Filed: May 02, 2003
Latest Update: Mar. 03, 2020
Summary: 120 T.C. No. 11 UNITED STATES TAX COURT BANK ONE CORPORATION (SUCCESSOR IN INTEREST TO FIRST CHICAGO NBD CORPORATION, FORMERLY NBD BANCORP, INC., SUCCESSOR IN INTEREST TO FIRST CHICAGO CORPORATION) AND AFFILIATED CORPORATIONS, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent Docket Nos. 5759-95, 5956-97. Filed May 2, 2003. F, a financial institution, enters into bilateral contracts which are a type of derivative financial product known as interest rate swaps. Most of F’s swaps are of t
Summary: 120 T.C. No. 11 UNITED STATES TAX COURT BANK ONE CORPORATION (SUCCESSOR IN INTEREST TO FIRST CHICAGO NBD CORPORATION, FORMERLY NBD BANCORP, INC., SUCCESSOR IN INTEREST TO FIRST CHICAGO CORPORATION) AND AFFILIATED CORPORATIONS, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent Docket Nos. 5759-95, 5956-97. Filed May 2, 2003. F, a financial institution, enters into bilateral contracts which are a type of derivative financial product known as interest rate swaps. Most of F’s swaps are of th..
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120 T.C. No. 11
UNITED STATES TAX COURT
BANK ONE CORPORATION (SUCCESSOR IN INTEREST TO FIRST
CHICAGO NBD CORPORATION, FORMERLY NBD BANCORP, INC.,
SUCCESSOR IN INTEREST TO FIRST CHICAGO CORPORATION)
AND AFFILIATED CORPORATIONS, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 5759-95, 5956-97. Filed May 2, 2003.
F, a financial institution, enters into bilateral
contracts which are a type of derivative financial
product known as interest rate swaps. Most of F’s
swaps are of the plain vanilla type where one party
(first party) agrees to pay to the other party (second
party) amounts ascertained as of certain dates by
applying a fixed rate of interest to a set notional
amount. The second party agrees to pay to the first
party amounts ascertained as of the same dates by
applying a floating rate of interest (e.g., LIBOR rate)
to the same notional amount. For purpose of the
mark-to-market rule of sec. 475(a)(2), I.R.C., which
applies to taxable years ended after Dec. 30, 1993, F
reported that the fair market value of its swaps as of
Dec. 31, 1993, equaled their mid-market values; i.e.,
the values derived through a net cashflow/present value
analysis that was based on the average of each swap’s
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market bid and ask rates. In addition, F deferred the
recognition of the difference between its valuation and
the bid or ask prices which it paid or received for the
swaps, treating that difference as deferred income
designed to compensate it for (1) the perceived credit
risks of its counterparties and (2) the estimated
administrative costs to be incurred on holding and
managing the swaps until maturity. F used a similar
method to report its swaps income for 1990 through
1992. F ascertained the values of its swaps for each
of the years 1990 through 1993 as of a date that was
approximately 10 days before the last day of F’s
taxable year and reported that value as the swaps’ fair
market value as of the last day of that year. R
determined that F’s method of reporting its swaps
income did not clearly reflect F’s swaps income for any
of the years from 1990 through 1993. R determined that
a proper method values F’s swaps as of the end of each
year at the midmarket values and does not take into
account any deferral for credit risk or future
administrative costs. Pursuant to sec. 446(b), I.R.C.,
R changed F’s method of accounting for its swaps income
to R’s “proper” method.
Held: The mark-to-market rule of sec. 475(a)(2),
I.R.C., including the valuation requirement subsumed
therein, is a method of accounting that is subject to
the clear reflection of income standard of sec. 446(b),
I.R.C.
Held, further, F’s method of accounting for its
swaps income does not clearly reflect its swaps income
under sec. 475, I.R.C., in that F’s values were not
determined at the end of its taxable years and did not
properly reflect adjustments to the midmarket values
which were necessary to reach the swaps’ fair market
value.
Held, further, R’s “proper” method of accounting
for F’s swaps income does not clearly reflect that
income under sec. 475, I.R.C., in that a swap’s
mid-market value without adjustment does not reflect
the swap’s fair market value.
Held, further, to arrive at the fair market value
of a swap and other like derivative products, it is
acceptable to value each product at its midmarket value
as properly adjusted on a dynamic basis for credit risk
and administrative costs. A proper credit risk
adjustment reflects the creditworthiness of both
parties, with due respect to netting and other credit
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enhancements. A proper administrative costs adjustment
is limited to incremental costs.
Jay H. Zimbler, John L. Snyder, Michael A. Clark, Michael R.
