Gerdau Macsteel, Inc. & Affiliated Subsidiaries, Petitioners v. Commissioner of Internal Revenue, Respondent, 139 T.C. 67

CONTENTS FINDINGS OF FACT . 74 I. Preliminary Matters . 74 II. Quanex . 74 III. Petitioners’ Expectation of Realizing Millions of Dollars in Taxable Capital Gains During TYE 1997 and TYE 1998 ... 75 TV. The Plan . 76 A. Background . 76 B. Health Care Offerings . 76 C. Health Care Cost Management Strategies . 77 1. Background . 77 2. CS . 77 a. Background . 77 b. Quanex’s Introduction to CS . 78 c. CS Fee Arrangements . 79 V. D&T . 79 VI. Other Quanex Employees/Officers o co A. Rose . OO B. Parikh . 00 C. Royce . 00 VII. Liability Management Companies A. Overview . oo K B. Rev. Rul. 95-74 . oo to C.

D&T’s Matrix . oo W 1. Background . oo to 2. DDCL . oo to 3. Singer Promotes DDCL-Type Transaction to Quanex oo ÜI VIII. Sales of LaSalle and Tube Group . oo cn A. LaSalle Sale . lo 00 B. Tube Group Sale . co CO IX. Engaging D&T To Structure QHMC Transactions . 00 <] X. Developing QHMC Transactions . GO CO A. Quanex’s First Proposal to CS . 00 CO B. D&T’s First Outline of Proposed Joint Venture Transactions . CO M C. WW . CO to 1. In General . CO to 2. FASB 106 . CO to 3. WW’s First Present Value Calculation of Quanex’s Health Care Benefits . CO co D. D&T’s Revisions to Proposed Transaction . CO cn 95 1.

August 6-7, 1997, Revisions . 97 2. August 13, 1997, Revisions and Cashflow Analysis . 99 3. August 22, 1997, Revisions . 99 E. Quanex’s Negotiations With CS . 103 F. WW’s Present Value Calculation Revisions . 105 G. Patrick Wannell . 105 1. Background . 105 2. Wannell and Health Care Costs at LaSalle . 106 3. Quanex’s Offer to Wannell . 107 H. D&T’s Revised Cashflow Model . 110 XI. Executing QHMC Transactions . 110 A. Quanex’s October 21-22, 1997, Board Meeting ..... 113 B. October 23, 1997 . 113 1. QW Recapitalization . 113 2. Amendment and Restatement of QW’s Certificate of Incorporation . 113 a.

Background . 114 b. Dividend Rights . 114 c. Preferences Upon Liquidation . 116 d. Voting Rights . 116 e. Call Rights . 116 f. Put Rights . 117 3. Quanex’s Transfer of QW Stock and Cash to QHMC in Exchange for Class A and Class B Stocks and Election of Directors . 117 4. Quanex’s Transfer of Cash and MPB Obligations to QS in Exchange for QS Stock . 118 C. October 24, 1997 . 118 1. Consulting Agreement Between Quanex and CS . 119 2. CS’ Transfer of Cash to Quanex in Exchange for Class B Stock . 121 3. Class B Directors . 121 D. October 25, 1997 . 121 1.

CS’ Transfer of Cash to QHMC in Exchange for Class C Stock . 2. QS’ Transfer of Cash and MPBs to QHMC in Exchange for Class C Stock . H CM rH 3. MPB Selection . CM CM tH 4. Class C Director . M CM i-H 123 E. October 28, 1997: QHMC’s Transfer of Cash to Piper in Exchange for Promissory Note . 124 F. October 30, 1997: QS’ Transfer of Class C Stock to Wannell in Exchange for Cash . 125 XII. Posttransaction Activities . 125 A. D&T’s Draft Opinion . 127 B. 1997 Return . 127 1. Background . 127 2. Income . 3. Enclosed Statements . 128 a. Overview . 128 b. Statement 20 . 128 c. Statement 22 . 129 d.

Statement 23 . 129 e. Statement 24 . 129 4. Deduction of Fees .:. 129 C. WW’s 1999 Valuations . 130 D. D&T’s 1999 Cashflow Model . 134 E. QHMC Operations . 140 1. QHMC’s Officers and Directors . 140 a. QHMC’s Board Meetings and Shareholders Meetings ... 141 b. Parikh as Director and Officer . 141 c. Peery as Director and Officer . 141 2. Bank Accounts . 141 3. Processing and Paying MPB-Related Expenses . 142 4. Shareholder Efforts To Manage MPB Obligations . 145 a. CS’Efforts . 145 i. Background . 145 ii. PPO Project . 146 iii. Union Negotiations . 147 iv. CS’ Consulting Bills . 148 b. Wannell’s Efforts . 149 5.

Dividend Payments . 150 6. Return on Investment Projections . 150 7. QHMC’s Tax Returns . 151 8. Financial Statements . 152 F. Notice of Deficiency . 152 OPINION . 154 I. Burden of Proof . 154 II. Witness Testimony . 155 A. Background . 155 B. Fact Witnesses . 156 C. Expert Witnesses . 156 1. Background . 156 a. Overview . 156 b. Strombom . 157 c. Ross . 157 d. Eisenstadt . 157 2. Analysis . 158 III. Net Short-Term Capital Loss . 158 A. Overview . 158 B.

Section 351(g) . 159 C. Economic Substance Doctrine . 167 1. Overview . 167 2. Standard of Analysis . 168 3. QHMC Transactions . 171 171 a. Objective Economic Substance . 171 i. Background . 172 ii. Lack of Substantive Changes as a Result of QHMC Transactions . 174 iii. Lack of Reasonable Expectation of Nontax Benefits on Petitioners’ Part . 175 b. Subjective Business Purpose . 175 i. Background . 176 ii. Petitioners’ Entering Into QHMC Transactions Solely as Means To Generate Artificial Capital Loss To Offset Capital Gains . 179 iii.

Petitioners’ Selection of Transferred MPBs Without Regard to Effective Medical Cost Management ... 180 iv. Equity Interest in QHMC Granted to CS and Wannell as Meaningless Incentive to Reduce Health Care Costs . v. Unnecessary Assumption of MPB Obligations by QHMC . T — 1 oo tH c. Conclusion . CN oo rH IV. Fees Incurred in Furtherance of QHMC Transactions . 182 V. Accuracy-Related Penalties . 183 A. Background . 183 B. Gross Valuation Misstatement . 183 C. Negligence . 186 D. Substantial Understatement . 188 E.

Section 6664(

c) Reasonable Cause Exception . 191 1. Overview . 191 2. Analysis . 193 VI. Conclusion . 197 Marvel, Judge: Quanex Corporation (Quanex) and its affiliated subsidiary corporations (collectively, petitioners) petitioned the Court to redetermine respondent’s determination as to petitioners’ taxable year ended October 31, 1997 (tye 1997). Respondent determined a $9,561,458 deficiency in petitioners’ Federal income tax and a $3,799,926 accuracy-related penalty under

section 6662(a), (b), and (h). The parties dispute three issues relating to respondent’s determination, and they agree that certain subissues and arguments underlie a decision regarding those issues. The three issues are: 1. whether petitioners may deduct a $37,989,000 net short-term capital loss from the sale of stock of Quanex Health Management Co., Inc. (QHMC). The sale was part of a series of transactions (QHMC transactions) that occurred in October 1997 between and among Quanex, certain of Quanex’s affiliated subsidiaries, and two independent (yet loyal) facilitators.

Petitioners claimed a $37,989,000 loss deduction on the sale and applied $26,966,201 of the claimed loss to tye 1997 and the balance to tye 1998. Respondent disallowed the claimed loss deduction in full. We hold that petitioners are not entitled to deduct any of the claimed loss; 2. whether petitioners may deduct $352,251 of transaction costs incurred to effect the QHMC transactions as ordinary and necessary business expenses under

section 162(a). Petitioners claimed the $352,251 as a deduction for TYE 1997, and respondent disallowed the claimed deduction in full. We hold that petitioners are not entitled to deduct any of this amount; 3. whether petitioners are liable for the 40% accuracy-related penalty that respondent determined under

section 6662(

a) and (h) (or alternatively, the 20% accuracy-related penalty that respondent determined under

section 6662(

a) and (b)) with respect to the underpayment of tax attributable to the disallowed capital loss deduction, and whether petitioners are liable for the 20% accuracy-related penalty that respondent determined under

section 6662(

a) and (

b) with respect to the underpayment of tax attributable to the disallowed transaction costs deduction. We hold in accordance with Heasley v. Commissioner, 902 F.2d 380 (5th Cir. 1990), rev’g T.C. Memo. 1988-408, and Todd v. Commissioner, 862 F.2d 540 (5th Cir. 1988), aff’g 89 T.C. 912 (1987), which we follow under Golsen v. Commissioner, 54 T.C. 742 (1970), aff’d, 445 F.2d 985 (10th Cir. 1971), that petitioners are not liable for the 40% accuracy-related penalty. We also hold that petitioners are liable for the 20% accuracy-related penalty under

section 6662(

a) to the extent of the underpayment of tax attributable to the disallowed capital loss deduction and to the disallowed deduction for the transaction costs. FINDINGS OF FACT I. Preliminary Matters The parties have stipulated many facts. Some stipulations note a party’s objection to the admissibility of the stipulated fact(s), and we have sustained some of those objections. We incorporate herein the stipulated facts to the extent we have not sustained an objection to their admissibility, and the stipulated facts are so found (except to the extent we sustained an objection to their admissibility).

