25 do a "poison pill." It ended up being sold anyway, but 26 not to Valeant. And Valeant now is in court for 27 multiple whatevers. I think they'll be there for quite 28 a while. 26 1 MS. CARLISLE: Mm-hmm. 2 MS. HARKEY: There are Ponzi schemes in LBOs. 3 And there are legitimate companies that take "poison 4 pills" or that apply "poison pills" so that they don't 5 just deplete everything that they have and lose 6 employees, lose business, and it all just goes away into 7 somebody's pocket to buy a boat. 8 MS. CARLISLE: Right. 9 MS. HARKEY: So, that being said, um, I have 10 some questions for Sherwin-Williams Company. 11 Did you establish an ESOP prior to the leverage 12 transaction in 2001? 13 MS. CARLISLE: In 1969, it was established as 14 part of the plan. 15 MS. HARKEY: Okay. I asked to get a list of 16 employees from my staff. 17 In 2001, the company had 23,246 eligible 18 employees; 14,000 -- roughly 14,000 participated, which 19 was 60 percent. 20 MS. CARLISLE: Right. 21 MS. HARKEY: By 2005, the company had 27,523 22 eligible employees; 20,287 participate, which was 73.7 23 percent. 24 By 2010, the company had 27,232 eligible 25 employees and the participation rate was 90 percent. 26 So I think clearly the employees think they got 27 some value out of the ESOP. And I understand the FTB's 28 argument, but I'm just trying to establish that there 27 1 were employees and they seemed to be quite satisfied and 2 the participation rate went up. 3 Were there, at the time of the LBO threat -- 4 which is noted here in various reports. I believe we 5 have Sherwin-Williams' takeover report here. That's 6 special supplement, mergers and acquisitions compendium, 7 buy-back sweep industry as stock prices tumble. That 8 was provided. 9 There has also been a Dow Jones Business News, 10 which is Exhibit A, that was provided. And that the 11 stock -- that was dated April 3rd, 2001. 12 It says: 13 "At 4:00 p.m. eastern daylight time 14 Tuesday, shares of Sherwin-Williams were down 15 by 5.33 or 21 percent to 20.31 on the New York 16 Stock Exchange." 17 And it looks like, you know, they're not 18 recommending any more for buy. But they're being a 19 hold. And they think that they're subject to hostile 20 takeover. Which is what happens, you can buy the stock 21 cheap on a threat. 22 MR. CUMMINS: Right. 23 MS. HARKEY: So -- but one of the key 24 components of LBOs are either you gotta have a lot of 25 cash that's sitting around in reserve, or undervalued 26 assets on the balance sheet. 27 MS. CARLISLE: Right. 28 MS. HARKEY: Um, could the gentleman here 28 1 answer, or either one of you answer. I'm sorry, I have 2 forgotten your name, sir. 3 MR. CUMMINS: Michael Cummins. 4 MS. HARKEY: Michael. Could you answer for me, 5 because we did get -- I did ask you for some 10-K's, and 6 I do see that you have land, uh, and buildings. Are 7 those company-owned? 8 MR. CUMMINS: Most of them. At this time most 9 of them were company-owned. 10 MS. HARKEY: Okay. So they were depreciated as 11 allowed to do. But they were still valued as land and 12 buildings. 13 MR. CUMMINS: Yes. 14 MS. HARKEY: What about equipment? Is that 15 depreciated? Did it still have a useful value? 16 MR. CUMMINS: Yes. 17 MS. HARKEY: Could it have been sold? 18 Okay. When we were looking at these and we 19 were financing these, back in the 80s and in the 90s -- 20 they come around every 10 years -- what you look at is 21 to see that if you -- if you -- can you collateralize 22 your loan? Because you're gonna have a leverage, 23 sometimes 10, 20 to 1 on your loan, which is never 24 smart. But if you've got the collateral and you've got 25 the assessment and the value, could you get out of it? 26 And that's what banks were doing. That's what finance 27 companies -- that's what everybody was doing. 28 So, if there was value in the land and 29 1 buildings that was not showing on the balance sheet, and 2 if there was value in the machinery and equipment, those 3 would be hard assets that somebody would look at to 4 liquidate, to sell the company, sell off, and repay 5 themselves. 6 MR. CUMMINS: Right. Yes. 7 MS. HARKEY: Um, how many employees -- 8 Oh, I got that in the first offering, how many 9 employees. 10 How did the company arrive at 250 million loan 11 to the ESOP? 12 MS. CARLISLE: The 250 million was in the first 13 2001 transaction. The 350 million was in the 2003 14 transaction. 15 MS. HARKEY: How did you arrive at 250? 16 MS. CARLISLE: 250 -- both of those were how 17 many shares could I convert into common stock if there 18 was a precipitous change in the value? What kind of a 19 voting block would I be able to put into the ESOP? 20 In 2001, relative to the amount of stock in -- 21 that the ESOP held, 250 was with that base value. 22 MS. HARKEY: Well, explain that to me. I'm 23 still not following it. Why did -- where did you -- how 24 did you arrive at 250? 25 MS. CARLISLE: 250 was the value of the stock 26 that we sold to the ESOP in 2001. That particular block 27 of convertible preferred stock -- 28 MS. HARKEY: Okay. 30 1 MS. CARLISLE: -- had with it the commitment of 2 the ser- -- of the company to repay the 250 million. It 3 had a base value component, which would allow the ESOP 4 to convert into common stock, and it had the ability to 5 appreciate in value. 6 MS. HARKEY: Okay. So what you're saying is 7 that you took -- in essence, if the stock was trading at 8 $15 a share, you took the equivalent numbers of shares 9 out of the common stock or converted -- how did you do 10 that? 11 MS. CARLISLE: No. Okay. The convertible 12 preferred stock was a new issuance -- 13 MS. HARKEY: Okay. 14 MS. CARLISLE: -- of stock that went and was 15 issued solely for purposes of being sold to the ESOP. 16 This is not uncommon in an ESOP trade. 17 MS. HARKEY: Right. But I'm trying to get at 18 how you arrived at 250. 19 MS. CARLISLE: 250 was looking at the stock, 20 looking at the base value of the stock, looking at the 21 anticipated appreciation. 22 MS. HARKEY: Of the common stock or -- 23 MS. CARLISLE: Of the common stock. 24 MS. HARKEY: Okay. 25 MS. CARLISLE: Of the common stock. And 26 looking at the value of the repayment of the 27 $250 million loan to the ESOP. Duff & Phelps evaluated 28 all of those things to determine that the stock we sold 31 1 to the ESOP was worth more than $250 million. 2 MS. HARKEY: Okay. So when was your litigation 3 resolved? Or you still have a piece? 4 MS. CARLISLE: We have one case remaining, one 5 case dealing with lead pigment paint. We are in a 6 lawsuit with three other -- 7 MR. CUMMINS: Three other defendants. 8 MS. CARLISLE: Three other defendants; so it's 9 The Sherwin-Williams Company, plus three other 10 defendants. 11 There is a lower court decision that is being 12 appealed right now. It is a substantial number, but it 13 would be split between four companies, and it is not a 14 "break the bank" number. 15 MS. HARKEY: When did you quit producing lead 16 paint? 17 MS. CARLISLE: 1940. 18 MR. CUMMINS: 1937 interior architectural, 1938 19 exterior. 20 MS. HARKEY: Okay. So it's just one of 21 those. 22 MS. CARLISLE: It's one of those. 23 MS. HARKEY: Okay. Um, why did the debt become 24 worthless in 2007? There's something in here about debt 25 becoming worthless or something like that, that you did 26 a swap or you reduced the debt. 27 MS. CARLISLE: What we tried to do during 28 this -- 32 1 MS. HARKEY: You wrote off debt. 2 MS. CARLISLE: Well, during this whole period 3 what we tried to do is make sure we had lots of things 4 in place in case of a hostile takeover as you -- as you 5 mentioned, and the analogy to Pretty Woman is exactly 6 correct. 7 We had put in place what Sean Hennessey, our 8 former CEO, negotiated and describes as a convertible -- 9 or, excuse me, a -- a CDS Letter of Credit, a Credit 10 Default Swap Letter of Credit. 11 The company wanted to make sure that if it was 12 in dire financial straits, A) It would have the base 13 value amount to pay to the ESOP so the ESOP could buy 14 the common stock that would increase its ownership of 15 the company. It wanted to make sure that it could pay 16 off all of its creditors. 17 All of you know that if the company went into 18 bankruptcy, the creditors would have a right over the 19 shareholders. The Credit Default Swap was put in place 20 to give it liquidity such that it -- it, the company, 21 could pay off its debt holders, okay, in the case of a 22 dire financial position. 23 In addition, the company packaged its real 24 estate holdings so that they could be sold if there was 25 a dire need to do so. 26 In addition, it -- didn't it package, as I 27 recall, its trademarks? 28 MR. CUMMINS: Yeah. I worked on this 33 1 transaction. We isolated all of our trademarks. And we 2 have very valuable trademarks; the Cover the Earth logo, 3 the Sherwin-Williams name are very valuable. And we 4 isolated them into separate subsidiary so that, if we 5 needed to, we could sell off that separate subsidiary, 6 thereby taking it out of the mix of assets an acquirer 7 would get, and also raising liquidity to fight off a 8 hostile takeover. 9 Luckily we never had to do that, but we put it 10 in place. 11 MS. CARLISLE: But those were all the things we 12 were trying to do. And I think that was the reference, 13 Board Member Harkey, to the -- the creditors. 14 MS. HARKEY: Okay. Yeah, that was -- that was 15 all part of it. 16 And -- and, in fact, had there been a hostile 17 takeover, the employees -- the ESOP would have -- the 18 call on the ESOP -- or shares would have created what? 19 Would have created -- they would have had to pay the 20 ESOP or -- 21 MS. CARLISLE: The ESOP trustee, okay, not the 22 company, but the ESOP trustee could have converted the 23 shares into $85 million. Okay. The convertible 24 preferred stock into $85 million, which would then have 25 purchased 85 million shares. I'm just talking about the 26 2003 -- 27 MS. HARKEY: Right. 28 MS. CARLISLE: -- as an example. Would have 34 1 purchased 85 million shares of common stock. That would 2 have brought the ESOP's ownership interest in the 3 company from about 17 percent and change to 49 percent 4 and change. 5 MS. HARKEY: Okay. Well, why did the IRS 6 change the deduction from -- I think I read 2008 going 7 forward. What was the agreement there? Because -- 8 explain that. 9 MS. CARLISLE: What we -- what the company did 10 with respect to the Internal Revenue Service is discuss 11 the 2003, 2006 leveraged ESOP transactions. 