Schlessinger, Bradford L. Ferguson, David M. Schiffman, John
Wester, Kevin R. Pryor, Michael M. Conway, Marilyn D. Franson,
and Hille R. Sheppard, for petitioner.*
Marjory A. Gilbert, Marsha A. Sabin, Joseph P. Ferrick, John
W. Rogers III, Charles W. Culmer, Michael O’Donnell, and William
Merkle, for respondent.
CONTENTS
FINDINGS OF FACT............................................. 14
I. Background....................................... 14
A. Stipulations of Fact........................... 14
B. Briefs on CD-ROM With Appropriate Hyperlinks... 14
C. Relevant Taxpayers............................. 15
1. FCC....................................... 15
2. First Chicago NBD Corp.................... 15
3. FNBC...................................... 15
4. Bank One Corp............................. 16
II. The Swaps Business............................... 17
A. Swaps in General............................... 17
1. Definition of a Swap...................... 17
* Brief of amici curiae was filed by Leslie B. Samuels and
Edward D. Kleinbard as counsel for the American Bankers
Association, the Institute of International Bankers, the
International Swaps and Derivatives Association, Inc., the
Securities Industry Association, the New York Clearing House
Association L.L.C., and the Wall Street Tax Association.
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2. Swaps Are Derivative Financial Products... 17
3. Types of Swaps in the Marketplace......... 19
B. Origin and Growth of the Swaps Market.......... 19
1. Origin of the Market...................... 19
2. Growth of the Interest Rate Swaps Market.. 20
C. Interest Rate Swaps............................ 21
1. Terms of an Interest Rate Swap Agreement.. 21
2. Notional Principal Amount and Related
Terms..................................... 21
3. Different Types of Interest Rates......... 23
4. Use of LIBOR as a Floating Interest Rate
Index..................................... 23
5. Plain Vanilla Interest Rate Swaps......... 25
6. Lack of Payments at Inception............. 27
7. Example of an Interest Rate Swap.......... 27
D. Currency Swaps................................. 28
E. Participants in the Market..................... 29
1. End Users................................. 29
a. Typical End Users.................... 29
b. End Users’ Uses of Interest Rate
Swaps................................ 30
i. Combat Interest Rate Changes.. 30
ii. Prosper From Market Forecast.. 31
iii. Reduce Cost of Funding........ 32
2. Dealers................................... 32
a. Typical Dealers...................... 32
b. Practice as to Swaps................. 33
c. Price Quotations..................... 33
d. Role in the Market................... 34
e. Need for Strong Credit .............. 35
3. Brokers................................... 35
F. Market for Swaps............................... 36
1. Types of Markets.......................... 36
a. Primary Market....................... 36
b. Secondary Market..................... 36
2. Brokers’ Dissemination of the Dealers’
Quotations................................ 37
a. Daily Quotations..................... 37
b. No Dissemination of Actual
Swap Prices.......................... 39
c. Spreads Included in Quotations....... 39
3. Midmarket Rate............................ 42
4. Midmarket Swap Curve...................... 43
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5. ISDA Form Agreements...................... 44
6. Assignments and Buyouts of Swaps.......... 47
G. Risks Assumed by Dealers....................... 48
1. Types of Risks............................ 48
2. Techniques Used To Minimize Credit Risk... 48
3. Techniques Used To Minimize Market Risk... 49
H. Dealer Spreads................................. 50
1. Bid-Ask Spread............................ 50
2. Bid-to-Mid Spread......................... 50
3. Example................................... 50
4. Significance of Spreads................... 51
5. Decline in Interdealer Spreads............ 52
III. Valuing Swaps.................................... 52
A. Relevant Valuation Standards................... 52
1. Fair Market Value......................... 53
2. Market Value.............................. 53
3. Fair Value................................ 53
B. Mark-to-Market Accounting...................... 54
C. Devon System and the Devon (Midmarket) Value... 54
1. Devon System.............................. 54
2. Devon (Midmarket) Value................... 55
3. Yield Curve............................... 56
a. Overview............................. 56
b. Constructing the Curve............... 57
c. Imprecise Measure.................... 58
D. Market Value................................... 58
1. Net Present Value–-Forward Rate Pricing... 58
a. Expected Cashflows................... 59
b. Discounting Expected Cashflows....... 59
2. Floating-Rate Note Method................. 60
3. Value at Origination...................... 61
4. Change in Market Value.................... 62
E. Primary Financial Reporting Methods............ 63
1. Overview.................................. 63
2. Amortized Cost............................ 63
3. Current Market Value...................... 64
4. Lower of Cost or Market................... 64
F. Relevant Standards of the FASB................. 65
1. The FASB and GAAP......................... 65
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2. Initial Role of Market Values in GAAP..... 65
3. SFACs..................................... 66
4. Change in Accounting Treatment............ 67
5. SFASs..................................... 68
a. SFAS No. 105......................... 69
b. SFAS No. 107......................... 69
c. SFAS No. 119......................... 70
d. SFAS No. 133......................... 71
G. Methods of Valuing Swaps....................... 71