Quanex’s principal office and principal place of business were in Texas when the petition was filed. II. Quanex Quanex is a Delaware corporation whose common stock is publicly traded on the New York Stock Exchange. Quanex was organized in 1927, and its principal activity is manufacturing specialized metal products made from carbon and alloy steel and aluminum. From at least 1995 through October 31, 1997, Quanex’s main operating groups consisted of a hot and cold finish steel bar business, a hot and cold finish tubing business, and an aluminum building products business.

Quanex is the common parent of petitioners’ “affiliated group” (as that term is defined in

section 1504(a)). On July 14, 1998, petitioners filed a consolidated corporate Federal income tax return for TYE 1997 (1997 return). Petitioners reported in the 1997 return that Quanex was the common parent of the affiliated group and that its subsidiaries and their principal business activities were as follows: Subsidiaries Principal business activities Michigan Seamless Tube Co. Manufacturing Manufacturing LaSalle Steel Co. Manufacturing Piper Impact, Inc. Quanex Wire, Inc. Investments Quanex Bar, Inc. Investments Investments Quanex Solutions, Inc. Investments Quanex Mfg., Inc. Investments Quanex Steel, Inc.

Inactive Quanex Enters., Inc. Subsidiaries Principal business activities Quanex Tech. Inc. Inactive Quanex Metals, Inc. Inactive Nichols-Homeshield, Inc. Inactive For TYE 1997 through tye 2001 petitioners had an annual accounting period ending on October 31, and they each maintained books and records using an accrual method of accounting. As of October 31, 1997, petitioners had 13 manufacturing plants throughout the United States and 1 plant in the Netherlands. Also as of that date, petitioners had 3,771 employees, approximately 1,000 of whom were covered by collective bargaining agreements. III.

Petitioners’ Expectation of Realizing Millions of Dollars in Taxable Capital Gains During TYE 1997 and TYE 1998 During tye 1997 Quanex was actively pursuing the sales of two subsidiaries. Those sales were expected to generate millions of dollars in taxable capital gains during TYE 1997 and TYE 1998. The first sale involved Quanex’s wholly owned subsidiary LaSalle Steel Co. (LaSalle). Quanex’s board of directors (Quanex’s board) resolved on February 27, 1997, to make that sale, and the sale closed shortly thereafter in TYE 1997.

For tye 1997, petitioners reported as to that sale (and to a minor extent the sale of other business property) that they realized a capital gain of $26,966,201 and ordinary income of $21,374,634. The second sale involved Quanex’s decision to sell a portion of its tubing operations (Tube Group). In or before September 1997 Quanex began negotiating that sale, and the sale occurred on December 3, 1997. For TYE 1998 petitioners reported as to that sale that they realized a net capital gain of $12,458,171 and ordinary income of $8,090,766.

Contemporaneous with petitioners’ activities with respect to the two sales, and with knowledge of petitioners’ intent to make those sales, petitioners’ outside accounting firm, Deloitte & Touche, LLP (D&T), through one of its tax partners, Steven Singer, approached petitioners and promoted an idea for a multistep transaction that, if artfully structured to comply literally with the Code and certain

interpretations thereunder, could create for petitioners a multimillion-dollar tax loss to shelter the gains from the unrelated sales for Federal income tax purposes. Quanex entered into the QHMC transactions as a result of that promotion, and Quanex claimed that it realized a $37,989,000 capital loss on one of the steps in the QHMC transactions that effectively offset the amount of gains on the unrelated sales.

The QHMC transactions were ostensibly structured around the Quanex Corporation Group Benefits Plan (plan) with an aim towards generating an artificial multimillion-dollar tax loss that would offset the large gains on the sales and would appear to be generated from Quanex’s business activities. IV. The Plan A. Background Effective September 1, 1949, Quanex established the plan to provide certain health, welfare, and other similar benefits for eligible Quanex employees and their dependents.

Quanex reserved the right to amend the plan at any time and reserved the right, without an authorizing resolution from Quanex’s board, to reduce or completely eliminate any coverage provided under the plan for current and/or former employees and their beneficiaries. Quanex also could terminate the plan at any time by a written resolution of Quanex’s board. B. Health Care Offerings Pursuant to the plan, Quanex offered both its nonunion and union employees a choice of medical plans, which were generally indemnity and health maintenance organization (HMO) plans.

In the early 1990s Quanex also instituted cafeteria benefits with respect to its indemnity plan offerings. Under the plan, Quanex was required to appoint a committee to perform any administrative function with respect to the plan that the respective insurer or HMO was not required to perform. Effective January 1, 1995, Quanex amended and restated the plan, and the plan remained in effect for TYE 1997.

From 1995 through the end of TYE 1997, Quanex provided group medical benefits to its employees under the plan, and Quanex deducted the costs of those benefits as they were incurred as ordinary and necessary business expenses. C. Health Care Cost Management Strategies 1. Background The cost of providing health care is influenced by numerous factors, e.g., an employee’s age, number of dependents, and geographic location. Other less predictable components, such as political pressures, also can influence health care costs.

From at least 1985 Quanex experienced a rise in the cost of providing health care to its employees. As early as 1985 Quanex began to look at ways to reduce its overhead and streamline its benefits, including its health care costs, pensions, and medical benefits for both active and retired employees. 2. CS a. Background ChapmanSchewe, Inc. (CS), is a health care management firm that Doug Schewe and Harry Chapman organized on July 1, 1992.

As of the time of trial CS had 12 subcompa-nies, all of which were devoted to health care, and its employee benefits practice managed health benefits for approximately 9 million individuals throughout the United States. During TYE 1997 Chapman was CS’ chairman and chief executive officer, and he owned approximately 37% of CS’ stock. Chapman has a bachelor’s degree and a master’s degree in public administration, and as of the time of trial he had 23 years of experience in the health care industry. b. Quanex’s Introduction to CS Ron Howard joined CS in 1994 as an associate/benefits consultant.

Howard was a former financial portfolio manager with a master of business administration (M.B.A.) degree and 10 years of experience in banking. During his previous career in banking, Howard had formed relationships with members of Quanex’s senior management, including Quanex’s then chief financial officer (cfo), Wayne Rose. Howard contacted Quanex shortly after he joined CS to persuade his Quanex contacts to let CS negotiate Quanex’s HMO contracts and to pursue a working relationship with Quanex. On April 7, 1994, CS representatives met with Quanex representatives.

During the April 7 meeting, Howard and Chapman gave a sales presentation to Joseph Peery. Peery has a bachelor’s degree in business administration and 34 years of experience in human resources, and he was Quanex’s vice president of human resources from 1984 until he retired in April 1998. Shortly after the April 7 meeting, Quanex gave CS the opportunity to reduce Quanex’s health care costs through HMO negotiations. In CS’ first project, Howard negotiated a fee for Quanex with one HMO, which saved Quanex money. Quanex then expanded its involvement with CS but still limited CS to HMO work.

The substance of CS’ work consisted of negotiating Quanex’s premium amounts with HMOs and of analyzing HMO cost structures. Howard was the CS executive in charge of the Quanex account during tye 1997, and sometime before 1998 he attempted to negotiate rate guaranties for Quanex. Howard had previously informed Quanex that CS could negotiate multiyear rate guaranties and performance guaranties with HMOS. Before the QHMC transactions, Chapman participated in the negotiation of Quanex’s HMO contracts.

Chapman tried to achieve the best results possible from the negotiations, and Chapman used the negotiations to speak more frequently with Quanex’s human resources department and to sell Quanex additional health care consulting services. c. CS Fee Arrangements CS offered flexibility to its clients through different payment arrangements (e.g., CS’ fee might be a percentage of the expense saved, or it might be calculated on the basis of a percentage of revenue).

Before the QHMC transactions, CS informed Quanex that CS’ compensation was performance based; i.e., CS would be compensated only if, and to the extent, CS saved Quanex money. Before the QHMC transactions, CS and Quanex did not have a written consulting agreement, but CS acted as a broker to secure medical coverage for Quanex’s employees through HMOs, and the hmos (or Quanex in one or two instances) paid CS a brokerage commission for its services. V. D&T Quanex first engaged D&T (or one of its predecessors) as early as 1978 for external auditing, tax, and consulting services.