12 The Internal Revenue Service received an 13 appraisal from their appraisal firm, their expert, that 14 did not agree with the Sherwin-Williams appraisal. 15 So, in essence, 404(a)(9) of the Internal 16 Revenue Code says that the company gets a deduction 17 equal to the purchase price of the stock. So that's why 18 valuations are very important. 19 We had our valuation expert, the service had 20 its valuation expert. It became a -- a dueling, whose 21 expert is correct. 22 As you noted in some of the exhibits that we 23 provided to you, we went to mediation, appeals, with the 24 Internal Revenue Service. The chief mediator from the 25 Internal Revenue Service questioned certain of the 26 arguments that the service was making. They were not 27 making economic substance. They were saying, "My 28 appraisal's better than your appraisal." 35 1 As I'm sure all of you know, whenever you start 2 dealing with appraisals, it's -- it's hard to say, 3 "That's the number." It may be within a range. 4 The company chose to settle the issue with the 5 Internal Revenue Service just to come to closure with 6 respect to the transactions and that's what it did. But 7 the service, in its determination and settlement with 8 the Internal -- with the Sherwin-Williams company chose 9 not to assess any penalties or interest, chose not to 10 assess amounts for the 2003 and 2004 tax years. 11 MS. HARKEY: Yeah, I do have -- I do have the 12 notes. I think we have them here as one of your Exhibit 13 C's that I have in my book, that says that they didn't 14 find anything wrong with it, in essence. They were 15 going to allow you to have that. It appeared to be -- 16 What were the words that were used? 17 MR. CUMMINS: It said the deduction was 18 proper. 19 MS. HARKEY: Yeah, it said, you know, had 20 discussion -- da, da, da. It was concluded that there 21 was no indication of anything unusual wrong and, 22 therefore, taxpayer handling of the leverage ESOP 23 appears to be proper. 24 MS. CARLISLE: And that was -- 25 MS. HARKEY: That was 5/26/06 -- 26 MS. CARLISLE: Correct. 27 MS. HARKEY: -- from the IRS auditor Jim 28 McCullough. 36 1 MS. CARLISLE: Correct. 2 MS. HARKEY: Okay. So then there's a claim 3 that the employees were never informed of the specifics. 4 They did get a couple letters. 5 I asked for 10-K's. And in the amended 2001 6 10-K, which is a public document -- 7 MS. CARLISLE: Right. 8 MS. HARKEY: -- it clearly lines out all of the 9 conversion formula. And I'm not saying every employees 10 going to go look at this, but this certainly wasn't a 11 secret. 12 The base value was there, the floor price, it's 13 all there and explained as to how they do it. Um, and 14 the fact that the employees continued to opt into the 15 leverage, or to the ESOP, indicates to me they didn't 16 feel like they were in any way harmed by it. 17 Um, I have stock price history sheet here that 18 I'll just hand out. I did kind of a little calculation 19 on the bottom of it. 20 Here, you might want to -- we can toss this 21 down and then we can give some of this to the FTB. I 22 don't know if it makes or breaks. I'm just saying I 23 have some data here. You could give one to the FTB and 24 one to the -- and then I'll pass these down. 25 This is something that I think seems more 26 complex on its face than it actually is. Um, I have 27 here the stock price. I just kind of pulled it up. It 28 was available on the computer, and I went -- and you can 37 1 see that the stock has -- has -- has increased every 2 year. Right now it's over 311, I think $311 a share as 3 of yesterday. So, truly, I think the employees are 4 probably -- and the ESOP, are probably doing okay. 5 Um, and I -- I just did a minor little 6 calculation here. On 4/2001 Dow Jones Business News 7 said the stock went down five eight -- five point -- 8 $5.33 or 21 percent. 9 And you can see on, uh -- it -- you know, you 10 can see where the stock has fluctuated, gone back and 11 forth. You can see on this graph, really better, where 12 it's up and down and up and down. And on this 13 particular graph, you can point and it gives you 14 whatever day you happen to land on, but it also gives 15 you for the month the kind of -- I think the average. 16 So if on 4/18/2001, that was the original issue 17 date, for 250,000 preferred convertible stock at a floor 18 price that I calculated at being roughly 15, $15.80, 19 because that was -- as I'm reading the formula, that was 20 the price on the date of the conversion of the -- of 21 the, uh, common stock. 22 Am I not reading that correctly? 23 MS. CARLISLE: Well, no, you're not reading it 24 correctly. 25 MS. HARKEY: Okay. 26 MS. CARLISLE: All right. 27 MS. HARKEY: Go on. 28 MS. CARLISLE: Because the value -- again, 38 1 we're talking about the value of the convertible 2 preferred stock -- was not solely equal to the amount 3 allocated to participants. Okay. It included the 4 amounts allocated to participants, plus the repayment of 5 the purchase money loan, plus a floor. Like an 6 option. 7 MS. HARKEY: So the floor, I -- I thought the 8 floor would be probably the stock price at 15 whatever. 9 Would that not be a floor? 10 MS. CARLISLE: No. The floor was the base 11 value. 12 MS. HARKEY: Okay. 13 MS. CARLISLE: I would always come -- I would 14 always have an amount of stock equal to the base value. 15 And in the 2001 transaction, it was 50 million. 16 MS. HARKEY: Okay. 17 MS. CARLISLE: In the 2003 -- 18 MS. HARKEY: Yeah, that -- that was in there. 19 It couldn't fall below -- it couldn't fall below 50 20 million, whichever was -- whichever was larger, either 21 the stock or the -- 22 MS. CARLISLE: That's correct. 23 MS. HARKEY: 50 -- 50 million -- 24 MS. CARLISLE: That's correct. 25 MS. HARKEY: -- or 50 billion. 26 MS. CARLISLE: That's correct. 27 MS. HARKEY: Fifty million. 28 Okay. Um, so I just kind of was looking at 39 1 this to see where the stock was going. And it looks 2 like it probably would have been a good investment. 3 So, to the FTB, I think we've proven there's 4 economic substance. You agreed there's economic 5 substance. You're just kind of debating how much. May 6 I -- should I say that? 7 MR. FOSTER: In a sense, yeah, I think that's 8 fair. The -- the -- the value allocated to the 9 employees is the economic substance of the arrangement. 10 So in my example where they purchase it for a 11 hundred and the employees get 60 -- which, again, their 12 formula's more complicated but that essentially is what 13 happens when you break it down mathematically. 14 MS. HARKEY: Okay. So -- 15 MR. FOSTER: Then the $60 given to the 16 employees has substance. That's economic value. We 17 have no problem with that $60 deduction. Our problem 18 was with the excess $40 that the employees can never 19 get. 20 MS. HARKEY: Okay. Because the use of the 21 formula's not one-to-one, is that the law, that it has 22 to be one-to-one? 23 MR. FOSTER: No. To my knowledge there's -- 24 there's no law on that. 25 And as far as substituting our judgment for the 26 company's, the company's management is free to use their 27 discretion and judgment to arrange this however they 28 want. We have no problem. It's their business. They 40 1 can do what they like with it. I personally happen to 2 be a fan of Sherwin-Williams. I've purchased their 3 paint before and I will do so again. 4 MS. HARKEY: No, it's not -- it's not personal. 5 I'm just trying to figure out where the law is here. 6 What -- what -- at what level is economic substance 7 established? 8 So I'm going to ask Appeals. Because you just 9 said that there was economic substance, it just wasn't 10 equal. You agree to part of it as economic substance, 11 but the other part you thought was strictly, I guess -- 12 MR. FOSTER: The excess is just a circular cash 13 flow that affects nobody's economics. 14 MS. HARKEY: It could've prevented a leveraged 15 buyout though and looks like it may have. So I think -- 16 I don't know if that's -- if that's economic substance 17 argument or not. But let me ask Appeals here. 18 So in theory, Appeals, avoiding a hostile 19 takeover, could it be a valid non -- non tax business 20 purpose for the conversion formula, putting aside 21 whether it was the most effective mechanism? 22 MR. THOMPSON: If the Board finds evidence 23 substantiates that as the actual purpose, then yes, that 24 could be a valid purpose. 25 MS. HARKEY: Okay. So if we find the evidence 26 shows that Sherwin-Williams truly and subjectively 27 structured this as a counter measure to avoid a hostile 28 bid, in the midst of their down stock due to impending 41 1 lead paint allegation, then it would be a non tax 2 businesses purpose. 3 MR. THOMPSON: Uh, correct. 4 MS. HARKEY: Okay. If we find objectively that 5 the conversion formula provided some protections against 6 a hostile bid, then this transaction would have had 7 economic substance? 8 MR. THOMPSON: Well, it goes back to purpose. 9 I think what you just stated was whether it would have 10 an effect. And whether it would have an effect is 11 different from whether that was the purpose. 12 MS. HARKEY: Okay. Okay. So I guess I get 13 back to how do we determine economic substance, and is 14 it on a one-to-one scale? Or is there -- and I think 15 I've shown by your answers that there's other -- there's 16 other means for economic substance. So if this is a 17 legal argument on economic substance, I think the 18 appellant has established that. And I think that's 19 where this case is, is that -- and so now it's just 20 should it be one-to-one, and is that the law? And I 21 don't believe that is the law. 22 So it's, uh -- it's a very complex case, but 23 not really when you boil it down. You know, what were 24 they doing at the time? And what -- what did they do to 25 prevent what could have happened? Are the employees 26 made whole? Looks like they have been over time. Quite 27 a bit going from 18 or 15 or whatever dollars a share to 28 311 today. All this, and the company stayed and the 42 1 employees' participation rate's at 90. I just -- I 2 can't see that the employees were harmed. 3 I know that the FTB would like a one-to-one 4 match, but I don't believe the IRS had a one-to-one 5 match. And I think this is federal. 