1. Bid-Ask Method............................ 71
2. Midmarket Method.......................... 72
3. Adjusted Midmarket Method................. 72
H. Nontax Purposes for Which Dealers Value Swaps.. 73
1. Overview.................................. 73
2. Regulatory Reporting...................... 73
3. Risk Management........................... 75
4. Management Reporting...................... 75
5. Financial Reporting and Pricing........... 76
I. The G-30....................................... 76
1. Overview.................................. 76
2. G-30’s Review of Industry Practices....... 77
3. G-30 Report............................... 78
4. BC-277.................................... 79
IV. Adjustments to Midmarket Value................... 81
A. Overview....................................... 81
B. Administrative Costs Adjustment................ 82
1. Overview.................................. 82
2. Dealers’ Practice......................... 82
3. Use of the Dealer’s Own Costs............. 83
C. Adjustment for Counterparty Credit Risk........ 83
1. Overview.................................. 83
2. Common Method of Calculating Adjustment... 84
a. Counterparty Credit Rating........... 84
b. Expected Loss Factor................. 85
c. Loan Equivalency..................... 85
i. Overview...................... 85
ii. Types of Credit Exposure...... 85
A. Current Credit Exposure.... 86
B. Potential Credit Exposure.. 86
C. Expected Exposure.......... 87
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iii. OCC’s Position................ 87
iv. Methods Used To Calculate...... 87
3. Market Data for Pricing Credit Risk of
Bonds..................................... 88
D. Other Adjustments.............................. 89
1. Investing and Funding Costs............... 89
2. Closeout Costs (Liquidity)................ 90
3. Dealer Margin............................. 90
V. Los Alamos Project............................... 91
VI. FNBC’s Swaps Business............................ 93
A. Overview....................................... 93
B. Trading Desks.................................. 94
C. Swaps Operations Personnel..................... 95
1. Overview.................................. 95
2. Traders................................... 96
a. Function............................. 96
b. Number Employed in Chicago........... 97
c. Practice as to Quotations............ 97
d. Risk Management Responsibility....... 98
3. Marketers................................. 99
a. Function............................. 99
b. Practice as to Quotations............100
4. Relationship Managers.....................100
5. Credit Officers...........................101
D. Weak Credit Rating.............................101
E. Quoting a Price................................102
F. Buyouts........................................103
G. Swaps Outstanding at Yearend...................104
H. Swaps in Issue.................................104
VII. FNBC’s Financial Accounting Practice.............106
VIII. FNBC’s Practice as to Its Valuation of Its Swaps.106
A. Financial Reporting Position...................106
B. Uses of Valuation..............................107
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C. RAP/GAAP.......................................108
IX. FNBC’s Calculation of Midmarket Value............108
A. FNBC’s Devon System............................108
1. Overview..................................108
2. Role of FNBC’s Devon System...............109
B. Accounting for Devon Value.....................109
C. Early Closing Date.............................111
X. FNBC’s Administrative Costs Adjustment...........112
A. Overview.......................................112
B. Calculation of the Adjustment..................114
C. Preparation for the Adjustment.................116
D. Expenses Included in the Adjustment............118
1. Direct and Indirect Budgeted Costs........118
2. Amounts From Other Areas of FNBC..........119
XI. FNBC’s Credit Adjustment.........................120
A. Overview.......................................120
1. Initial and Subsequent Methods............120
2. First Method..............................121
3. Second Method.............................121
a. Methodology..........................121
b. Effect of Methodology................123
B. Swaps in Issue for 1993........................124
1. Identification of Swaps...................124
2. Duration of Swaps.........................124
3. Credit Adjustments Claimed................125
C. Components of the Second Method................127
1. CEM Amount................................127
a. Overview.............................127
b. Hsieh Model..........................128
c. FNBC’s VEP System....................129
i. Evolution of the System.......129
ii. Effect of the System..........130
iii. System’s Operation............131
2. Credit Risk Ratings.......................133
a. System of Risk Classification........133
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b. Credit Procedures....................134
c. Review of Risk Classifications ......136
3. CRESCO Loss Reserve Factors...............137
a. Loss Reserves........................137
b. CRESCO...............................137
c. Accuracy of CRESCO Loss Factors......138
d. Same Factors Applied to Loans an
Swaps................................139
e. FNBC’s Credit and Tenor Enhancements.139
D. Static Instead of Dynamic Procedure............141
E. Netting........................................142
1. Types of Netting..........................142
a. Closeout Netting.....................142
b. Single Transaction Netting...........143
c. Multiple Transaction Netting.........143
2. Netting in the Industry...................143
3. Status of Netting Arrangements............144