The consulting services related to, among other things, debt restructuring, potential bankruptcy filings, and the purchases and sales of assets and subsidiaries. During tye 1997 D&T certified petitioners’ consolidated financial statements and reviewed petitioners’ consolidated Federal income tax returns, in addition to providing petitioners with other professional services. Singer is an attorney and a certified public accountant (C.P.A.), and he has practiced in the field of taxation for over three decades. He joined D&T in 1981, and he became a partner in D&T’s tax practice one year later.

He became the D&T partner in charge of the Quanex account in 1989. Singer was based in D&T’s office in Houston, Texas, during TYE 1997, and he remained in charge of D&T’s Quanex account as of the time of trial. From 1989 through the end of TYE 1997, Singer consulted with Quanex regarding its current and prospective purchases, and he reviewed and signed Quanex’s corporate returns as a paid preparer.

From 1995 through the end of tye 1997, Singer had intimate, first-hand knowledge of Quanex and its business, acquired mainly from his supervising and managing D&T’s Quanex account since 1989, his visits to some of Quanex’s facilities, his participation in Quanex’s financial statement audits, and his conversations with Quanex’s senior management. VI. Other Quanex Employees / Officers A. Rose Rose is a C.P.A. with a bachelor’s degree and an M.B.A. degree, and he was Quanex’s CFO from 1986 through 1998.

He was Quanex’s controller before 1986 (and before that, he worked for a large national public accounting firm for six years), he was the president of Quanex’s engineered products group from the end of 1998 until 2001, and he was Quanex’s vice president of special assignments from June 2000 through March 2001. When Quanex bought or sold a substantial asset, Rose, as CFO, and his department were responsible for projecting the results of that transaction. Rose generally knew what tax results he wanted going into purchase or sales negotiations, and he preferred to buy net assets and to sell subsidiaries.

During his tenure as Quanex’s CFO, Rose knew the importance of tax basis and the effect that liabilities had on a determination of Quanex’s bases in its subsidiaries. B. Parikh Viren Parikh is a C.P.A. with a bachelor’s degree and a master’s degree, both in accounting, and he was Quanex’s controller from 1993 through December 2002. He left Quanex on December 31, 2002. As Quanex’s controller, Parikh was responsible for Quanex’s accounting department; its duties included financial reporting, corporate accounting, and tax return preparation.

Parikh, as controller, also (with Thomas Royce and Rose) was responsible for reviewing Quanex’s asset sales and projecting their results. If Quanex sold a significant asset, Parikh decided how the transaction would be recorded on Quanex’s financial statements, and he was involved in deciding how any tax implication would be reported. He and his department also, while negotiations for Quanex’s potential sales were ongoing, would project gains and losses on those potential sales for purposes of financial reporting, periodically updating the projections as the negotiations drew to a close. C.

Royce Royce is a C.P.A. with a bachelor’s degree in business administration (majoring in accounting), and he was Quanex’s tax director. Beginning in TYE 1997, Royce also was Quanex’s director/manager of financial benefits administration (FBA manager). Royce reported to Parikh during TYE 1997, and Royce remained Quanex’s tax director and FBA manager as of the time of trial. As tax director, Royce was responsible for Quanex’s consolidated Federal income tax returns and any subsidiary returns, for all tax planning, for tax audits, for employee benefit returns, and for all State income and franchise tax returns.

As FBA manager, Royce was responsible for the accounting of the employee benefits in Quanex’s pension and

section 401(

k) plans, for audit preparation, for the filing of employee benefit information returns, and for working with welfare benefit plans and third-party administrators for both pension and

section 401(

k) plans. Royce, as tax director and eventually also FBA manager, also reviewed Quanex’s sales and made corresponding projections. When Quanex negotiated the sale of a substantial asset, Royce projected the potential Federal income tax ramifications from the sale during the negotiations. If a sale was concluded, Quanex would usually at the end of the year calculate the actual Federal income tax consequences of the sale.

Parikh would review the overall tax provision that had been made for the sale for financial statement purposes, but Parikh would not review Royce’s estimates of the potential income tax consequences. VII. Liability Management Companies A. Overview As of the end of TYE 1996, Quanex had a potential liability for medical plan benefits (mpbs) that might be provided under the plan. Quanex also faced a potential environmental liability of $15 million to $20 million. Quanex assumed the potential environmental liability in 1996 when Quanex acquired Piper Impact, Inc. (Piper).

As part of that acquisition, the seller established an escrow to cover this exposure. B. Rev. Rul. 95-74 Singer, Parikh, Royce, and Rose attended a Quanex quarterly meeting in 1996, in or before the summer of that year. During that meeting, Singer informed the Quanex representatives that the Internal Revenue Service (IRS) had issued a ruling, Rev. Rul. 95-74, 1995-2 C.B. 36 (revenue ruling), which Singer believed allowed Quanex to achieve tax benefits by transferring either its environmental liabilities or its MPB obligations to a liability management company in a joint venture.

In the revenue ruling the IRS ruled that certain contingent environmental liabilities that a transferee assumed in a

section 351 exchange were not liabilities for purposes of sections 357(c)(1) and 358(

d) and that the transferee, in accordance with its method of accounting, could, as appropriate, either deduct the liabilities as business expenses under

section 162 or capitalize the liabilities as capital expenditures under

section 263. C. D&T’s Matrix 1. Background D&T maintained an electronic repository of tax ideas that D&T professionals could discuss with D&T clients to increase D&T’s business with those clients and generate additional revenue for D&T. Various D&T professionals contributed ideas in their areas of expertise to the repository (referred to as D&T’s client service matrix (matrix)), and D&T envisioned that D&T might, provide the client with a tax opinion on any transaction described in the matrix which a client entered into.

The matrix was for internal use only, and D&T believed it would be at a competitive disadvantage if competitors gained access to the ideas in the matrix. 2. DDCL Singer occasionally consulted the matrix to obtain ideas to present to D&T clients. In the summer of 1996, after Singer learned of the revenue ruling, he read an undated

section of the matrix referenced as “Double Deducting Environmental and Other Contingent Liabilities” (ddcl). Singer was not responsible for the ideas in the DDCL, and he believed the DDCL was the only

section of the matrix referencing the revenue ruling. The DDCL proposed a transaction for accrual method taxpayers whom the accrual method prevented from deducting accruals on their balance sheets for estimated future environmental liabilities. The DDCL concluded that, in the setting of a consolidated group, a transaction could be structured to allow such a taxpayer to immediately deduct a capital loss equal to the amount of the environmental reserve and to claim an additional deduction when the accrued liability was paid.

The DDCL stated that the “proper structuring” of the transaction revolved around the use of an environmental management company and the sale outside the group of some of the company’s stock at a price equal to the stock’s fair market value. The DDCL summarized the transaction as follows:

SUMMARY OF TRANSACTION Parent Corporation (Parent) is a parent corporation in a consolidated group, which includes Environmental Management Company (EMCo) and several other operating companies. EMCo is a newly established, wholly-owned subsidiary of Parent. Parent also owns SI, and SI owns S2. Parent now desires to use EMCo to strategically manage the groups [sic] environmental liabilities and clean-up efforts. SI has a reserve for environmental liabilities on its books in the amount of $10x, which has not been deducted for income tax purposes.

SI also has an intercompany receivable account with S2 in excess of $10x. First, S2 pays off a portion of its intercompany debt to SI by issuing a 10-year promissory note for $10x. SI then contributes this note receivable, and its $10x environmental reserve, to EMCo in exchange for 100 shares of new, voting Class B stock. These shares may be either preferred or common.

These shares have only a nominal value, as the net book value of the contributed property is nominal. (SI remains legally liable for the environmental costs if EMCo is unable to pay them.) These shares should be designated as being entitled to a limited percentage of dividends and distributions paid to all classes of stock (for example, 15%). The percentage must be established so that at least 80% of the vote and value of all stock remains with the Class A (common) stock. SI then sells the Class B shares of EMCo to EMCos [sic] officers for their fair market value, a nominal amount.

As the tax basis in this stock is $10x, SI recognizes a capital loss of $10x on the sale. As EMCo makes expenditures on the environmental reserve, it also has a deduction for these payments.

The DDCL noted that “it is clear that a business purpose is required for the transaction” and listed the following business purposes for the transaction: (1) better management of Si’s environmental liabilities through EMCo’s devotion of its resources solely to environmental projects, (2) the ability to provide incentives more easily for the better management of the environmental liabilities by creating a separate company, and (3) improvement of Si’s credit arrangements and banking relationships by taking its environmental liabilities off its balance sheet and transferring them to another of P’s subsidiaries.