6 So, with that, I'll just end, and I may come 7 back. But I've really -- I really put a lot of work 8 into this because I was trying to understand it. Other 9 than just -- other than just a credit or LBO argument. 10 I was trying to really understand what happened on the 11 way. 12 Thank you. 13 MS. MA: Okay. Ms. Stowers. 14 MS. STOWERS: Thank you. I'm going to start 15 with the appellant first. I want to get clarification. 16 You indicated that the IRS did not adjust on 17 the 2003 and the 2004 year. 18 MS. CARLISLE: Yes, ma'am. 19 MS. STOWERS: Was the 2004 year part of the 20 closing agreement? 21 MS. CARLISLE: Yes, ma'am. 22 MS. STOWERS: Okay. That's what I -- that's 23 what I thought you were indicating that was separate. 24 MS. CARLISLE: No. Sorry. 25 MS. STOWERS: Okay. So it was part of the 26 closing agreement. And they initially had proposed to 27 make adjustments on 2004. 28 MS. CARLISLE: They had proposed to make 43 1 adjustments, yes. 2 MS. STOWERS: Okay. 3 MS. CARLISLE: Yes. 4 MS. STOWERS: 2004 through 2008. 5 MS. CARLISLE: Eight, correct. 6 MS. STOWERS: And through the settlement 7 negotiation they agreed not to make it for 2004 and 8 2005. But that's through settlement, that does not mean 9 that the reported deductions were proper or improper. 10 It's just what was agreed upon in settlement. 11 MS. CARLISLE: It was a settlement, yes, 12 ma'am. 13 MS. STOWERS: Okay. 14 With the settlement, you guys amended your 2006 15 through 2008 California tax returns? 16 MS. CARLISLE: Yes, ma'am. 17 MS. STOWERS: Franchise Tax Board, did you 18 guys -- were you in agreement to accept those returns? 19 Did you -- or are they subject to audit? 20 MR. FOSTER: I'm not aware that they're subject 21 to audit right now. I mean I can say if -- to the 22 extent they amended the returns to stop deducting the 23 excess amount, certainly FTB would've been happy with 24 that result. 25 MS. STOWERS: Did you guys pay additional tax 26 when you amended your returns? 27 MS. CARLISLE: Yes, ma'am. 28 MS. STOWERS: Um, to the, um -- to the actual 44 1 transaction, in my reading you talked a lot about, and 2 it appears that the IRS was challenging the transaction 3 based on valuation. 4 MS. CARLISLE: Yes. 5 MS. STOWERS: They were like the battles of the 6 experts. 7 Um, FTB is not disputing value. FTB is just 8 talking about the conversion formula that's used. That 9 seems to be the issue, whether or not that conversion 10 formula had economic substance. 11 So would you please explain why you used that 12 conversion formula and how it had value and economic 13 substance, especially considering that the employees did 14 not know about that formula as detailed? 15 MS. CARLISLE: Certainly. Again, economic 16 substance of a transaction depends upon whether -- if I 17 look at the definition in the case law, which the Board 18 has accepted, it requires a change in the economic 19 position of the parties and it requires a business -- 20 non tax business purpose for the transaction. 21 What the FTB is -- is saying and your question, 22 Board Member, is -- relates to a component of a 23 transaction, the conversion formula, which all goes to, 24 What is the value of the stock that we sold to the ESOP? 25 The reason that the stock in the business 26 judgment of the company was structured the way it was, 27 was to provide the ESOP with a set amount of dividends 28 so that it could repay the interest, provide the ESOP 45 1 with a guaranteed prefunded amount so that matches could 2 be made of employee contributions. And that 3 appreciation would be available on the stock that was 4 eventually, uh -- or on the convertible preferred stock, 5 appreciation in the common stock, and that no matter 6 what -- most importantly, no matter what happened to the 7 company, there would be a base value to that stock. So 8 that that convertible preferred stock would always be 9 converted, be capable of being converted into a 10 substantial block of common stock if the company, um -- 11 and I'll use the term -- "went to hell in a hand 12 basket." 13 MS. STOWERS: Okay. 14 MS. CARLISLE: And, you know. So that was the 15 company's judgment, that that's what they wanted to 16 do. 17 MS. STOWERS: All right. Um, looking at the 18 press release from the U.S. Department of Labor. 19 MS. CARLISLE: Yes, ma'am. 20 MS. STOWERS: Um, how do you reconcile the sort 21 of non tax business purpose of employee retention when 22 the Department of Labor found that Sherwin-Williams' 23 purpose in the transaction was to take advantage of 24 substantial tax benefits which are designed to reward 25 companies that provide workers with significant stock 26 ownership, but yet Sherwin-Williams at that time ensured 27 that the employees did not actually receive the stock or 28 retirement benefits in the amount -- in amounts close to 46 1 what they actually -- what the plan paid for. 2 So here you're getting a substantial tax 3 deduction. You're supposed to be setting up the plan to 4 benefit your employees, but the Department of Labor 5 found that that's not -- that was not the case, and 6 basically in your settlement required you to restore, 7 give back to the employees, $80 million. I'm taking 8 that to mean that that conversion formula prevented them 9 from getting the 80 million and that's why you had to 10 give it back, to make them whole. 11 MS. CARLISLE: Okay. A couple of things. 12 First off, number one, that was not a determination. 13 In dealings with the Department of Labor, the 14 Department of Labor issues press releases, unlike the 15 Internal Revenue Service, or I'm sure unlike the Board 16 of Equalization, where they can say virtually anything 17 they want to say. These were not determinations made by 18 any judicial body. This was what the Department of 19 Labor thought. 20 The amount paid to settle the Department of 21 Labor case was an $80 million payment that was 22 negotiated by the company with the Department of Labor 23 to provide $80 million to the employees of the company. 24 The management of Sherwin-Williams agreed to do 25 that. And as I believe Sean Hennessey in his 26 declaration has stated, they did that, number one, 27 because it was going solely to the employees. And two, 28 they just wanted to get rid of any concerns with respect 47 1 to the leveraged ESOP. 2 But I want you to please understand that that 3 $80 million was approximately -- and help me, Mike -- 15 4 percent of what the Department of Labor determined was 5 inappropriate, 15 percent. So it was almost a nuisance 6 settlement. But that's -- so, the $80 million was not 7 pegged to a tax deduction. This is purely an ERISA 8 call. 9 MR. CUMMINS: And I would also add that it was 10 paid at a time after many of our most loyal employees 11 had gone through tough times with us through the lead 12 paint. That $80 million could not have been paid 13 otherwise because of the IRS limitations on annual 14 contributions. So it was actually a way for us to 15 reward our employees who had stuck with us. 16 MS. CARLISLE: And that's what the company in 17 fact did. 18 MS. STOWERS: And on the IRS closing agreement, 19 um, how much tax did Sherwin-Williams end up paying? 20 MR. CUMMINS: In total? 21 MS. CARLISLE: Oh. I'm trying to remember. 22 MS. STOWERS: I did a quick little estimate, 23 looking at what they originally proposed and what 24 they -- what was agreed upon and just the adjustments 25 itself for the 404(a) and 404(k). And looking at it, 26 using a 38 percent tax rate, I came up with about 27 $59 million in tax. 28 MR. CUMMINS: I think it was a little more than 48 1 that. 2 MS. STOWERS: Little more than that? 3 MS. CARLISLE: But it was -- it wasn't 4 substantially more than that. It was -- again, it was 5 17 percent of what they originally assessed. 6 MS. STOWERS: But that's -- but 17 -- actually, 7 looking at what the settlement adjustments agreed to, 8 I've got 158 million in adjustments, compared to 846 9 million that was claimed on the original tax return, so 10 that's 33 percent. 11 Looking at the 404 -- looking at all the 12 deductions claimed and deductions allowed, that's 33 13 percent for tax owed at 59 million. On top of that, you 14 have the excise tax through the, um, government exempt 15 entity for $60 million. 16 So it was not just a small amount. It was 17 substantial understatement of tax that was owed at the 18 federal level, on top of the $80 million paid to the 19 Department of Labor. 20 MS. CARLISLE: Well, the Department of Labor 21 payment was not to -- 22 MS. STOWERS: Correct. 23 MS. CARLISLE: -- the Department of Labor. 24 MS. STOWERS: Okay. The settlement that was 25 given to the employees. 26 MS. CARLISLE: To the employees. 27 MS. STOWERS: Just looking at the -- the -- the 28 tax dollars and the payments to the employees, there 49 1 were substantial -- there were significant concerns on 2 both federal agencies' side that something was wrong 3 with this transaction. 4 MS. CARLISLE: They -- the settlement was 17 5 percent of what they assessed. 6 MS. STOWERS: Okay. 7 MS. CARLISLE: Seventeen percent. 8 MS. STOWERS: Okay. 9 MS. CARLISLE: So -- 10 MS. STOWERS: Well, my numbers don't show 17 11 percent. My numbers show that they disallowed 33 12 percent of the claimed deductions. 13 MS. CARLISLE: I believe in one of the 14 exhibits -- and I'm sorry, I don't have it specifically 15 with me -- we did provide to you the -- the sheet. It 16 was an email from the head of the Appeals Division that 17 negotiated the settlement with the company. And that's 18 where we get the 17 percent. 19 MS. STOWERS: I did see that. I did see that. 20 And that's why I took the time to crunch the numbers, 21 because you had said and I read that letter that said 17 22 percent. 23 MS. CARLISLE: We can -- 24 MS. STOWERS: But I'm just saying that based on 25 when you crunched the numbers of what was reported on 26 the tax return and what was disallowed, just adjustments 27 alone, that's 33 percent. And then when you run the 28 estimated tax rate of 38 percent, you just agreed that 50 1 the tax amount was about $59 million. That's not 2 insignificant in tax. 3 MR. CUMMINS: We agree. 4 MS. CARLISLE: Oh, we agree. That's why we 5 fought them very, very hard. 6 MS. STOWERS: That's what I'm saying. 7 Now, to the Franchise Tax Board, um -- 8 MR. CUMMINS: I just -- if I could, maybe -- 9 I'm thinking maybe the discrepancy in the percentages is 10 the IRS also assessed many penalties that eventually 11 they dropped. 