4. Practicability of Accounting for Netting..146
5. Impact of the Failure To Account for
Netting...................................146
6. FNBC’s Use of Netting Provisions..........147
XII. FNBC’s Adjustments Were Designed To Defer Income.147
A. Overview.......................................147
B. FNBC’s Policy Statements.......................147
XIII. FNBC Had No Schedule M Adjustments...............148
XIV. Nature and Amount of the Proposed Disallowances..148
XV. Petitioner’s Facts Set Forth in Its Petition.....149
XVI. Pretrial Order of August 14, 2000................151
XVII. Expert Testimony.................................152
A. Identity and Qualifications....................152
1. Experts Retained by Petitioner............152
2. Experts Retained by Respondent............153
3. Experts Appointed by the Court............155
B. Procedure Used by the Court To Appoint Our
Experts........................................156
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OPINION......................................................159
I. Overview.........................................159
II. Does Section 475 Involve a Method of Accounting?.162
A. Overview.......................................162
B. Identification of a Method of Accounting.......164
III. Burden of Proof..................................169
IV. Tax Accounting for Methods of Accounting.........172
V. FNBC’s Mark-to-Market Book Method................179
A. Mark-to-Market Method Acceptable for Section
475............................................179
1. Acceptable in Theory......................180
2. Acceptable In Practice....................183
a. Market Valuation of Inventories......183
b. Comprehensive Mark-to-Market
Accounting...........................184
B. Standard of the Mark-to-Market Method Is Not
Reasonableness.................................189
VI. Application of Fair Market Value.................198
A. Overview.......................................198
B. History of the Term “Fair Market Value”........200
C. Determination of Fair Market Value.............204
1. Market Approach...........................205
2. Income Approach...........................205
3. Asset-Based Approach......................206
D. Fair Market Value Compared With Fair Value.....206
1. Meaning of the Term “Fair Value”..........206
a. GAAP Purposes........................206
b. State Law Purposes...................206
2. Difference Between Fair Market Value and
Fair Value................................207
3. Conclusion................................211
VII. Property To Be Valued............................211
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VIII. Applicable Valuation Date........................214
IX. Proper Hypothetical Market.......................215
X. FNBC Implemented Its Mark-to-Market Method
Inconsistently With Section 475..................219
A. Overview.......................................219
B. Midmarket Values...............................220
C. Adjustments in General.........................221
D. Credit Adjustment..............................223
1. Need for a Credit Adjustment..............223
2. One-Month Lag in Reporting Swaps..........226
3. Credit Ratings of Both Counterparties.....227
4. Midmarket Values Reflected AA
Counterparties............................230
5. Credit Enhancements.......................231
6. Netting...................................232
7. Static or Dynamic Procedure...............233
8. Confidence Levels.........................235
9. Mirror and Partially Offsetting Swaps.....236
10. Per-Swap Adjustments......................236
E. Administrative Costs...........................237
1. Overview..................................237
2. Incremental Costs.........................238
3. Use of Own Costs..........................239
F. Other..........................................239
XI. Respondent’s Method of Accounting................240
XII. Conclusion.......................................242
XIII. Postscript–-Weight Given to Expert Testimony.....244
A. Role of the Experts............................244
B. Court’s Impression of the Experts..............246
Appendix A...................................................249
Appendix B...................................................254
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LARO, Judge: These cases were consolidated for purposes of
trial, briefing, and opinion. In docket No. 5759-95, First
Chicago Corp. (FCC) and its affiliated corporations, one of which
was a corporation formerly known as the First National Bank of
Chicago (FNBC), petitioned the Court to redetermine respondent’s
determination of deficiencies of $1,661,112 and $2,956,794 in the
affiliated group’s consolidated Federal income taxes for 1990 and
1991, respectively. In docket No. 5956-97, First Chicago NBD
Corp., the successor in interest to FCC and affiliated
corporations, petitioned the Court to redetermine respondent’s
determination of a $95,156,499 deficiency in the 1993
consolidated Federal income tax of FCC and its affiliated
corporations. The latter petition placed in issue a nonnotice
year, 1992, by alleging entitlement for that year to adjustments
which would affect the notice year 1993.
As relevant herein, the deficiencies stem from FNBC’s claim
to “swap fee carve-outs” of $5,468,418 for 1990, $3,543,182 for
1991, $4,294,471 for 1992, and $5,799,724 for 1993.1 As to swaps
(defined infra p. 17) for which it was a party, FNBC valued these
swaps at the mid-market values which it computed on its version
of a computerized system known as the Devon Derivatives System
(Devon system) (as discussed infra, FNBC’s midmarket valuation
1
Whereas the parties sometimes use the term “adjustment” to
refer to the carveouts discussed herein, so do we.