The DDCL described the business purposes regarding incentives (No. (2) above) as follows: SI will sell Class B stock in EMCo to the EMCo officers in order to give these individuals an ownership interest in EMCo. SI also then agrees to repurchase each officers [sic] shares, once the environmental liabilities have been settled or the officer leaves the employment of EMCo, at the greater of their cost to the officer * * * or the per share book value of EMCo.

If the environmental liabilities are satisfied for less than the amount originally estimated, the book value of EMCo will increase, providing the individual officers with a gain when their shares are sold back to SI. The DDCL acknowledged that the transaction referenced therein presented risks and could be subject to antiavoidance provisions such as

section 269 or

section 1.1502-20, Income Tax Regs. The DDCL envisioned that its substance could be adapted for use with a variety of contingent liabilities and reserves, including medical claims. D&T structured the transaction described in the DDCL to offer to its qualifying clients a deductible capital loss equal to the amount of contingent liabilities transferred in the transactions. The appeal of the DDCL transaction (or a variation thereof) was to minimize a taxpayer’s Federal income tax liability by accelerating the deduction of and double deducting environmental or other contingent liabilities. 3.

Singer Promotes DDCL-Type Transaction to Quanex Singer decided to approach Quanex to promote to Quanex the transaction described in the DDCL, or a variation thereof. While the DDCL referenced a consolidated setting, Singer preferred implementing the transaction described therein in a deconsolidated setting because he was concerned about rules under which the loss could be disallowed in the consolidated setting. Before discussing the DDCL and the revenue ruling with Quanex, Singer read some of the cases mentioned in the ruling.

He had developed an understanding of the revenue ruling and its implications, and he had previously discussed a contingent liability transaction with at least one other client. Singer took the position that an implication of the revenue ruling was that a taxpayer could use a liability management company to create a capital loss which, in turn, could reduce the taxpayer’s Federal income tax liability. In February 1997 at Quanex’s quarterly review meeting with D&T, Singer advised Rose, Parikh, and Royce that D&T could structure a contingent liability transaction for Quanex to generate a tax loss for Quanex.

At that time, Singer knew that Quanex was selling LaSalle and would have a significant gain on the sale. VIII. Sales of LaSalle and Tube Group A. LaSalle Sale On February 27, 1997, Quanex’s board resolved to sell all of Quanex’s stock in LaSalle to a third party. The LaSalle sale closed on April 18, 1997. Singer knew at least as early as the 1996 quarterly meeting that this sale was probable, and he understood in or before March 1997 that Quanex hoped to close the sale by April 1997. Singer and Rose also both knew that the sale was expected to generate a significant gain.

On January 13, 1998, petitioners filed their Form 10-K, Annual Report Pursuant to

Section 13 or 15(

D) of the Securities Exchange Act of 1934, for TYE 1997 (1997 Form 10-K). Petitioners reported in the 1997 Form 10-K that they completed the LaSalle sale for approximately $65 million. In their 1997 return petitioners reported that they realized a $28,697,957 capital gain and a $20,721,360 ordinary gain on the sale. Petitioners’ 1997 return included their

section 338(h)(10) election regarding the sale of LaSalle. From April 18, 1997 (the date of the LaSalle sale), through July 14, 1998 (the date petitioners filed their 1997 return), LaSalle’s buyer tried to renegotiate a lower purchase price, and the buyer and Quanex disagreed on purchase price allocation issues related to the

section 338(h)(10) election. In or before that period Quanex made several estimates of the income tax ramifications of the sale. Royce, in particular, performed rough calculations comparing the results of completing the sale as a stock sale rather than an assets sale under

section 338(h)(10). Royce shared his calculations with Parikh. Singer knew during April 1997 that petitioners would realize millions of dollars of ordinary income and capital gain on the LaSalle sale. Over the next five months, he devoted a substantial portion of his time to determining the tax implications of the sale, including the amount of ordinary income and capital gain to be generated from the sale. Before the QHMC transactions closed, Singer and Royce discussed the anticipated amount of capital gain on the LaSalle sale. B. Tube Group Sale The Tube Group sale involved the sale of both stock and assets.

The first closing occurred on December 3, 1997. Petitioners reported on their 1997 Form 10-K that the Tube Group sale was completed for approximately $30 million, and they reported a $12,458,171 capital gain and $8,090,766 of ordinary income from the Tube Group sale on their Federal income tax return for TYE 1998 (1998 return). IX.

Engaging D&T To Structure QHMC Transactions Over several months, at a time when D&T and Quanex were already aware of petitioners’ expected multimillion-dollar sales, D&T and Quanex discussed the possibility of Quanex’s engaging in a series of transactions similar to those in the DDCL and the revenue ruling. During some of these discussions, D&T gave presentations either through Singer alone or through Singer and one of his Houston-based tax partners, Mark Schneider.

Singer asked Schneider during 1997 to help him structure a contingent liability transaction for Quanex, and they discussed the potential tax implications of the transaction. When Singer initially discussed the DDCL and the revenue ruling with Quanex, he informed Quanex about potential issues with

section 1.1502-20, Income Tax Regs., and similar loss limitation rules that applied to consolidated groups. Singer advised Quanex that its liability management company (QHMC), if deconsolidated from petitioners’ affiliated group, could be reconsolidated with the group if puts and calls were exercised in relation to the company’s stock. Singer advised Quanex that it needed a business purpose for the QHMC transactions.

On the basis of the discussions between D&T and Quanex, Rose believed that D&T’s structuring of a joint venture to manage petitioners’ liabilities could result in a capital tax loss that petitioners could use to shelter the anticipated unrelated gains. Singer advised Quanex from the outset, however, that he did not know whether D&T could actually structure such a joint venture.

Nevertheless, at some time on or before March 24, 1997, Rose asked D&T for an engagement letter concerning the structuring of a series of transactions between Quanex, some of Quanex’s affiliates, and a third-party liability management consulting firm (what became the QHMC transactions). Singer wanted the engagement letter so that he could be certain that D&T would be paid for its time whether or not the transactions were completed. Quanex and D&T entered into an agreement that was set out in an engagement letter dated March 24, 1997 (engagement letter).

The engagement letter was signed by Singer on D&T’s behalf, and it was executed by Rose on Quanex’s behalf on June 30, 1997.

Through the engagement letter, which was prepared by or under the direction of Singer, Quanex asked D&T to provide Quanex with— assistance in considering the federal income tax consequences associated with a series of prospective transactions between Quanex Corporation and several of its affiliates * * * an independent third party management consulting firm specializing in either employee benefits and medical insurance matters, or in environmental matters,* * * as well as with a form of the prospective transaction that additionally or alternatively may contemplate an independent third party investor.

The engagement letter notes that “the form and content of this prospective transaction is [sic] somewhat fluid at present” and that D&T would participate in meetings and discussions related to the structuring of the transaction. Singer informed Rose that the transaction contemplated by the engagement letter was a recent development, and Singer did not represent that he had experience with the type of transaction described.

The engagement letter stated that D&T’s professional fees would be calculated on the basis of its standard hourly charges, but if the transaction were completed, the fees would be approximately $400,000 plus an estimated additional $10,000 for out-of-pocket expenses.

D&T and Quanex contemplated under the engagement letter that D&T’s assistance and advice would “culminate in the delivery to Quanex of a tax opinion letter * * * limited solely to the specific federal income tax consequences to Quanex” and that the opinion letter would be “based upon all the facts of the transactions and representations made to * * * [D&T] in a Letter of Representation provided by Quanex.” The engagement letter stated that D&T could not confirm the conclusions it reached until it signed its opinion letter, although it might “informally indicate prior to that point whether or not * * * [D&T] anticipate^] that a position taken by Quanex should be sustained on its merits if challenged by the IRS”, and conditioned D&T’s agreement to provide a tax opinion on D&T’s “ability to satisfy ourselves that all of our professional standards for the conduct of this work and the issuance of our opinion have been met.” D&T required as a condition of the engagement that Quanex agree in the engagement letter that D&T’s liability for any damages arising out of the services that D&T provided in the engagement be limited to the fees paid to D&T for its services giving rise to the liability.

D&T required as a condition of the engagement that Quanex agree in the engagement letter that it would indemnify D&T from any liability, cost, or expense (including attorney’s fees and expenses) stemming from the engagement, absent D&T’s bad faith or willful misconduct. When Singer signed the engagement letter, he contemplated that D&T would provide Quanex with a tax opinion letter if a transaction were completed and Quanex wanted such a letter.