12 MS. STOWERS: I -- I kept that separate. I saw 13 the accuracy-related penalty which -- which they took 14 away. 15 MS. CARLISLE: Exactly. 16 MS. STOWERS: Yeah, I kept -- in my 17 calculations, I kept it separate. 18 MS. CARLISLE: Thank you. 19 MS. STOWERS: To the Franchise Tax Board, what 20 is your take on the Department of Labor's press release? 21 MR. FOSTER: Well, as you might imagine, we 22 have a different take from appellant on it. We think 23 the Department of Labor, they're -- they're looking into 24 the issue and the settlement and what was stated in the 25 settlement, not just the press release, we believe 26 supports our case. 27 I mean they did make certain findings of fact. 28 Now, whether it was a determination or not, if we want 51 1 to argue about the wording, that's fine. They did reach 2 a settlement that worked for both parties, which 3 agencies do all the time. But they got to that 4 settlement because the Department of Labor made findings 5 that the intent of this was not to help the employees. 6 MS. STOWERS: Um, let's talk about the 2003 7 year. So Franchise Tax Board, you started your audit of 8 2003 and 2004. Um, when you started your audit, were 9 you aware of ongoing IRS audit for the 2003 year? 10 MR. FOSTER: I'm not sure if the auditor was 11 aware or not. In the audit stuff I was looking at, um, 12 I don't recall seeing mention of that. 13 MS. STOWERS: I understand that FTB would do 14 their own independent audit. And I actually don't have 15 a problem with 2003 then an independent audit of 2003. 16 Just looking at the work paper that you guys did provide 17 us for your IRS 2003 audit, it's really clear in my eyes 18 that that auditor did not even know what a ESOP was or 19 if it was tax shifter. So that's a perfect example of 20 why the Franchise Tax Board would run their own 21 independent audit. 22 However, I am struggling with the 2004 year 23 because the 2004 was part of the closing agreement. And 24 if they came to an agreement on 2004, basically to 2008, 25 and made adjustments on their California returns for 26 2006 forward and FTB is not disputing it, it seems to me 27 that you're accepting the IRS closing agreement for '05 28 through '08 -- or '06 through '08, and you should be 52 1 doing the same thing for '04 and '05. Can you speak to 2 that, please? 3 MR. FOSTER: Well, if we're accepting the 4 self-assessed adjustments that appellant would make on 5 the amended return, in FTB's view does not indicate 6 acquiescence to the entire IRS closing agreement. 7 In this sense, this was a closing agreement 8 that appeared not to be specific on the merits but more 9 of a settlement nature that reached a final number 10 everybody could come to terms with. And the issues are 11 exactly the same for the different years. 12 And the result was, for whatever reason the IRS 13 decided that for certain years going forward, and 14 appellant agreed, they would stop deducting the amounts 15 that are in excess of the value the employees received. 16 And we're simply trying to apply that same methodology 17 to the earlier years, to reach a similar result. And 18 the results of our work apply equally to the different 19 years, regardless of which one was included in the 20 closing agreement or not. 21 MR. CUMMINS: May I address the 2003 year? 22 MS. STOWERS: Yes, go ahead. 23 MR. CUMMINS: The two thou- -- I don't know 24 what you have in the record, but the 2003 year was taken 25 to the national office of the IRS, and it was presented 26 to the IRS ESOP expert and we do have the documentation 27 on it. There's a series of emails between the local 28 auditor who did not understand ESOPs, that's why he went 53 1 to the national office and asked for that. 2 MS. STOWERS: I have that. That's the 3 information I was referring to. 4 MR. CUMMINS: Okay. 5 MS. CARLISLE: Yeah. 6 MS. STOWERS: Um, so that's why I was saying 7 that it was for that local auditor. 8 MS. CARLISLE: He needed assistance. 9 MS. STOWERS: Yes. 10 MS. CARLISLE: Yes. 11 MS. STOWERS: When the FTB was -- to the 12 appellant. When FTB was auditing the 2003 through the 13 2004 year, my notes indicate at some point in time, um, 14 your communication broke down? Their audit issue 15 section report says that the taxpayer stopped providing 16 information. Can you speak to that? 17 MR. CUMMINS: I have no recollection of that 18 whatsoever. 19 MS. CARLISLE: No. 20 MS. STOWERS: FTB, do you -- do you have any 21 information on why, what happened? 22 MR. FOSTER: No. What's in the audit file -- I 23 wasn't there at the time. But the audit file indicates, 24 um, I think the auditor used the word "stopped 25 cooperating" or "uncooperative." 26 MR. CUMMINS: That's not our nature. 27 MS. CARLISLE: No. 28 MR. CUMMINS: We -- we don't operate that way 54 1 in the tax department. 2 MS. STOWERS: And that was back in July of 3 2009. 4 So in 2009, were you in settlement with the IRS 5 for these -- for 2004 through 2008; were you negotiating 6 then? 7 MS. CARLISLE: Not yet. 8 MR. CUMMINS: We were still in the audit 9 process. 10 MS. CARLISLE: We were in the audit process. 11 We were not in settlement talks. 12 MS. STOWERS: You were in audit? 13 MS. CARLISLE: Yes, ma'am. Because, remember, 14 it was through 2008. 15 MS. STOWERS: Okay. Thank you. 16 Thank you. 17 MS. MA: Mr. Horton. 18 MR. HORTON: Yeah, I guess so. 19 Um, question of the taxpayer. Did the Board of 20 Directors -- were the Board of Directors advised of this 21 strategy? 22 MS. CARLISLE: Yes. 23 MR. HORTON: Do you have documentation to 24 indicate that they were? 25 MR. CUMMINS: Yes. 26 MS. CARLISLE: Yes. 27 MR. HORTON: You provided that to the Franchise 28 Tax Board? 55 1 MR. CUMMINS: Yes. 2 MS. CARLISLE: Yes. 3 MR. HORTON: Franchise Tax Board, what do you 4 think about that, relative to the economic purpose? 5 MR. FOSTER: The documentation that we have 6 that was given to the Board of Directors does not talk 7 about economic substance or business purpose. It just 8 describes the mechanics of the transaction. 9 MR. HORTON: Taxpayer, response? 10 MS. CARLISLE: Of course it describes the 11 mechanics of the transaction. I mean the judgment of 12 the company, the management was to unpursue this 13 particular transaction for employee retention and 14 hostile takeover concerns. 15 MR. HORTON: Is the, uh -- question of the 16 Department. Is there -- is it required to have a 17 one-to-one value? 18 MR. FOSTER: No, there's no requirement. As we 19 said, FTB's fine with the company using whatever 20 judgment it wants. What we're not okay with is taking 21 what we see as an artificially inflated tax deduction. 22 They can do whatever they like with the transaction, but 23 they don't always get the tax consequences they want 24 from it. 25 So here, to the extent that -- that there was a 26 circular cash flow which exceeded the actual economic 27 value given to the employees, that circular cash flow 28 produced no economic effect and under the economic 56 1 substance doctrine then does not produce a deduction. 2 MR. HORTON: What about the intangibles -- the, 3 um -- that exist in the transaction? 4 MR. FOSTER: This literally today is the first 5 we've heard of that. So, I can't speak to it. 6 MR. HORTON: Okay. Let's go to the taxpayer. 7 In regards to the intangibles, there was a discussion 8 between the Internal Revenue and the business, I would 9 presume, around valuation. 10 MS. CARLISLE: Yes. 11 MR. HORTON: In that discussion the intangibles 12 probably took front and center -- 13 MS. CARLISLE: Of course. 14 MR. HORTON: -- as to what the valuation was. 15 What was your position relative to the intangibles? 16 MS. CARLISLE: Our position was that the -- 17 that Duff & Phelps appropriately valued the stock as 18 being worth more than the purchase price that was paid 19 by the ESOP, which determines the deduction for the 20 company. 21 The appraisal expert for the Internal Revenue 22 Service, um, discounted certain, you know, values that 23 Duff & Phelps included in their valuation. So it was -- 24 it was the dueling experts, Board Member Horton. 25 MR. HORTON: Giving weight to the consideration 26 of the cost of litigation, why didn't the taxpayer 27 settle? 28 MS. CARLISLE: Seventeen percent, and also the 57 1 fact that this is -- these are transactions -- I mean 2 right now we're -- we're talking about tax years 2003 3 and 2004. This is 2017. Okay. 4 The company is no longer utilizing the 5 leveraged ESOP program because, as we said, there is one 6 case remaining dealing with lead pigment, and we hope 7 that will be successfully resolved soon. 8 The company is just trying to get, uh -- not 9 worry about this anymore, cost of litigation. 10 MR. HORTON: Okay. Subsequent -- subsequently, 11 in the subsequent years, the company decided to amend 12 the returns and paid additional tax; why was that? 13 MS. CARLISLE: Because it's supposed to do 14 that. 15 MR. HORTON: What was the amendments? 16 MS. CARLISLE: Uh -- 17 MR. CUMMINS: Just to reflect the settlement 18 with the IRS. 19 MS. CARLISLE: Just to reflect the settlement 20 with the Internal Revenue Service. I mean -- 21 MR. CUMMINS: Changed our income, so we amended 22 all of our state returns to reflect the interest 23 income. 24 MR. HORTON: So the amendments had nothing to 25 do with the valua- -- the original valuations? 26 MS. CARLISLE: Well, they had to do with the 27 settlement, which was the -- the resolution between the 28 two valuations, yes. 58 1 MR. HORTON: Question of the Department. The, 2 um -- establishing a floor, a floor base value, a lot of 3 people make investments to -- because they're not 4 risk-takers, and so they look for an opportunity to 5 guarantee a return on their investment and that that 6 floor base value is there. 7 What says the Department about the valuation of 8 the company establishing the floor base value as well 9 as setting up an allocation for repayment of the 10 purchase money loan? 11 MR. FOSTER: Well, a couple of things. I mean 12 one on the, um -- and this kind of overlaps what you 13 were previously asking about the -- the original 14 valuations and the experts. 15 The FTB didn't get into trying to -- the battle 16 of the experts, as you called it, because that just kind 17 of goes back and forth forever. And ultimately, we 18 didn't believe the original valuation mattered because 19 it was never going to always get to the employees. 