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using the Devon system was based on the midpoint between a swap’s
market bid and ask rates, or, in other words, the average of
those rates). FNBC’s swap fee carveout as to each of those swaps
represented the difference, determined at or about the time of
each swap’s initiation, between the swap’s midmarket value and
the bid or ask price which it paid or received for the swap.
FNBC treated the carved-out amounts as deferred income designed
to compensate it for (1) the perceived credit risks of its
counterparties (credit adjustments) and (2) the estimated
administrative costs which it expected to incur in holding and
managing the swaps until maturity (administrative costs
adjustments). Respondent determined that the method by which
FNBC claimed the carveouts was improper in that the method did
not clearly reflect FNBC’s swaps income in accordance with
section 4462 and section 1.446-3, Income Tax Regs. Respondent
determined that FNBC was required to report its swaps income by
using a method that reported each swap’s midmarket value without
any adjustment.
We hold that neither FNBC’s method of accounting as to its
swaps income nor respondent’s method of accounting as to that
income clearly reflected FNBC’s swaps income. We direct the
parties to file with the Court a computation (or computations)
2
Unless otherwise indicated, section references are to the
applicable versions of the Internal Revenue Code, and Rule
references are to the Tax Court Rules of Practice and Procedure.
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under Rule 155 that reflects (or reflect) FNBC’s swaps income in
a manner consistent with this Opinion.
FINDINGS OF FACT
I. Background
A. Stipulations of Fact
Many facts were stipulated. We incorporate herein by this
reference the parties’ stipulations of fact and the exhibits
submitted therewith. We find the stipulated facts accordingly.
B. Briefs on CD-ROM With Appropriate Hyperlinks
The trial of these cases began on October 30, 2000, and
(with recesses) concluded on November 28, 2001. The record,
which includes a trial transcript of approximately 3,500 pages
memorializing the testimony of 21 fact witnesses and 7 expert
witnesses, consists of 43 “red” files and more than 10,000 pages
of exhibits. For briefing purposes, the Court ordered the
parties to file written briefs conforming to Rule 151 with copies
on CD-ROM that included Hyperlinks to the relevant part or parts
of the exhibits, testimony, pleadings, or stipulations relied
upon for each proposed finding of fact. The written briefs,
inclusive of their proposed findings of fact and objections to
the other party’s proposed findings of fact, totaled more than
3,300 pages. The copies of the briefs on CD-ROM were very
helpful to the Court.
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C. Relevant Taxpayers
1. FCC
FCC was a Delaware corporation and registered bank holding
company. By virtue of its status as a bank holding company, FCC
was regulated during the relevant years by the U.S. Federal
Reserve Board (FRB). At all relevant times, including at the
time of the filing of its petition to this Court, FCC’s principal
place of business was in Chicago, Illinois.
For Federal income tax purposes, FCC was an accrual method
taxpayer that joined with its affiliates in the filing of
consolidated Federal income tax returns. FCC filed those returns
timely and on the basis of the calendar year.
2. First Chicago NBD Corp.
First Chicago NBD Corp. was a Delaware corporation and
registered bank holding company. First Chicago NBD Corp. was the
corporation resulting from the merger, effective December 1,
1995, of FCC with and into NBD Bancorp, Inc., a Delaware
corporation and registered bank holding company. At all relevant
times, including at the time of the filing of its petition to
this Court, the principal place of business of First Chicago NBD
Corp. was in Chicago, Illinois.
3. FNBC
FNBC was a national bank organized and existing as a
national banking association under the National Bank Act, current
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version at 12 U.S.C. secs. 21-216 (2000). By virtue of its
status as a national bank, FNBC was regulated by the Office of
the Comptroller of the Currency (OCC).
During the relevant years, FNBC was FCC’s primary
subsidiary. For Federal income tax purposes, FNBC was an accrual
method taxpayer, and it joined in the consolidated Federal income
tax returns filed by FCC.
4. Bank One Corp.
Bank One Corp. is a multibank holding company registered
under the Bank Holding Company Act of 1956, ch. 240, 70 Stat.
133, currently codified at 12 U.S.C. secs. 1841-1850 (2000). It
was incorporated in Delaware on April 9, 1998, to effect the
merger of First Chicago NBD Corp. and Banc One Corp., an Ohio
corporation and registered bank holding company. The merger was
effective October 2, 1998.3 By virtue of its status as a bank
holding company, Bank One Corp. was regulated during the relevant
years by the FRB. Bank One Corp.’s principal office was in
Chicago, Illinois, at all relevant times.
3
Shortly thereafter, the Court, pursuant to an unopposed
motion by petitioner, ordered that the caption be changed to the
present caption.
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II. The Swaps Business
A. Swaps in General
1. Definition of a Swap
A swap is a bilateral agreement obligating the parties
(often referred to as counterparties) to exchange at specified
intervals (e.g., monthly, quarterly, semiannually) cashflows
ascertained from applying specified financial prices (e.g.,
interest rates, currency rates) to a specified underlying amount.