D&T assisted Quanex with the QHMC transactions, and the process of developing the transactions (including the discussions before the engagement letter) extended from approximately February through October 1997. Petitioners conducted no independent investigation of the tax consequences of the QHMC transactions. X. Developing QHMC Transactions A. Quanex’s First Proposal to CS On several occasions in 1997, Rose met with Quanex’s management group and Singer to form an initial proposal to tender to CS as to its participation in the QHMC transactions.

By letter dated July 21, 1997, Peery contacted Chapman to determine CS’ interest in the proposal for the “somewhat unique arrangement we are seeking” to “manage[] our corporation’s non-union medical expenses, including both HMO and indemnity plan coverage for active employees and retirees.” Rose and Peery drafted this letter together, and they showed the letter to Singer before Peery sent it.

The July 21 letter described Quanex’s proposal as an opportunity for an employee benefits firm to enter into a partnering arrangement with Quanex for a term of approximately 7 to 15 years to assume responsibility for and management of ongoing health care costs. The letter stated that the management responsibilities would include meeting the insured health care needs of certain nonunion Quanex employees at care levels comparable to those already in place, but with more efficient service delivery to Quanex’s employees and an ultimate result of reduced costs to Quanex.

The letter explained that the management firm would acquire a class of stock in a medical management subsidiary of Quanex, the subsidiary would hold a 7- to 15-year promissory note issued by a Quanex entity, and the subsidiary would use the interest and principal payments on that note to reimburse the insured health care costs of the covered nonunion Quanex employees.

The July 21 letter further explained that although CS would be paid, in part, for contract services on a periodic basis, Quanex was seeking an arrangement where CS’ performance premium for economic savings under the contract would be partially realized by efficiencies and cost savings. According to the letter, Quanex anticipated that these savings would lead to an accretion in the value of a designated class of the subsidiary’s stock and that the premium for performance would be shared through equity holdings in the subsidiary.

The letter stated that Quanex designed this arrangement because “The senior management of Quanex is committed to delivering above market returns to our equity shareholders, and as such, has increasingly focused on reconfiguring certain central business relationships into a shared ownership or joint venturing mode.” Because Quanex was a good customer for CS and CS wanted to retain its relationship with Quanex in any way it could, CS agreed to meet with Quanex to discuss the proposal.

CS and Quanex met during the summer of 1997, and Quanex informed CS that Quanex wanted to create a medical management business unit that would focus on self-insured, indemnified contracts. B. D&T’s First Outline of Proposed Joint Venture Transactions Sometime on or before July 30, 1997, but at a time when Quanex knew it would have substantial gains from the LaSalle and Tube Group sales, Quanex requested that D&T prepare an outline of the first draft of the proposed QHMC transactions. Singer and Schneider prepared the outline.

Schneider reviewed the outline before it left D&T, and by letter dated July 30, 1997 (July 30 outline), he sent the outline to Parikh, Rose, and Peery. The July 30 outline stated that Quanex wished to broaden the scope of CS’ HMO evaluation services to include review of Quanex’s indemnity medical plan and other medical cost and quality matters. The outline reiterated that CS’ compensation with regard to the additional scope of services would be paid pursuant to a consulting agreement that provided for either hourly or performance-based compensation and for “additional long term incentive equity”.

The outline proposed that

(1) Quanex or QHMC have the option of purchasing the incentive equity after five years for cash,

(2) CS have the option of selling the same to Quanex or QHMC after seven years for cash, and (3) the purchase or sales price be the greater of $12,500 or a formula value based, in part, on QHMC’s expectations for its medical claim expenses. The capital loss deduction generated through the QHMC transactions would be approximately equal to the amount of the MPBs that were transferred in those transactions, and the amount of the MPBs Quanex would transfer in the QHMC transactions would be based on the amount of the capital gains Quanex wanted to offset.

Under the proposal set forth in the outline, all actuarial calculations for the QHMC transactions, including calculations of the present values of the MPBs to be transferred, would be done by the actuarial firm of Watson Wyatt & Co. (WW) or another Quanex designee. WW was Quanex’s then-current consultant on pension plans and retiree health care plans. Sometime before June 30, 1997, Royce asked WW to compute the present value of Quanex’s future health care benefits for active and retired Quanex employees.

Royce did so because he wanted Quanex to know the amount of its outstanding MPBs as it analyzed the structure of the proposed transactions. c. WW 1. In General As part of WW’s consulting services provided to Quanex, WW prepared Quanex’s report (FASB 106 report) required by Financial Accounting Standards Board Statement No. 106 (FASB 106). The FASB 106 report includes a calculation of a liability for the balance sheet and an annual expense for the income statement as to an organization’s retiree health care plans and other retiree welfare plans.

An FASB 106 liability is a liability for financial statement purposes. The MPB obligation, i.e., the future health care costs for active employees of Quanex, is not an FASB 106 liability. 2. FASB 106 FASB 106 sets forth standards for determining the present value of an employer’s future retiree health care payments owed to currently retired individuals and current employees who will retire in the future and ratably accruing that present value on the employer’s financial statement over each employee’s career in an effort to match the benefits paid to employees to their service as they earn the benefits.

FASB 106 requires the making of certain actuarial assumptions on matters such as the average cost of health care per person, the projection of increases in future average costs, and a discounting of projected future costs to calculate present value. (An assumption relating to increases in health care costs into the future is referred to as health care cost inflation or a health care cost trend.) Other assumptions relate to employee demographics, including mortality, job turnover, retirement age, and the likelihood of electing coverage under the employer’s plan upon retirement.

Different types of trends exist for short-term and long-term calculations. For purposes of FASB 106, the timeframe for short-term calculations is typically from 4 to 10 years. Commonly, for a valuation under FASB 106, after a trend rate is determined for the first year of the calculation (initial trend rate), the initial trend rate gradually changes over the years to an ultimate health care inflation rate (ultimate trend rate). From the initial year of the calculation until the ultimate trend starts, the ultimate trend rate can be adjusted and is generally not the same number for all 4 to 10 years.

The initial trend rate may be either greater or less than the ultimate trend rate. 3. WW’s First Present Value Calculation of Quanex’s Health Care Benefits WW had the information to perform the present value calculations requested on or before June 30, 1997, because it had prepared Quanex’s FASB 106 report for TYE 1996. By letter dated June 30, 1997, Michael Ringuette, a WW actuary, sent Royce (in his capacity as Quanex’s tax manager) the requested calculations for FASB 106 (June 30 calculations).

The letter stated that the calculations applied only to people employed by or retired from Quanex as of November 1, 1996, and that WW did not include any additional amounts for employees that might be hired later. The letter was the first written product WW gave Royce as a result of the assignment to compute the present value of the future benefits, and Quanex knew WW’s calculations were estimates. Rose decided which groups of employees were included in WW’s calculations and the length of the term WW’s projections covered. Rose also ratified WW’s decisions about what assumptions were included in the calculations.

WW’s June 30 calculations were entitled “Present Value of Active Health Care Benefits Provided to Employees Hired as of 11/1/96”. The calculations relied on data from Quanex’s salaried employees at its Corporate, GST, Heat Treating, Macsteel (MS)-Michigan, MS-Arkansas, MS-General Office, MST, and Tube Group Office locations, and from Quanex’s hourly employees at its GST, MS-Michigan, MS-Arkansas, and MST locations.

The calculations were broken down by the estimated present value of active health care benefits and of retiree health care benefits for active employees, on the one hand, and for retired employees, on the other hand.

WW provided the following estimated present values of the active health care benefits: Estimated P.V. of Current active health care Location employees benefits Salaried employees: $2,468,146 Corporate 3,741,751 GST 2,148,863 Heat Treating 8,113,866 MS-Michigan I — 1 8,976,903 MS-Arkansas r-1 2,044,664 MS-General Office 4,530,899 MST 3,471,742 Tube Group Office Total 496 35,496,834 Hourly employees: 15,799,142 GST bO ^ go 11,399,603 MS-Michigan M o or 17,479,494 MS-Arkansas tO en to 13,164,471 MST tO to to Total 887 57,842,710 The June 30 calculations relied on the following assumptions: Aging . 2% Initial trend rate. 9.29% Ultimate trend rate (2004) . 5.5% Average cost per employee (1997 age 40) . $3,500 Interest rate . 7.5% The accompanying letter stated that the interest rate and trend rate assumptions for the active employee and retiree health care were the same as those used for WW’s “November 1, 1996 FASB valuation (published February 20, 1997)”.

D. D&T’s Revisions to Proposed Transaction 1. August 6-7, 1997, Revisions Quanex and D&T revised the terms of the QHMC transactions according to information that Royce gave D&T on how the QHMC transactions could be structured. Upon Quanex’s request, by letter dated August 6, 1997, D&T (through Singer and Schneider) provided Quanex with revisions to the July 30 outline (August 6 outline). Singer and Schneider prepared the letter together, and Singer signed the letter and reviewed it before it left D&T.