20 If -- 21 MR. HORTON: I mean, when you -- my apologies 22 for interrupting, but when you put forth an argument in 23 the example, the 60/40 example, that the 40 circular had 24 no value whatsoever and, therefore, it had no value that 25 would tie into the economic purpose, acknowledging that 26 the 60 did have an economic purpose and, um, that the 40 27 did not because it just was circular, indirectly you are 28 making a value judgment to the 40 in your example. 59 1 MR. FOSTER: Well -- 2 MR. HORTON: So, in making that valuation 3 judgment, it would seem that you would have to consider 4 the, both, tangible and intangible values associated 5 with the stock. 6 MR. FOSTER: What we're saying is that it 7 was -- it was never -- it was never a real value. The 8 extra 40 was only ever going to be a circular cash flow 9 that could never get to the employees. And there was 10 the -- there was the floor value when its effect was 35 11 percent. So it's telling the employees you can get 12 somewhere between 35 and 60, but you can never get the 13 100, no matter what. 14 MR. HORTON: Wow. Question of Appeals, 15 because -- only because I just can't recall. IRS code 16 404 allows for a, uh, deduction for payment on -- 17 payment of a loan utilized in the purchase of the 18 employees' securities. Given that that's the case, it 19 would seem to me that the intangible security of having 20 that repayment for the loan would have a value and would 21 be deductible if in case they -- they did so. 22 MR. THOMPSON: Uh -- uh, right. I -- I do 23 think, uh, it may have some value. It's difficult for 24 me to see how, uh, it could have a value of 350 million 25 when under no circumstances could the ESOP beneficiaries 26 get 350 million. 27 MR. HORTON: 350 million. 28 Okay. Um, we -- we -- we seem to be in the 60 1 ballpark somewhere. The FTB is at first base. 2 MR. CORNEZ: I think that there's a step 3 missing in -- in what I'm hearing. 4 I've heard the question "Is there one-to-one 5 value?" The ESOP -- the ESOP borrowed a hundred 6 dollars -- 7 MR. HORTON: Well -- well -- well, let me 8 share. I don't believe that the law prescribes that 9 there has to be a one-to-one value in order to have the 10 deduction. I believe that the law allows to have these 11 other intangibles. The question now becomes -- the 12 similar question that the Internal Revenue has is, "What 13 is the actual value that you assign to the economic 14 purpose?" 15 Uh, it seems to be that everyone submits that 16 there was an economic benefit. There was a business 17 purpose. One party, uh, believes that that purpose 18 is -- is value based on -- in the example -- the $60 19 because that's all the employees would receive. 20 Uh, but it would seem to me that the benefit or 21 the fiduciary responsibility is to the board of 22 directors and the stakeholders and so forth. And the 23 decision to participate is not a mandatory decision. 24 And so the valuation is a risk valuation that 25 the employees made, that where the employees looked at 26 the overall benefit of their investment and decided to 27 make the investment. 28 Uh, which gave it some value. I just 61 1 personally, you know, doesn't seem to be enough evidence 2 to support what that value was aside from the settlement 3 agreement between the Internal Revenue and possibly 4 looking at the amended -- subsequent amended returns to 5 see what actually took place then. 6 So, thus, my thoughts that we're somewhere in 7 the ballpark, but I just -- 8 Is that, maybe directional? Not helpful but 9 directional. 10 MR. CORNEZ: Well, so there's a difference 11 between the business decision that the company makes and 12 the business standard of making that decision to create 13 an ESOP and the fiduciary standard that the trustees of 14 the ESOP have to make when they decide to purchase the 15 stock of the company. 16 That is, the fiduciary -- 17 (Break in video/audio recording from 1:57:29 to 18 2:02:42.) 19 MR. HORTON: -- is that -- and I -- I just want 20 to say to the Department, I mean I appreciate taking a 21 hard-line position relative to the valuation. But then 22 you put this body at a disadvantage of having to make 23 some judgment call based on decisions made by the 24 Internal Revenue and subsequent filings and so forth. 25 But, such is the case. 26 Thank you, Madam Chair. 27 MS. MA: So I think I agree with where you're 28 going. 62 1 MR. HORTON: Yeah. 2 MS. MA: But I do have some questions for the 3 Franchise Tax Board. 4 Um, when you -- in your handout, in example 5 number three, it's a pretty simple handout; you know, 6 shares, conversion formula to common shares. 7 Um, in this case, they have an $85 million base 8 floor value that doesn't have anything to do with the 9 stock price. How do you account for that in your 10 diagram? 11 MR. FOSTER: If you wanted to change the 12 diagram to be precise in that manner, then the -- the -- 13 the bottom part on the right side, the $60, it would 14 read somewhere between 35 and 60. 15 We're sort of being generous there assuming 16 that the upper end -- and, again, the $60 is -- is even 17 generous there. In real life it was more like 55. 18 But the base value is a 35 percent number. So 19 that means the employees would get somewhere between 35 20 and 60. And then somewhere between 40 and 65 would 21 be -- 22 So the -- the green number or the bottom half 23 would be flexible on the 60. It could go lower. And 24 the top half of the circular cash flow could get larger 25 if we're taking account of that. 26 MS. MA: Okay. So to the taxpayers. 27 MR. CUMMINS: I think the FTB's 28 misunderstanding the base value. The base value is 63 1 incremental to what gets allocated to accounts. If you 2 want to take a $35 value to the base value, that's 95. 3 You would add the two, not subtract. 4 MS. MA: Okay. And that's my understanding. 5 So, um, it's not directly related to the value of the 6 stock. But, um, to the extent the stock prices go down, 7 they're still going to get that price. 8 MR. CUMMINS: To make incremental benefit. 9 MS. MA: Correct. 10 MS. CARLISLE: Yeah. And intangible, yes. 11 MS. MA: And then, um, you know, to Appeals, I 12 know that you said that the IRS appraised the value of 13 the convertible stock at 135. The value of the 14 respondent's proposed assessment places a value of 15 convertible stock at 212. And then the independent 16 trustee value of the convertible stock at 350 million. 17 And you say that there's no way that the employees could 18 actually, um, get the 350. 19 So, based on their formula of an $85 value, 20 base value, plus the appreciation, right, for stock, I 21 mean how -- how -- isn't there a scenario that they 22 could get over 350? 23 MR. THOMPSON: First, I'm not sure what you're 24 reading from there. But no, there's no way they would 25 get above $350 million or $350 million. Under no 26 circumstances can the ESOP participants receive what the 27 ESOP paid for the stock. 28 MS. MA: Okay. To the taxpayers. 64 1 MS. CARLISLE: Let's just take the 2003 2 transaction. The ESOP borrowed $350 million to purchase 3 convertible preferred stock. The ESOP was given 4 $350 million to repay the loan, plus the ESOP was given 5 the right to convert that convertible preferred stock 6 into common stock which appreciated in value. In the 7 2003 transaction, that was 212 plus 350 million. 8 So the ESOP and the ESOP participants received 9 572 million for the 350 million value of convertible 10 preferred stock. 11 MR. CUMMINS: The value of the convertible 12 preferred paid off the loan and -- 13 MS. MA: Funded the ESOP. 14 MS. CARLISLE: -- and gave 212. And -- and the 15 guarantee. 16 MS. MA: And the guarantee. 17 MS. CARLISLE: And the guarantee. 18 MS. MA: So it's actually above the 350. 19 MS. CARLISLE: We are. Yes. And that is in 20 effect what Duff & Phelps came up with. 21 MS. MA: Okay. So -- 22 MR. FOSTER: If I might. 23 MS. MA: Yeah, Franchise Tax Board, did you not 24 agree with the -- 25 MR. FOSTER: This would be -- 26 MS. MA: -- trustee evaluation? 27 MR. FOSTER: This would be literally the first 28 time we have heard appellants argue that the ESOP 65 1 participants could get up to or greater than 2 350 million. We have been stating over and over that 3 they can't because it's just a simple mathematics of the 4 formula. 5 There -- there are terms in the formula. There 6 are two terms in there that are factions less than one. 7 There are no terms in there that are fractions greater 8 than one. Therefore, the formula always mathematically 9 comes out to less than 100 percent. It's a mathematical 10 certainty. 11 MS. MA: I don't see it like that, but I 12 think there's a disagreement with that formula. 13 And did you agree with the independent trustee, 14 the value? I mean, is this trustee a reputable firm? 15 MR. FOSTER: Well, I will say, under the 16 Department of Labor settlement, um, they had all of 17 their fiduciary obligations audited and were told never 18 to engage in this kind of transaction again. 19 MS. MA: Tax -- taxpayer, what happened at the 20 Department of Labor? 21 MR. CUMMINS: Did not do a valuation. They 22 offered us a settlement. They offered us a way to put 23 $80 million into our participant's accounts that we 24 otherwise could not have after we -- our participants 25 had gone through this very difficult time with us. 26 MS. MA: And why was -- 27 MS. CARLISLE: And the independent trustee was 28 Great Bank Trust Company, a company that is known 66 1 throughout the United States and is a very reputable, 2 uh, organization that represents ESOPs. 3 MS. MA: So the fact that Department of 4 Labor -- you know, the settlement was to give 5 $80 million more to your employees, why was that? Were 6 you undervaluing your ESOP calculations and -- 7 MS. CARLISLE: We did not think we were. Okay. 8 And we were -- this, again, goes to hazards of 9 litigation, cost of litigation and the ability to just 10 get things behind. 