The specified underlying amount is either a notional principal
amount which is not exchanged (as usually occurs when the subject
matter of the swap is interest rates) or an amount which may
actually be exchanged (as usually occurs when the subject matter
of the swap is currency rates). The exchange of cashflows at the
periodic intervals is sometimes referred to as “periodic
payments” and is usually done on a net settlement basis. Each
party to a swap bears the risk that its counterparty will default
on its obligation to make a periodic payment, and, thus, that it
(the party) will not receive a periodic payment owed to it by the
counterparty.
2. Swaps Are Derivative Financial Products
Swaps are derivative financial products (financial
derivatives). A financial derivative is a bilateral agreement
the value of which is derived (as implied by its name) from the
performance of an underlying asset, reference rate, or index.
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Other common forms of financial derivatives during the
relevant years included: (1) Interest rate guarantees such as
caps, floors, and collars; (2) interest rate options;
(3) swaptions; and (4) forward rate agreements (FRAs).4 Interest
rate caps, floors, and collars are contracts with notional
principal amounts but not necessarily with periodic payments.
Interest rate caps and floors require the seller, in exchange for
a fee, to make a payment to the purchaser only if, in the case of
a cap, a specified market interest rate exceeds the fixed cap
rate on specified future dates or, in the case of a floor, the
specified market interest rate falls below the fixed floor rate
on specified future dates.5 Interest rate options are contracts
that grant one party, for a premium payment, the right to either
purchase from or sell to the other party a financial instrument
at a specified price within a specified period of time or on a
specified date. Swaptions are options to purchase a swap in the
future. FRAs are contracts with notional principal amounts that
settle in cash at a specified future date on the basis of the
difference between a fixed interest rate and a specified market
4
During the relevant years, FNBC was a party to swaps as
well as to one or more of these financial derivatives.
5
An interest rate collar is essentially an interest rate
cap combined with an interest rate floor.
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interest rate.6 FRAs are different from swaps in that FRAs lack
periodic payments.
3. Types of Swaps in the Marketplace
Swaps in the marketplace during the relevant years consisted
primarily of interest rate swaps (sometimes, IRSWs), currency
swaps (sometimes, CYSWs), and commodity swaps (sometimes, COMs).7
An interest rate swap, the primary swap at issue, is a bilateral
agreement calling for the periodic exchange of interest payments
ascertained by applying specified interest rates to an agreed-
upon notional principal amount. A currency swap is a bilateral
agreement to exchange payments denominated in different
currencies. A commodity swap is a bilateral agreement to
exchange cashflows ascertained by applying commodity prices to a
notional quantity of a particular commodity.
B. Origin and Growth of the Swaps Market
1. Origin of the Market
The origin of the swaps market is generally traced to a
currency swap negotiated between the World Bank and IBM in 1981.
6
A forward rate is a rate that the parties to a forward
contract agree will be applied at a future date. Assume, for
example, that a person agrees to borrow money 1 year from today
and repay it with 6-percent interest at the end of the second
year. The 6-percent interest rate is a forward rate, and the
contract is a forward contract.
7
During the relevant years, FNBC was a party to each type
of these swaps. The specific swaps in dispute are FNBC’s
interest rate swaps, currency swaps, and commodity swaps.
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That transaction involved an exchange of payments in Swiss francs
for payments in deutschmarks. The first interest rate swap was
negotiated with the Student Loan Marketing Association in 1982.
The first commodity swap occurred in 1986.
2. Growth of the Interest Rate Swaps Market
Interest rate swaps were the most common swaps during the
relevant years. In 1992, dealers generally participated in four
to five interest rate swaps daily and one currency swap every 2
days. The corresponding figures for 1987 were three interest
rate swaps every 2 days and one currency swap every 4 days. A
dealer’s use of commodity swaps during 1987 and 1992 also was
less common than the dealer’s use of interest rate swaps during
the same years.
The outstanding notional amount of interest rate swaps
worldwide totaled approximately $683 billion, $12.8 trillion, and
$43 trillion at the end of 1987, 1995, and 1999, respectively.8
The growth of the outstanding notional amount of interest rate
swaps is attributable primarily to the use of interest rate swaps
as an effective, inexpensive way in which to manage financial
risks from interest rate fluctuations. Those who use financial
derivatives in general can identify, isolate, and manage
separately the fundamental risks and other characteristics which
8
The outstanding notional principal of currency swaps at
the end of 1999 is estimated at approximately $2 trillion.
-21-
are bound together in traditional financial instruments. In
addition to increasing the range of financial products available,
financial derivatives have fostered more precise ways of
understanding, quantifying, and managing financial risk. Most
institutional borrowers and investors currently use financial
derivatives. Many of these entities also act as intermediaries
dealing in those financial products.