The revisions included an outline of the proposed capitalization and subsequent sale of QHMC and Quanex Steel, Inc. (QS), another wholly owned Quanex subsidiary, which the letter characterized as “part of the overall plan to expand the scope of services of consultants”. The August 6 outline combined the proposed QHMC transactions into five steps.

Step 1 provided for the reconfiguration of an inactive Quanex subsidiary (which eventually was QW) through certain substeps that included, among others: (1) renaming the subsidiary QHMC; (2) amending QHMC’s articles of incorporation to provide for three classes of stock, to wit, class A voting common stock (class A stock), class B voting preferred stock (class B stock), which the letter termed “Incentive Equity”, and class C voting preferred stock (class C stock); (3) providing for voting rights measured in terms of ability to elect directors, and including CS principals or employees on QHMC’s board of directors (QHMC’s board) and as officers; (4) providing for dividends on the class A stock as declared and dividends of 9.5%, payable quarterly and cumulative, for the class B and class C stocks; (5) allowing for the transfer of stock only with the consent of all shareholders; (6) providing that the class A stock be subject to assessment for capital calls and that the capital call assessment for the class B and class C stocks be limited to an assumed $100 per share investment price; (7) providing Quanex or QHMC with call rights after five years and CS with put rights after seven years; and (8) providing for a liquidation value of the class B and class C stocks at an amount equal to the greater of $125 or a formula value that was based on CS’ success in achieving certain performance goals set by Quanex and on the difference between the value of QHMC’s projected and actual mpb expenses.

Step 2 of the August 6 outline addressed the “Determination of Medical Liability and Contribution of Note” and stated that the present value of Quanex’s and Piper’s medical liabilities had to be determined. The purpose of this step was to determine which groups of employees would have their contingent medical liabilities contributed to QHMC. Under this step, Quanex would contribute $45 million and $44,998,000 worth of contingent liabilities to QS, and Piper would contribute $2 million and $1.99 million of contingent liabilities to QS.

As a footnote to Quanex’s proposed contributions to QS (footnote), the outline stated that for purposes of the document, “we have assumed that $36 million pertains to LaSalle and $9 million to mst (and possibly gst).” This footnote referred to the anticipated gains on the sales of those assets. Step 3 provided for CS’ purchase of all of the class B stock for $41,700. Step 4 provided for CS to contribute $6,000 to QHMC in exchange for class C stock, and for QS to contribute the cash and liabilities it received from Quanex to QHMC in exchange for class C stock with a net fair market value of $11,000.

Step 5 provided for QS to sell some or all of its class C stock for the same price per share that CS “paid” for its class C stock. Royce gave D&T some comments on the August 6 outline, and those comments were read by Singer, Schneider, and Walt Mooney. Mooney was a recently hired senior tax manager in the D&T tax department in Houston, and he was assigned to the Quanex engagement to work under Singer, assisting him with tasks related to the QHMC transactions but without any authority to make material decisions about the structure of the transactions.

Mooney, in consultation with Singer or Schneider, prepared a memorandum (Mooney memorandum) with respect to Royce’s comments, and D&T forwarded a copy of the Mooney memorandum to Royce on August 7, 1997. The Mooney memorandum stated that the August 6 outline was incorrect in that QS was to contribute a note to QHMC along with the liabilities rather than cash.

The Mooney memorandum stated in response to one of Royce’s comments, “Why do we need Quanex Steel?”, that QS “creates tax basis in the note.” The Mooney memorandum did not state that the footnote in the August 6 outline was incorrect or otherwise address the footnote. The Mooney memorandum also gave no indication that Royce or anyone else had commented on the footnote. In a letter dated August 7, 1997, D&T provided Quanex (through Parikh, Perry, Rose, and Royce) with revisions that Quanex requested with respect to the August 6 outline.

The August 7 letter proposed the same general structure for the QHMC transactions as the August 6 outline, but revised step 4 to propose that QS contribute a $45 million note to QHMC, rather than cash, along with $44,998,000 of contingent liabilities. The August 7 letter retained the proposal that Quanex contribute $45 million and $44,998,000 of contingent liabilities to QS and included a footnote stating that D&T assumed that $36 million pertained to LaSalle and $9 million to MST and GST. Singer reviewed and signed the August 7 letter. 2.

August 13, 1997, Revisions and Cashflow Analysis By a fax transmission dated August 13, 1997 (August 13 fax), Singer sent Rose a letter with new versions of the proposed transactions that were designed to overcome what Singer believed was a potential issue with

section 1.1502-13(g), Income Tax Regs. The August 13 fax stated that Singer and Schneider had “further refined” the transactions as Quanex had requested and included details with respect to the class C stock. The primary changes to the transactions as described in the August 13 fax were the deletion of a provision requiring Piper to contribute cash and liabilities to QS and the addition of a provision stating that in no event would the formula value result in the aggregate value of the class B and class C stocks’ equaling or exceeding 50% of the total value of all classes of stock.

The August 13 fax retained the same five general steps as the previous outlines of the proposed transactions. In addition, the August 13 fax retained the proposed Quanex contribution to QS and the accompanying footnote regarding LaSalle, MST, and GST. By a second fax dated August 13, 1997 (second August 13 fax), D&T provided Quanex with two documents to assist Quanex in its presentations to and negotiations with CS. One document was a checklist entitled “QHMC/QUANEX TRANSACTION TASK CHECKLIST FOR CHAPMAN” (checklist).

The checklist retained most of the provisions discussed in the August 13 fax, but eliminated those that did not directly address CS’ potential role in the transactions. The second document was a discounted cashflow analysis (August 13 cashflow analysis) that D&T used to value all of the proposed classes of QHMC stock as of October 1997. The August 13 cashflow analysis assumed, among other things, that QHMC would hold a $38 million note receivable with a 15-year term and that a $4,714,000 payment, comprising both interest and principal, would be made on the note each year.

The August 13 cashflow analysis projected Quanex’s “Cash Flow from Operating and Investing Activities” over a 15-year period. The analysis projected that 576 employees would be covered by QHMC in each year, that interest income from the note receivable would decrease steadily, and that the projected medical costs for the covered employees would increase steadily.

The August 13 cashflow analysis projected that the “Cash Flows from Financing Activities (excluding Dividends)” would consist of 15 annual principal payments on the note in amounts that increased from $1,294,000 in year 1 to $4,325,000 in year 15 (for total principal payments of $38 million over the 15-year period) and that positive cashflow would be available to the equity holders for only the first 6 years. The analysis projected increasing net operating losses (NOLs) for years 2 through 7.

The relevant specifics of the August 13 projections included the following amounts (in thousands): Year Interest income Medical costs Total cashflow from operating ana investing Principal repaid Cashflow available to equity holders Cumulative cashflow NOL 1 $3,420 ($3,193) $227 $1,294 $1,521 $1,521 $227 2 3,304 (3,470) (166) 1,411 1,244 2,765 (166) 3 3,177 (3,748) (572) 1,538 966 3,731 (738) 4 3,038 (4,026) (988) 1,676 689 4,419 (1,726) Year Interest income Medical costs Total cashflow operating ana investing Principal repaid to equity holders Cashflow available Cumulative cashflow NOL 2,887 (4,298) (1,411) 1,827 416 4,836 (3,137) 2,723 (4,561) (1,839) 1,991 153 4,988 (4,975) 2,544 (4,812) (2,269) 2,171 (98) 4,890 (7,244) 8 2,348 (5,077) (2,729) 2,366 (363) 4,528 -0- 2,135 (5,356) (3,221) 2,579 (642) 3,885 -0- 10 1,903 (5,651) (3,748) 2,811 (937) 2,949 -0- 11 1,650 (5,962) (4,311) 3,064 (1,247) 1,701 -0- 12 1,375 (6,290) (4,915) 3,340 (1,575) 126 -0- 13 1,074 (6,635) (5,562) 3,640 (1,921) (1,795) -0- 14 746 (7,000) (6,254) 3,968 (2,286) (4,081) -0- 15 389 (7,385) (6,996) 4,325 (2,671) (6,753) -0- Total 32,714 (77,466) (44,753) 38,000 (6,753) No D&T No D&T total total 3.