11 If the $80 million settlement had been "You 12 have to give $80 million to the government," I don't 13 believe the company would have settled. I really -- I 14 really -- I really don't. 15 MS. MA: Because that means that you didn't 16 calculate -- do your calculations correctly, right, if 17 the government said, you know -- 18 MS. CARLISLE: No. But the government said 19 "We'd take $80 million and you must give it to your 20 employees." The -- the company determined that that was 21 an okay thing to do. One of the reasons -- and Mike -- 22 Mike said it just a moment ago -- was they could not 23 give those extra amounts even if they wanted to, to 24 their employees, because of plan limitations on what you 25 could contribute to an ESOP. 26 MS. MA: Right. 27 MS. CARLISLE: This enabled them to give -- 28 MS. MA: Right. 67 1 MS. CARLISLE: -- a -- 2 MS. MA: And so, um, like ERISA, you know, 3 under the ERISA laws, what -- what do they use to value 4 that the employees were entitled to more? 5 MS. CARLISLE: Uh, you're asking me to second 6 guess the Department of Labor, and heaven forbid that I 7 would ever be able to do that. 8 MS. MA: Was there no writeup or -- 9 MS. CARLISLE: No. What they were doing was 10 basically just saying in this particular transaction, 11 uh, the value of the stock was not worth what you -- you 12 thought it was. They did not ever do a valuation, at 13 all. 14 MR. CUMMINS: And in my opinion -- 15 MS. MA: So your calculations, right, if they 16 decided to give $80 million more to the employees, that 17 your calculations were too low. Or the value of the 18 stock was not correct or -- 19 MS. CARLISLE: I have no -- 20 MS. MA: Okay. 21 MS. CARLISLE: I mean, as I said, it was 15 22 percent of what they originally assessed. Okay. 23 MS. MA: Okay. 24 MR. CUMMINS: In my opinion, I don't think the 25 DOL ever really understood the transaction. 26 MS. CARLISLE: I don't either. 27 MR. CUMMINS: The settlement was palatable to 28 our management, whether it was deserved or not, because 68 1 it went to the participants. 2 As we noted earlier in the presentation, we had 3 the ability to alter the amount of match we made, and we 4 did that during the years. So there were some years 5 where our match was lower. This was a way to restore 6 the match. We thought it was a wonderful settlement for 7 our participants. Very, very palatable. 8 MS. MA: Okay. So -- so they got more money 9 than -- 10 MS. CARLISLE: Than they would have gotten. 11 MS. MA: That was -- yeah. Okay. 12 Ms. Harkey? 13 MS. HARKEY: Well, I just -- I just want to 14 kind of circle back that, um, the 250 or the 350, I -- 15 you know, that was just like almost a prefunding of 16 loans that could be repaid so everything could happen. 17 It's kind of like when you are -- take out a loan, or 18 your parents take out a loan on their house, uh, because 19 they want to have that -- that, you know, reducing 20 equity. What's that called, where -- where you've got, 21 you know -- 22 MS. CARLISLE: Reverse equity? The reverse 23 mortgage. 24 MS. HARKEY: Yeah, the reverse equity mortgage. 25 Where you just -- they figure out what the value is and 26 include -- be sure it has all the payments and all the 27 interest in it and just pays it off so that the ESOP -- 28 number one, that would have the effect of increasing 69 1 your debt on your balance sheet, so increase your own 2 personal leverage or the company's leverage. Number 3 two, it would lock in the ability for the employees to 4 get something, not to be -- not to be leveraged out -- 5 MS. CARLISLE: Correct. 6 MS. HARKEY: -- should a hostile bid take over 7 or should you have a bankruptcy scenario which was 8 highly likely looking at what you were looking at in 9 litigation. Um, so that did have economic substance, 10 very strong economic substance. 11 And so I was always trying to get to how you 12 got the 250. And over the course of the conversation 13 and the questions with the other Members, it kind of 14 came to me as to what you were actually doing. 15 So, um, I think there was economic substance. 16 I don't think we have to have a one-to-one match. I 17 think I've established that with Appeals. 18 Avoiding hostile take -- takeover was a 19 nonbusiness purpose for the conversion formula. Uh, 20 we're just arguing about the conversion formula; do we 21 like it or do we not? And that, to me, does not -- does 22 not go to the argument which was, you know, is -- 23 is there -- is there ec- -- did it meet the economic 24 substance argument? And I think the fact that the 25 shareholders did get value, the fact that you were 26 warding off hostile takeovers, which is a non tax 27 business purpose and, um, that, you know, the -- the 28 participation rate of the employees is -- is tremendous. 70 1 And, you know, after the fact, the stock price has truly 2 shown that you did ward off the hostile takeover. 3 So I -- I just -- I think you've made your case 4 very, very strongly. And I don't think the FTB, in 5 assigning, or trying to decide what the formula should 6 be has made their case. 7 I think that you've just said that what they 8 put in is what they should get out. And I think that 9 there are other non tangible benefits to these 10 employees, as Member Horton pointed out, that were 11 really important at the time. 12 The IRS settlement seemed to accept most of 13 that, that there was a little negotiation at the end. I 14 think when you're in years of litigation, you've got 15 IRS, you've got Department of Labor, you've got 16 everybody in the world looking, investigating, and 17 you're a publicly traded company, you probably try to 18 cut your deals and, you know, figure out what -- at what 19 point, you, um -- 20 The fact that the company continued in the 21 litigation and did not settle, uh, and has not settled, 22 and has warded off just about everything now down to 23 one, speaks to its, uh -- its strength and its ability 24 to keep, uh -- keep operations going and keep employees 25 and whatnot. 26 So, I think there was a strong economic 27 substance argument here on either one of the prongs. 28 And so with that, I will, uh, end my comments. I just 71 1 wanted to be sure everybody understood the money. 2 MS. MA: Ms. Stowers. 3 MS. STOWERS: Yes. Thank you, Chairwoman. 4 To the Franchise Tax Board, the appellants were 5 making comments regarding valuation and some intangible 6 items and the ability to, uh -- for your -- for the 7 employees to receive more than, I think it was 250 8 million or 350 million. 9 Um -- good, I got it all right. 10 To the Franchise Tax Board, um, you indicated 11 that some of those comments, some of those arguments 12 were new for you to hear today? 13 MR. FOSTER: Well, we have -- we have never 14 heard the intangible argument before. And we have never 15 heard appellants assert that the employees could get 16 more than the 350 or the 250. And I'm having trouble 17 understanding that one, quite frankly, because the -- 18 the formula is fairly simple arithmetic. 19 MS. STOWERS: Could you -- would -- would it be 20 beneficial for the Franchise Tax Board to take a look at 21 those arguments and review the conversion formula and 22 the value and come back? 23 MS. CARLISLE: It is in our briefs. Okay. It 24 is. We have -- we have clearly demonstrated over and 25 over again in our submissions that the loans were 26 repaid, that the $85 million was there as a base value 27 to be converted into common stock. 28 I -- I am -- I am surprised to hear that the 72 1 FTB is surprised. 2 MS. STOWERS: Appeals, is it in the briefs? 3 MR. THOMPSON: FTB asked, at least twice in the 4 briefing, for appellant to provide an example of where 5 the ESOP beneficiaries could receive more than 6 $350 million, and appellant's answer was somewhat 7 evasive. 8 In additional briefing the Appeals Division 9 repeated that question; and appellants, again, did not 10 provide an example. So this -- 11 MS. CARLISLE: But again -- 12 MR. THOMPSON: This is the first time that we 13 have heard them make the argument that the beneficiaries 14 could receive more than the 350 million. 15 MS. STOWERS: I think it would be beneficial -- 16 I understand what you're saying, but I -- I -- I, 17 Members, think it would be beneficial if you would 18 provide an example of what you just said and give the 19 Franchise Tax Board an opportunity to evaluate what 20 you're saying, because they may have a different 21 position once they're able to look and evaluate your 22 arguments in writing. 23 MS. CARLISLE: May I -- may I make one point, 24 please? 25 MS. MA: Yeah, taxpayer. 26 MS. CARLISLE: The -- the valuation that we 27 have submitted from Duff & Phelps for the 2003 28 transaction and 2001, and the other -- we -- we got an 73 1 absolutely different valuation. That is exactly what 2 goes to "What's the value?" 3 There is a slight difference here in -- in the 4 terminology that we're using. When the Appeals office 5 and the FTB says "value," they're saying, "What is 6 allocated to the participants?" That is the one-to-one 7 ratio. And we all know that you don't have to have a 8 one-to-one ratio. 9 The value that we are talking about and the 10 value that is very plain in the appraisals we have given 11 from day one to the Department is -- includes, uh, the 12 repayment of the loan, plus the appreciation, plus the 13 base value. So it is -- they're two different things. 14 Okay. 15 MR. THOMPSON: Uh -- 16 MS. STOWERS: I think -- go ahead. I think 17 that's the problem, there's two different ways of 18 looking at it. 19 Appeals? 20 MR. THOMPSON: Right. 21 I thought I heard appellants say that there are 22 some scenarios in which the ESOP beneficiaries would 23 receive more than $350 million. 24 Uh, we had not been provided with those 25 scenarios in the briefing, despite repeated requests. 26 MS. CARLISLE: No. I'm -- I'm sorry. We have 27 never said that amounts allocated to the participants in 28 their account may equal more than the purchase price. 74 1 We did not say that. No. 2 I mean what we have said is that the purchase 3 price reflected more than the fair market value of the 4 securities. And we have said that from day one. 5 MR. CUMMINS: I just heard this gentleman very 6 effectively describe the conversion formula. I don't 7 know how more briefing on a conversion formula could be 8 helpful here. 9 MS. STOWERS: Okay. FTB, you have -- you want 10 to add anything before I say thank you? 11 MR. FOSTER: I guess we're all finally in 12 agreement that the participants could never get 13 allocated the full value. 14 MS. CARLISLE: The full value includes the base 15 value, the amounts allocated to the participants, and 16 the repayment of the loan. So we agree. 