C. Interest Rate Swaps
1. Terms of an Interest Rate Swap Agreement
Interest rate swaps generally require that the parties
thereto negotiate and agree upon several economic terms. These
terms generally include (1) a notional amount, (2) a fixed
interest rate, (3) a floating interest rate index, (4) a duration
(term or tenor) of the contract, (5) an effective date of the
contract, and (6) a payment schedule. The parties to an interest
rate swap also must negotiate a particular country’s currency (or
countries’ currencies) in which a swap is denominated. During
the relevant years, the U.S. dollar was overwhelmingly the
dominant individual currency for interest rate swaps.
2. Notional Principal Amount and Related Terms
The notional principal amount of an interest rate swap is
not actually exchanged but is simply the reference point for the
-22-
parties’ obligations.9 The parties to an interest rate swap
agree to exchange for a set length of time (term or tenor) and as
of specified intervals (payment schedule) streams of interest
payments ascertained on the basis of a notional principal amount.
At least one of these streams of payments is ascertained on the
basis of a floating-rate index. The respective streams of
payments are often referred to as “legs”; e.g., a fixed leg and a
floating leg.
The party that is paying the fixed rate (i.e., receiving the
floating rate) is said to have bought the swap.10 The party
receiving the fixed rate (i.e., paying the floating rate) is said
to have sold the swap. The party that is receiving the fixed
rate also is said to be “short” the swap, while the party paying
the fixed rate is said to be “long” the swap.11
The trade date is the date on which the swap transaction is
agreed. The effective date is the date on which the interest
included in the payments begins to accrue. Once interest has
begun to accrue, it continues to accrue until the day before the
9
Nor is the notional amount shown on either party’s balance
sheet.
10
The negotiated fixed rate is sometimes called the price
of the swap.
11
Assume, for example, that C agrees to pay to B a fixed
interest rate in return for B’s agreeing to pay to C an interest
rate that floats in accordance with a certain floating interest
rate index. C is the buyer of the swap (and is long on the
swap). B is the seller of the swap (and is short on the swap).
-23-
termination date. The termination date is the date on which the
last payment is due. The termination date sets the maturity of
the contract.
3. Different Types of Interest Rates
Swaps generally involve two types of interest rates. The
first rate, a fixed interest rate, is applied for each payment
date to ascertain the agreed-upon payment in the fixed leg. By
definition, the fixed interest rate is fixed in that it is
constant. The second rate, a floating interest rate, is applied
for each payment to ascertain the agreed-upon payment in the
floating leg. By definition, the floating interest rate floats
in accordance with an agreed-upon index and usually changes with
time.
The date on which the floating interest rate is changed
(i.e., is “reset”) is known as the reset date. Except in the
case of the first payment, the floating interest rate applicable
to each payment period is generally set at the beginning of the
interval, on the basis of the interest rate in effect 2 business
days before the most recent reset date. The floating interest
rate applicable to the first payment is generally set on the
trade date, 2 days before the effective date.
4. Use of LIBOR as a Floating Interest Rate Index
The most common floating interest rate index for interest
rate swaps is the London Interbank Offering Rate (LIBOR), the
-24-
rate of interest at which banks are willing to offer deposits
(i.e., lend Eurodollars) to other prime banks, in marketable
size, in the London Interbank market. In order to determine the
LIBOR rates, the British Bankers’ Association maintains a
reference panel of banks with London offices. Each of these
banks ascertains the rate at which it could borrow funds, were it
to do so by asking for and then accepting interbank offers in
reasonable market size just before 11 a.m. that day. The
deposits have a zero-coupon structure, meaning that no interest
is paid during the life of the deposits but is accrued and paid
at maturity.12 Each LIBOR rate is computed by disregarding the
four highest and the four lowest rates offered by these banks and
then taking the average of the others.
The LIBOR rates, when determined, are instantly communicated
around the world by electronic (on-line) services such as the
Associated Press/Dow Jones Telerate Service, Bloomberg, or
Reuters Monitor Money Rates Service. Separate LIBOR rates are
available and quoted for each standard term (e.g., 1-month, 3-
month, 6-month, 12-month), and the parties to a swap may agree on
any of these LIBOR rates. In most cases, the floating-rate payor
pays no increment or decrement (spread) with respect to the LIBOR
rate, and the rate is said to be quoted flat.
12
A zero rate means that interest, if paid, is paid only at
maturity.
-25-
In lieu of a LIBOR rate, the parties to an interest rate
swap may agree to use a less common floating interest rate index.
Other common floating interest rate indices during the relevant
years included the T-bill rate (the rate on the most recent issue
of U.S. Treasury bills), the commercial paper rate, the bankers
acceptance rate, the prime rate, and the tax-exempt rate.