August 22, 1997, Revisions By letter dated August 22, 1997 (August 22 letter), Singer sent Parikh and Royce some documents to assist them in their presentation of the QHMC transactions to CS. These documents included, among other things, a schematic diagram of the capitalization of QHMC (and other transfers related thereto), two examples of CS’ potential return on investment, another task checklist for CS (which was nearly identical to the previous CS task checklist), and a proposed Letter of Intent to be executed by Quanex and CS. The diagram proposed the following transactions related to QHMC’s capitalization:

(1) Quanex transfers $50,000 to QHMC in exchange for class A stock;

(2) Quanex transfers $13,000 to QHMC in exchange for class B stock;

(3) Quanex transfers class B stock to CS in exchange for $13,000;

(4) CS transfers $2,000 to QHMC in exchange for class C stock;

(5) QS transfers $38 million and $37,989,000 worth of MPBs to QHMC in exchange for class C stock; and

(6) Piper transfers a $38 million affiliated note to QHMC in exchange for $38 million. The $37,989,000 assigned to the MPBs was the present value ultimately assigned to the MPBs that were transferred as a part of the QHMC transactions. E. Quanex’s Negotiations With CS By letter dated September 3, 1997, Singer provided Royce with a set of documents for WW and a set of documents for CS. Quanex had asked D&T to prepare those documents for Quanex to gauge CS’ and WW’s interests in becoming medical consultants with QHMC.

D&T prepared the documents with input from Quanex, and Singer considered the documents to be part of an effort to present CS with key points of the transaction. The documents contained a PowerPoint presentation of key deal terms (September 3 presentation), a task checklist for the investing medical consultant, and the same capitalization diagram that D&T provided to Quanex in the August 22 letter.

According to the September 3 presentation, CS would provide health management consulting services, including vendor management for both HMO and indemnity plans, continue its HMO consulting agreements, receive service contracts for specific additional projects, and purchase QHMC stock for an equity stake in QHMC. The terms did not differ significantly from those discussed above with respect to the August 6 outline and its subsequent revisions.

According to the September 3 presentation, the purpose of the QHMC transactions was to “reduce Quanex’s overall medical costs, without compromising quality of care provided to employees.” The September 3 presentation contained no reference to the tax aspects of the QHMC transactions or to the role that tax aspects played in structuring the transactions. The September 3 presentation also included a

summary of return-on-investment scenarios which assumed annual savings in medical costs of 5%, on the one hand, and 10%, on the other hand.

The example scenarios projected the following net returns for a five-year investment and for a seven-year investment: Net return Annual savings of 6% Annual savings of 10% Length of investment 5 Years 7 Years 5 Years 7 Years If personnel remain constant $170,502 $295,072 $413,783 $660,073 If personnel increase 5% per annum for the first 5 years 182,666 313,322 438,111 696,573 Net return Annual savings of 5% Annual savings of 10% Length of investment 5 Years 7 Years 5 Years 7 Years If personnel decrease 5% per annum for the first 5 years 158,338 276,822 389,455 623,572 Sometime on or before September 10, 1997, Peery again contacted CS about the potential transactions and to inquire into whether CS would be interested in participating in them.

On September 10, 1997, Chapman and Howard met with Quanex to discuss the proposal. Quanex proposed all aspects of the structure of the transactions to CS, including that Quanex’s MPB obligations be put in a separate corporation, and the substance of Quanex’s presentation at the September 10 meeting was the same as at the September 3 presentation. Quanex provided CS with the return on investment example scenarios, but Quanex did not give Chapman any support for the computations.

When CS and Quanex representatives discussed Quanex’s participation in the QHMC transactions, CS was not represented by counsel, CS was not involved in structuring the relevant corporate entities or transfers, CS did not determine the QHMC stock’s issue price, and CS did not select the liabilities that were ultimately transferred to QHMC. Chapman prepared a memorandum for CS’ board of directors and officers dated September 11, 1997 (memo).

In the memo, Chapman informed CS’ board of the terms of the proposal and stated that, under the proposal, CS and Quanex would enter into a joint venture that would be responsible for the cost of Quanex’s benefits program.

Chapman also informed CS’ board that for a $15,000 investment in QHMC stock, Quanex would guarantee the stock, CS would earn a guaranteed annual dividend of 9.5%, and “when Quanex reacquires the stock it will be based on its actual value but no less than $125 per share.” Chapman explained that the stock value would be calculated on the basis of actual savings as compared to actuarial formulas that WW developed.

Chapman understood that the only risk CS faced from participating in the QHMC transactions was Quanex’s credit risk and that CS, by accepting the proposal, could potentially expand its business relations with Quanex. In describing the proposed transactions, Chapman explained that the number of Quanex employees that CS served would increase significantly because CS would have responsibility with respect to approximately 600 salaried nonunion employees (whose health benefits were included in the QHMC transactions), in addition to all other employees at Quanex facilities (not included in the QHMC transactions).

Chapman also explained that Quanex had 3,900 employees at that time but planned to sell two divisions with a combined total of 900 employees, which in turn, Chapman explained, meant that CS would lose the commission income it was earning on those 900 employees. Chapman stated in the memo that if CS took

part in the joint venture, it would have global responsibility for 3,000 employees, with the 600 salaried/nonunion employees being covered by the proposed health care arrangement and the remaining 2,400 by CS’ standard commission schedule. Chapman explained that CS would earn an estimated $50,000 in consulting fees for servicing the QHMC population as well as CS’ standard earnings formula on the nonunion employees whose MPBs would be transferred to QHMC.

By letter dated September 19, 1997, Parikh informed Chapman that Quanex was pleased with Chapman’s interest in the proposal, that Quanex believed “a proven employee benefits firm can offer an expertise in the management of ongoing health costs”, and that “Establishing a health management company and allowing your employee benefits firm an opportunity to participate in its ownership can prove to be beneficial to all parties.” Parikh also stated that Quanex was still in the process of refining the pool of MPBs that would be transferred to QHMC.

Parikh included a draft set of working documents with the September 19 letter, and he requested that Chapman provide Quanex with his comments to the documents “by Friday, September 26, 1997.” Parikh emphasized in the letter that Quanex was on a “tight time schedule” for completing the transactions, as CS already knew. Parikh wanted the transactions completed by October 31, 1997, because he knew that Quanex anticipated a gain from the LaSalle sale and that the QHMC transactions would result in an artificial capital loss that could offset the gain. F.

WW’s Present Value Calculation Revisions Royce was Ringuette’s main contact for most aspects of Ringuette’s assignments related to present value calculations. Before September 19, 1997, but after receiving the June 30 calculations, Royce directed WW to revise the June 30 calculations without taking into account the Tube Group locations that Quanex intended to sell. Royce gave WW the Quanex companies to use in the calculations. In addition, Quanex gave WW the actual claims activity for the given locations.

WW had further discussions with Quanex relating to present value calculations, and WW gathered more specifics on the claims experience for the Quanex locations and performed additional present value calculations. On September 19, 1997, Ringuette sent Cprek and Maureen Cotter, a WW health care consultant, an email describing a conversation with Royce on September 18, 1997.

Ringuette stated that Royce wanted WW to value all Quanex salaried groups (except for the Tube Group) and the MS-Arkansas nonunion hourly group and that “this calculation will be used to determine the amount of the promissory note to be given to the medical management subsidiary.” By letter dated October 13, 1997, that Ringuette prepared and signed, WW provided Royce with the revised calculations of the present value of lifetime health care benefits for certain groups of active Quanex employees.

Ringuette stated in the cover letter that the calculations addressed Quanex’s corporate, MS-Michigan salaried, MS-Arkansas salaried, MS-Arkansas nonunion hourly, MS-General Office, Heat Treating, and Nitro Steel employees. No retirees were included in the analysis. As Ringuette and Royce had discussed, WW based its calculations on only those employees employed by Quanex as of October 13, 1997, and did not include any amounts for future Quanex hires.

WW determined the number of active employees and their average age using November 1, 1996, employee census data provided for the FASB 106 valuation performed as of that date, and WW assumed the number and average age of employees in each division from November 1, 1996, to November 1, 1997, would not change.

WW also projected the assumed number of employees remaining in future years and their average age using assumptions used for the November 1, 1996, FASB 106 valuation, and WW assumed the average cost of health care would increase in future years in accordance with the following assumptions: “2.0% increase in cost for each/year increase in average age” and “8.75% inflation in 1998, decreasing linearly over time to 5.50% in 2004 and remaining at that level thereafter (same as FASB Statement No. 106 assumption).” The 2% aging assumption was chosen on the basis of data WW had collected on health care costs for many different health care plans and was used, in part, because WW wanted to reflect that some of the groups had a higher average age than others and might have corresponding higher health care costs.

Ringuette used the 8.75% initial trend to project the increase in the average health care costs per person from November 1, 1997, through October 31, 1998, to November 1, 1998, through October 31, 1999. WW also assumed an average health care cost per employee of “$5,877 (1998 Age 40)”, which represented the estimated health care cost per employee included in the present value calculation for TYE 1998, adjusted to assume an average age of 40, and a 7.5% interest rate to discount future cashflows to November 1, 1997.

WW included with the October 13 letter a chart entitled “Development of Average Health Care Cost Per Active Employee”, which showed how WW arrived at its $5,877 assumption.