17 MR. FOSTER: So the ESOP participants could 18 never get what the ESOP paid for the stock. 19 MS. MA: Correct. That's correct because the 20 loan, part of that money is also the loan repayment. 21 MS. HARKEY: Prefunded. 22 MS. MA: Right, for the convertible stock. 23 I have a question for our IT folks. I know 24 that the video was black for a little bit. Has this 25 whole recording been recorded? I'm just trying to think 26 about Mr. Runner who, you know, may want the benefit of 27 watching the recording. 28 So, what happened? I know it was black on our 75 1 screens. But has all of the proceedings been recorded, 2 is my question. 3 Well, I think if it's not fully recorded, we're 4 going to try to make a decision with the existing Board 5 that have been here to listen. But if it's been 6 recorded, then we will wait and put the case under 7 submission so that Mr. Runner can watch the 8 proceedings. 9 MR. GAU: David Gau, Executive Director. 10 According to the video people, we've lost maybe 11 five to ten minutes of the video transmission -- 12 MS. MA: Yeah. 13 MR. GAU: -- and recording. 14 MS. HARKEY: Just that one part. 15 MS. MA: Okay. So, um -- all right. Since 16 we've lost some of it, um, is there a motion on the 17 table or -- 18 MS. HARKEY: I'll make a motion to grant the 19 appeal. 20 I believe that there was economic substance. 21 The use of the formula one-to-one is not a mandatory 22 benchmark under the law, as to avoid a hostile takeover 23 which is a valid non purpose for the conversion formula, 24 and that the employees did receive value. And, uh, the 25 leveraged buyout -- the leveraged buyout was a very 26 important, uh, method of helping to retain ownership in 27 the company and the employees in the company. And the 28 companies truly did -- the company's employees truly did 76 1 benefit by the leveraging. 2 The company always retained the value. The 3 stock shares have increased; that's hindsight. But I do 4 believe that it was a very solid transaction. I 5 understand the questioning of it. But I think it was a 6 very solid transaction from a very solid company that 7 had assets, that had to really fear a leveraged buyout, 8 and who was being sued for several years for something 9 that happened that the company did in the 1930s, but 10 they were cast into a big pot. 11 I've also confirmed with Appeals that 12 one-to-one is not a necessary requirement, that avoiding 13 a hostile takeover was a valid non tax business, and 14 that they subjectively structured this as a 15 countermeasure to avoid hostile bid in the midst of 16 their down stock due to the impending litigation, that 17 it was a non tax business purpose, um, and that all 18 parties agreed to themselves, ESOPs in themselves do not 19 lack economic substance. 20 So there's not -- I don't see an argument for 21 second-guessing on the FTB's part for what the -- what 22 the value was. I think to make it so simple one-to-one 23 makes it easy to understand, but that's not really the 24 value of what the ESOP was or what the payments were. 25 I don't think the company got enriched by it. 26 I think they merely retained their employees and the 27 employees had a good solid ESOP plan. They were 28 guaranteed a floor. And they were guaranteed that if 77 1 there was a hostile takeover, that they wouldn't be out 2 in the cold. And I could only say I wish more employers 3 would do that, because there are many that were out in 4 the cold. 5 Thank you. 6 MR. HORTON: Madam Chair? 7 MS. MA: Mr. Horton. 8 MR. HORTON: I believe the appellant has met 9 the requirements relative to the economic standards and 10 business benefit. The concern that I have is the 11 granting of a deduction for more than what the actual 12 value was. And it just doesn't -- I don't think -- I 13 think possibly FTB taking a hard-line position that 14 there is no value and not giving value somewhat to the 15 intangibles that exist there, uh, is concerning. 16 And, quite frankly, I would like to encourage 17 the FTB to take a look at those items and give those 18 items some valuation, look at the assessment made by the 19 Internal Revenue and get with the parties and see if you 20 can settle this. Because I don't necessarily agree with 21 the Department in their position. And I don't agree 22 with the valuation of the taxpayer. And would have 23 preferred that we actually had a briefing, uh, that 24 seems to have evolved in this process. We've gotten a 25 verbal briefing from all the parties that the 26 350 million value could never be reached. And that 27 seemed to be relatively clear to me and seemed to be the 28 arguments put forth by the Department, as well as the 78 1 appellant. 2 However, then that puts us in a position to 3 determine what is the value of the deduction? How do we 4 determine what the actual value of that deduction was if 5 not 350, or if they didn't meet that level? 6 So, I'm in somewhat of a quandary on this and, 7 uh, would suggest, Members, that -- 8 I would concur with Member Stowers that to 9 allow both parties to address the concerns of the -- of 10 Appeals, where Appeals has asked for certain 11 information, that both parties provide a briefing 12 relative to the questions presented toby Appeals and 13 that that would put us on -- in a better position to 14 sort of assess what the deductible amount should be. 15 Which is really not something I think the -- the role of 16 this body is. Which, uh -- and would have -- would have 17 preferred that the FTB actually have addressed those 18 issues better in their briefing. But they didn't, and 19 it's certainly not incumbent upon the appellant to do 20 the job of the FTB. It's upon the appellant to defend 21 their clients, and they've done a -- I think, a very 22 good job in doing so. 23 So, I'm in a catch-22 here. 24 MS. MA: So I would agree. I'm -- I'm kind of 25 where Mr. Horton is. You know, I do think there is 26 economic substance and a rationale for doing what the 27 company did. 28 I can't talk to the valuation, um, without the 79 1 Franchise Tax Board offering why that valuation is not 2 the right amount. You know, was the trustee not, you 3 know, reputable? Did you do your own valuation with 4 your own independent trustee? 5 I mean it's very hard for us to figure out what 6 the value is. So I'm kind of at the same point as -- as 7 Mr. Horton. And I don't know the issues in the case, is 8 this a valuation issue? Or is this an economic 9 substance issue? And is this eligible for a 30/30/30 or 10 do we -- or additional -- time? I'm not sure. 11 MS. STOWERS: Madam Chair. 12 MS. MA: Ms. Stowers. 13 MS. STOWERS: I agree. I actually think 14 additional briefing to address this valuation would be 15 really helpful. 16 And another point that has been bothering me is 17 the 2004 year was part of the closing agreement. And 18 the fact that the appellant's representative presented 19 the closing agreement to the Franchise Tax Board during 20 protest, and at protest FTB was aware of what took place 21 for those years. I feel that FTB should have taken a 22 position then on whether or not -- a complete position 23 on whether or not they were accepting the closing 24 agreement and not just say they amended their tax 25 returns in a self assessment. 26 So I think that additional briefing should also 27 address, um, FTB following the closing agreement for all 28 years that was part of the closing agreement. 80 1 MS. MA: So is there a revised motion? I don't 2 hear a second. 3 MS. STOWERS: I -- I move for additional 4 briefing to, um, address the valuation issue and all 5 years of the closing agreement, mainly the 2004 and 6 2005. 7 MR. HORTON: I would second that. But let me 8 be clear to the Department. I think this is an economic 9 substance case, and I think the taxpayer has made their 10 case relative to the economic substance. 11 The pause that I have is how much is allowing a 12 deduction for the full amount when -- or not allowing 13 the deduction for the full amount. I just, uh -- we've 14 got these arguments that have evolved, uh, during this 15 hearing without looking at any documentation or any 16 briefing relative to some of these arguments. 17 I mean I appreciate that the -- that in the 18 briefings it was covered to some degree. Uh, but the 19 concurrence that both parties have submitted now that 20 the valuation could not exceed the 350 million, in and 21 of itself is progress, but certainly somewhat new to -- 22 to me. 23 But, um, I second that motion, Madam Chair. 24 MS. HARKEY: Can I -- can I just add -- can I 25 just add -- 26 MS. MA: Ms. Harkey. 27 MS. HARKEY: -- that I would like this, if this 28 is going back on a 30/30/30, I want to be sure that it's 81 1 focused on just those two points and that we don't start 2 exhuming new skeletons. I want to be sure it's focused. 3 And I -- I do think that, you know, I don't 4 agree that there wasn't value in what was done. I think 5 it was done with a purpose. And I -- I -- I think the 6 one-to-one argument, I think economic substance is a -- 7 is a -- is a law. It's a -- a point of law that I think 8 the FTB, quite honestly, may have to refute why this 9 doesn't meet the standard. 10 So I'd like -- I'd like our -- if we're going 11 to send this back, which I -- I can count -- it's going 12 to go back on a 30/30/30, but I want to be sure it's 13 coming back to this Board and -- if it's not worked out. 14 Because I think -- I think the taxpayers made a very 15 strong case. I think that, you know, they've got the 16 appraisals, the assessments, this is 2003, 2004, long 17 time ago. We can look back and see, did they stay in 18 business? Were they doing funny things with their 19 employees? Were they using it as a tool? And I think 20 we can see clearly that's not happened. 21 So I just want to be sure it's not a continued 22 prodding and prying over the 2004 and 2003 year. 23 MS. CARLISLE: Chairman Ma, may I please ask 24 one question -- 25 MS. MA: Yes. 26 MS. CARLISLE: -- before the vote? 27 MS. MA: Taxpayer. 28 MS. CARLISLE: Thank you. 82 1 From the beginning, we have said in our protest 2 and throughout our discussions and our many briefings 3 that this is a valuation issue, that the economic 4 substance of this transaction is without doubt. 