WW’s October 13, 1997, “Present Value of Active Health Care Benefits Provided to Employees Hired as of 11/1/97” calculations were as follows: Location No. of am-ployees today Aug. em-tained age Avg. retire-Active health care benefits Estimated present value retiree health care benefits Active employees Retired employees Grand total Corporate 35 46 63 $3,792,243 -0- Heat treating 27 35 63 3,302,078 -0- MS-Michigan 112 45 12,469,349 -0--0-12,469,349 MS-Arkansas 120 42 13,796,098 -0--0-13,796,098 MS-General Office 30 47 3,142,329 3,142,329 Location No. of employees today Avg. attained age Avg. retirement age Active health care benefits Estimated present value retiree health care benefits Active employees Retired employees Grand total Nitro Steel 13 46 63 1,337,608 -0- -0- 1,337,608 Total 337 43 63 37,839,705 -0- -0- 37,839,705 At various times from approximately a week or two after receiving the October 13 report through early 1999, Royce asked WW to change its present value calculations to, for example, (1) include the MS-Arkansas nonunion hourly information in the present value calculation, (2) change the lifetime until retirement projection to a 15-year projection for estimated present value, and (3) exclude the Heat Treating and Nitro Steel Divisions in the groups of employees.

G. Patrick Wannell 1. Background Patrick Wannell is a chartered engineer and an Institution of Metallurgists fellow. He received his formal education and professional training in England, and he worked for approximately 20 years primarily in technical positions for a large integrated steel company in England. He later joined LaSalle in the summer of 1980 and was given a range of management responsibilities. He became LaSalle’s vice president and general manager in May 1991, and he worked in that capacity until he retired in February 1997.

After LaSalle was sold in April 1997, Wannell consulted for LaSalle’s new owners for approximately one year to help them understand LaSalle’s operations, and he performed one other consulting project for Quanex, primarily reviewing documents related to the sale for accuracy. Neither consulting project dealt with medical expenses. 2. Wannell and Health Care Costs at LaSalle While working for LaSalle, Wannell believed that the business was “clearly struggling” because it was breaking even financially.

He reviewed the business and concluded that LaSalle’s health care costs were high in relation to those of other Quanex divisions and were rising annually by approximately 30%. He formed a two-step approach to reduce LaSalle’s health care costs. First, he renegotiated the health care contract for LaSalle’s hourly employees because it did not require an employee payment. Second, he developed a wellness program that looked at the causes of employees’ illnesses rather than the employees’ symptoms.

The wellness program addressed issues (such as weight, diet, exercise, stress, and smoking) through, among other things, annual physicals, exercise facilities, and subsidized health club memberships. When Wannell retired, LaSalle had approximately 450 employees, and LaSalle’s health care costs were declining by approximately 10% per year. 3. Quanex’s Offer to Wannell Rose had known Wannell since 1982 and was familiar with his efforts to control health care costs at LaSalle. By letter dated October 13, 1997, Rose asked Wannell to join qhmc’s board as a director.

The letter stated: We are establishing a company to manage our health care benefits and selling a minority interest to a benefits management consulting firm. We believe giving the consulting firm an equity interest will be an extra incentive for them to come up with creative and innovative strategies in health care management.

Since this is a new concept we will start small and try this out on Corporate and MACSTEEL salaried employees health benefits only. * * * Further, the letter stated, Quanex wanted Wannell to join qhmc’s board because We need your knowledge and experience in the areas of labor relations, negotiations, employee management, and morale. This company will manage the health care benefits of employees. We want it to be efficient as possible but also fair to the employees it will effect [sic].

We need an outside director who will bring a balance to the discussion and consider all points of view, not just those of* * * [QHMC] or * * * [CS], On or about October 20, 1997, after the negotiations between Quanex and CS were completed, Wannell spoke with Rose by telephone. During that call, Rose offered Wannell the opportunity to invest $11,000 in QHMC. Peery, Quanex’s vice president of human resources, did not know that Rose was inviting Wannell to participate in QHMC, and Peery was not asked for his advice or recommendation on individuals who might be interested in participating.

Wannell expressed concern that he would have to incur travel and hotel costs for QHMC board meetings, but Rose assured Wannell that the costs would be reimbursed, meetings would be minimal, and Wannell could vote by fax. Rose also informed Wannell that although the term of the investment would be 15 years, the parties could unwind the investment in either 5 or 7 years. Wannell made handwritten notes during the call that expressed, in part, his understanding of the worst case scenarios for his offered investment.

Under the heading “worst case”, Wannell made three entries: “9.5%/yr”, which reflected his understanding of the annual dividend he would receive; “no loss of $11,000”, which reflected his understanding that he would not lose his investment; and “+ 25% over 5 yrs”, which reflected his understanding that his investment would grow 5% each year to the five-year point where Quanex could wind things up. Wannell accepted Rose’s October 20, 1997, offer to invest in QHMC the same day. The terms of Wannell’s investment were set by Quanex, without any negotiations between Quanex and Wannell.

Wannell viewed the dividend payments as approximately equivalent to consultant fees for his time and the five-year, total $25 per share return on his $100 per share investment as equivalent to what he was earning in his bank account. Wannell understood that QHMC’s credit risk was minimal because it was a subsidiary of Quanex. H. D&T’s Revised Cashflow Model D&T prepared revised cashflow calculations for Quanex for the proposed transactions and gave them to Royce in a document entitled “Cash Flow Model as of 10/21/97” (October 21 calculations).

The purpose of these calculations was to model the liabilities QHMC would need to satisfy, the payments QHMC would be obligated to make, and the income QHMC would need to pay the liabilities. The calculations also were needed to set the reported fair market value of QHMC’s stock.

Within the October 21 calculations, D&T estimated the present value for the medical costs associated with Quanex’s corporate, MS-Arkansas, MS-General Office, and Nitro Steel locations to total $37,320,000, as determined as follows: Employees Cashflows as of 1997 10/21/97 Location Grand total ofPV $420,000 Corporate $3,496,000 CO cn 86,000 MS-Arkansas 11,051,000 tO 470,000 MS-Arkansas 18,421,000 H to 457,000 120 MS-General Office 3,062,000 128,000 30 Nitro Steel Division 1,290,000 Total 37,320,000 1,561,000 324 D&T also projected that for all years of the investment, other than the first year, medical costs would exceed the interest income from the $38 million note receivable but, taking into account the principal repayments, cashflow would be available to equity holders for the first seven years of the investment and NOLs would accumulate in years 2 through 6 of the investment.

D&T also projected positive net present value of the cashflows. Relying on these factors and others, D&T projected that the total value of equity for all classes of QHMC stock would equal $76,000, as determined as follows: Total PV of cashflows . $879,000 Plus cash on hand . 65,000 Less uncertainty of future medical costs adjustment ... (868,000) Equals total value of equity. 76,000 Within the October 21 calculations, D&T also projected liquidation and net return values with respect to QHMC’s preferred stock.

D&T projected that if the five-year call option was exercised and a five-year cumulative savings of $1,622,959 was assumed, the liquidation value of the class B and class C stocks would be $356,441 and the net return on investment for the underlying shareholders would be $348,566. D&T projected that if the seven-year put option was exercised and a seven-year cumulative savings of $2,430,142 was assumed, the liquidation value of the class B and class C stocks would be $565,998 and the net return on investment for the underlying shareholders would be $560,973.

D&T also made cumulative savings projections for 1998 through 2012 as follows (in thousands): The projections assumed a 10% variance factor and 324 covered plan participants per year. D&T also included in its October 21 calculations a

section entitled “Analysis of NOL Usage” for 1998 through 2004. D&T included this

section to show Quanex the amount of NOLs that QHMC would generate but that the Quanex consolidated group could not use if QHMC were deconsolidated.

The NOL projections assumed a 6% risk-free rate and a 40% tax rate and were as follows (in thousands): 1998 1999 2000 2001 2002 2003 2004 NOL generated -0-co 00 o to <1 1-1 o CO CO CO sa-co -0 o cq cq CO to CO E> cq to NOL carryforward -0-a o o CO to CO to 1-1 CO ir co <3 CO t> 05 00 CO I> cq 98 209 309 400 482 555 PV of annual NOL tax benefit -0- 2,054 Cumulative PV of NOL benefits • (as rounded) at the end of year 7 At a time not disclosed in the record, Royce reviewed the October 21 calculations. Royce subsequently requested new calculations from both D&T and WW.

Royce testified at trial that the October 21 cashflow model used the wrong groups of employees and assigned the wrong numbers of employees to those groups. XI. Executing QHMC Transactions A. Quanex’s October 21-22, 1997, Board Meeting On October 21 and 22, 1997, Quanex’s boa

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