5 We have offered -- we offered to go to 6 settlement. We were rejected. We have requested the 7 FTB's valuation. They have said no. And I'm very 8 concerned now after all this time and all the briefing 9 that you're now telling us to go back on valuation. 10 I would request that the Board direct the FTB, 11 if we're going to do that, to get a valuation. We 12 have -- we have a valuation from Duff & Phelps which was 13 contemporaneous when the transactions were entered into. 14 The company paid Stout Risius Ross, another very 15 well-respected appraisal firm, to make a valuation when 16 the Internal Revenue Service looked at the issue. So we 17 have two appraisals. Okay. 18 If -- if we're going to go back and continue 19 fighting about years that were more than a decade ago, I 20 would request that the Board direct the FTB to get a 21 valuation if that's what the issue is. 22 MS. MA: Yeah, so, um -- and that's what I 23 think we all agree with. It's not the economic 24 substance argument, but it is really the value. And if 25 it is the value, what year? Because I think we do need 26 to narrow it, because I'm kind of confused what we're 27 trying to -- what the motion is. 28 So -- 83 1 MS. CARLISLE: Me too. 2 MS. MA: -- Mr. Horton, or Ms. Stowers, who 3 made the motion originally? 4 MS. STOWERS: I made the motion. 5 MS. MA: Okay. 6 MS. STOWERS: I withdraw my motion and I will 7 let Mr. Horton make the motion. 8 MS. CARLISLE: I'll make a motion. 9 MS. STOWERS: I'll keep my motion. My motion 10 is to do additional briefing, to address the valuation; 11 for the Franchise Tax Board to either get their own 12 value through appraisal or experts, or at the very least 13 look at what the appellant's done, and agree that it's 14 right or it's wrong; for FTB to look at the 2004, 2005 15 years that was part of the closing agreement, that was 16 presented to you at protest; and, short of me saying 17 "follow the closing agreement," explain why you're not 18 following it when it was part of the protest; and to 19 continue the hearing, so they would come back to this 20 Board. 21 MS. MA: Okay. So the 2003 is off the table? 22 MS. STOWERS: 2003 is still on the table. It's 23 the 2004 and two thousand -- basically the 2004 and 24 2005, they negotiated closing with the IRS on that. 25 They presented that closing agreement to the Franchise 26 Tax Board during protest. 27 MS. CARLISLE: Correct. 28 MS. STOWERS: And I'm -- I'm just at loss on 84 1 why FTB would say you didn't make a position on -- on 2 the closing and you're still going after it when it was 3 part of the protest arguments. It seems to be a misstep 4 there. 5 MR. HORTON: Madam Chair, if I may, I'd like to 6 hear from Appeals relative to the -- to the motion. 7 MR. THOMPSON: Right. 8 MR. HORTON: And I'd also like to augment the 9 motion to continue the hearing, uh, so that we can keep 10 this open, and at the same time direct FTB that -- from 11 my mind I'm actually shifting the burden more to FTB, to 12 do their due diligence in this regard than I am the 13 taxpayer. The taxpayer should be respondent relative to 14 their effort. 15 Appeals? 16 MR. THOMPSON: Just to clarify. And I 17 appreciate, Ms. Stowers, your listing of the points. 18 But we would also ask, I assume, about the intangible 19 value argument? 20 MS. HARKEY: That should -- that should be the 21 valuation. 22 MS. CARLISLE: That's the valuation. 23 MR. THOMPSON: Okay. And then is there a 24 desire for us to ask whether the participants could 25 receive -- 26 MS. HARKEY: No. 27 MR. THOMPSON: -- 350 or more? 28 MS. HARKEY: No. 85 1 MS. MA: No. 2 MS. HARKEY: We're looking at valuation only. 3 MS. MA: That's a deduction that they took on 4 their taxes. 5 MR. HORTON: Only because that's been somewhat 6 established; I think all parties seem to agree. 7 MR. THOMPSON: Yeah, I think -- well, just to 8 be clear what we're agreeing on. I think we've agreed 9 that under no circumstances could the ESOP participants 10 receive the $350 million paid by the ESOP. 11 MS. CARLISLE: No, no, no. We are not agreeing 12 that the value -- 13 Okay. Again, the issue is what is the value of 14 the convertible preferred stock? Okay. 15 MS. MA: Exactly. 16 MS. CARLISLE: And we are saying that the value 17 that the participants received exceeded 350 million. 18 When you start talking about amounts allocated 19 to participant's accounts, that's a portion of the 20 value. It is not the entire value. 21 MR. THOMPSON: Then to the extent they're 22 arguing the value received may exceed 350 million, we 23 have a disagreement in the record. 24 MS. HARKEY: Okay. Well, I don't think we did. 25 I think we've had that really clear. And I just want to 26 be sure we're focused and that the hearing comes back 27 here, Madam Chair. 28 MR. HORTON: I think Appeals just -- 86 1 MS. MA: The motion is 30/30/30. 2 MR. HORTON: To be continued. 3 MS. MA: To be continued. 4 MS. HARKEY: And not on the H calendar. 5 MS. STOWERS: No. It will come back here. 6 MS. MA: It'll come back here. And to look at 7 2003, 2004 and 2005 as it relates to the IRS closing. 8 MR. THOMPSON: Can I add, suggest a couple more 9 points quickly? 10 MS. MA: Okay. 11 MR. THOMPSON: The parties aren't going to like 12 this, but it's designed to benefit you. All right. 13 I would like to nail down this issue that 14 appellant raised about the common stock. And they've 15 endeavored to do that, but it's not as clear as it could 16 be. And I think as part of that we need to have an 17 understanding of what these Schedule N-1 amounts were 18 comprised of, because that's what FTB used to reach its 19 assessment. 20 MR. HORTON: Yeah, I agree. I agree. Yeah, 21 that makes sense. 22 MS. CARLISLE: I'm sorry. 23 MS. STOWERS: On some of the, um, dividends 24 that was disallowed, you guys said some of that was 25 common stock, not part of the leveraged transaction? 26 MS. CARLISLE: But that all goes away if we 27 prevail. That issue -- that issue totally goes away. 28 MR. HORTON: Well, that's a -- 87 1 MS. STOWERS: Yeah, I understand. 2 MR. HORTON: That's an action subsequent to 3 prevailing. So we -- 4 MS. CARLISLE: Exactly. 5 MR. HORTON: We've got to get there. 6 MS. HARKEY: I don't want to expand this too 7 much. 8 MR. HORTON: I agree with Appeals. I think 9 that should be included in the motion. 10 MS. HARKEY: I think we're expanding this -- 11 MS. MA: Yeah. 12 MS. HARKEY: -- really a lot and we're starting 13 a whole new investigation. 14 MS. CARLISLE: The briefing is so extensive 15 already. 16 MS. HARKEY: What we asked for was a valuation. 17 That was the -- that's where -- we all decided there's 18 economic substance, but we're trying to determine the 19 value. And that's -- I think we ought to stay very 20 narrowly focused. Otherwise, we're going to have a 21 whole new briefing. 22 And there were a couple appraisals; pick one, 23 do your own, but let's get a number. Let's let the 24 parties determine if they can reach a settlement somehow 25 with the number. If they can, then report will go back, 26 we won't see it again. If they can't, they'll be back 27 here again. 28 But I don't think we ought to open this up. 88 1 And I do think the 2004 that Yvette made a point of, or 2 Ms. Stowers made a point of that, you know, it was 3 already in the briefing, make a decision, I think that's 4 an important point. 5 But to go on and back and all this other -- I 6 don't want to go there. I think it's -- we've got a ton 7 of data here, a ton of data. So if we could just keep 8 it simple to those two points, I would appreciate that 9 being the purpose of coming back. Because we understand 10 economic substance. We're just trying to reach a 11 valuation, and there are a couple out there. We need to 12 reach one. 13 MS. MA: Okay. Mr. Horton. 14 MR. HORTON: Madam Chair, for the -- for the 15 sake of this discussion, I concur. Let's just move 16 on. 17 And let me just -- the process itself certainly 18 opens up opportunities for Members to ask additional 19 questions, and particularly in the absence of Member 20 Runner; I can't necessarily speak for him. And once I 21 receive the data, I, quite frankly, don't know if I 22 would have subsequent questions. 23 But I -- I do want to re-emphasize that I 24 believe that the taxpayer has met the burden to a 25 certain degree. And, um -- and I have concerns. 26 So, and I concur with excluding that for now, 27 the recommendations of Appeal for now, go back to the 28 original motion made by Member Stowers. I would second 89 1 that original motion and call for the question. 2 MR. THOMPSON: Excuse me, Madam Chair, just to 3 clarify. I just want to make sure -- 4 MS. MA: Your motion again? 5 MR. THOMPSON: Well, actually I want to make 6 sure that when I, uh -- you know, I understand what's 7 desired. 8 MS. MA: Okay. 9 MR. THOMPSON: So the two components for us to 10 look at in the briefing would be the valuation, and 11 address why FTB did not get a valuation in the context 12 of that and whether perhaps they might want to. And 13 then the second, I believe, was Ms. Stowers' point about 14 FTB receiving notice of the closing agreement -- 15 MS. MA: Right. 16 MR. THOMPSON: -- during audit or protest. 17 Does that cover it? 18 MS. MA: Yes. 19 MS. HARKEY: Yes. 20 MR. THOMPSON: Thank you very much. 21 MR. HORTON: Including those intangibles. I 22 heard someone wanted to take that out, but let's keep 23 that in. 24 MS. HARKEY: Well appraisals or valuations will 25 be everything. 26 MR. HORTON: And let me just share with you -- 27 MS. MA: Value should -- 28 MR. HORTON: -- all of the parties, Members 90 1 aren't restricted here to ask additional questions. So 2 this is the direction of the Board. 3 MS. MA: Okay. So 30/30/30. 4 MR. HORTON: Continued. 5 MS. MA: To continue this. 6 Thank you very much to all the parties. Okay. 7 ---oOo--- 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 91 1 REPORTER'S CERTIFICATE 2 3 State of California ) 4 ) ss 5 County of Sacramento ) 6 7 I, Kathleen Skidgel, Hearing Reporter for the 8 California State Board of Equalization state that I 9 transcribed from recorded audio, to the best of my 10 ability, the proceedings in the above-entitled hearing; 11 and that the preceding pages 1 through 91 constitute my 12 transcription of the proceedings. 13 14 Dated: March 8, 2017 15 16 17 ____________________________ 18 Kathleen Skidgel, CSR #9039 19 Hearing Reporter 20 21 22 23 24 25 26 27 28 92