5. Plain Vanilla Interest Rate Swaps
Interest rate swaps may be of the plain vanilla type. A
plain vanilla interest rate swap, the simplest and most common
type of interest rate swap, is a swap with standard terms and
without another financial derivative as part of the agreement.
One party to a plain vanilla interest rate swap (first party)
agrees to pay to the other party (second party) amounts equal to
a fixed rate of interest multiplied by a set notional amount.
The second party agrees to pay to the first party amounts equal
to a floating rate of interest multiplied by the same notional
amount. The fixed and floating amounts are offset against each
other as of each payment date, and the party paying the higher
rate of interest remits a payment to the counterparty equal to
the notional amount multiplied by the difference between the
interest rates. An analogy of a plain vanilla interest rate swap
is the exchange of a fixed-rate loan for a floating-rate loan.
The schedule of payments on a plain vanilla interest rate swap
-26-
exactly matches the schedule of net payments on an exchange of
the fixed- and floating-rate loans.
In contrast to a plain vanilla interest rate swap, a more
creative interest rate swap may have nonstandard terms.13 A
combination deal (sometimes, COMB) has embedded option features
such as a callable or extendable swap or a contract giving one of
the parties the option, but not the obligation, to enter into an
interest rate or currency swap at prearranged terms. An
amortizing or accreting swap has a notional amount that decreases
or increases, respectively, during the life of the transaction.14
A basis swap has two floating legs, instead of a fixed leg and a
floating leg, with each party agreeing to exchange payments
determined by a different floating-rate index (e.g., one party
floats with LIBOR while the other party floats with the
commercial paper rate). In some swaps, the payment dates for the
counterparties do not coincide, whereas in other swaps the
counterparties’ payments are in different currencies. There also
are swaps with different fixed rates during different periods.
13
The expression “structured swap” is used to capture any
swap with specially tailored features. Relatively new and
unfamiliar types of swaps are called “exotics”.
14
An amortizing swap mimics the fixed and floating interest
rate schedules on regular amortizing loans.
-27-
6. Lack of Payments at Inception
For most interest rate swaps during the relevant years,
neither counterparty made a payment at the inception of the swap
to effect the transaction. The entire consideration for a
party’s promise to make future payments to the counterparty lay
in the counterparty’s promise to make its agreed-upon future
payments. An initial payment was not generally required to
induce the counterparties to enter into the swap agreement.
One exception to the nonpayment rule was off-market swaps
which required upfront payments. In an off-market swap, a
counterparty agreed to receive or pay an interest rate that was
significantly different than the going market rate.
7. Example of an Interest Rate Swap
To illustrate the mechanics of an interest rate swap, assume
that a plain vanilla interest rate swap originated on
November 29, 1992, the trade date, with the following terms:
Notional principal $1 million
Fixed rate 5 percent per annum
Floating rate 6-month LIBOR rate
Effective date Dec. 1, 1992
Termination date Dec. 1, 1995
Payment dates June 1 and Dec. 1 of each year
Fixed-rate payor F
Floating-rate payor L
Day count conventions Actual/3601
1
The computations as to swaps are generally based
on a 360-day year, a convention that is common in
banking.
-28-
The table below shows the payments on the swap for a hypothetical
scenario of the 6-month LIBOR rate over the life of the swap. In
this example, F has promised to pay to L a semiannual interest
payment calculated on the basis of a notional principal of $1
million and a fixed 5-percent interest rate as adjusted by a
ratio the numerator of which equals the number of days in the
payment period and the denominator of which equals 360. L has
promised to pay to F a semiannual interest payment calculated on
the basis of the same $1 million amount but using, instead of the
fixed rate, a floating 6-month LIBOR rate as adjusted by the same
ratio. The sixth column, the net of the fixed and floating
payments, is the only amount that is actually paid by one party
or the other.
Number of
Payment Days in Fixed Hypothetical Floating Net Cashflow
Dates Period Payment 6-Month LIBOR Rate Payment To L (To F)
6/1/1993 182 $25,278 4.0% $20,222 ($5,056)
12/1/1993 183 25,417 4.320 21,960 (3,457)
6/1/1994 182 25,278 5.130 25,935 657
12/1/1994 183 25,417 5.901 29,997 4,580
6/1/1995 182 25,278 6.210 31,395 6,117
12/1/1995 183 25,417 6.842 34,780 9,363
D. Currency Swaps
A plain vanilla currency swap involves the exchange of a
series of fixed-rate interest payments denominated in a foreign
currency for a series of floating-rate interest payments
denominated in U.S. dollars. Other currency swaps include
exchanging a fixed rate in a foreign currency for a fixed rate in
U.S. dollars, exchanging a fixed rate in U.S. dollars for a
-29-
floating rate in a foreign currency, or exchanging a floating
rate in a foreign currency for a floating rate in U.S. dollars.
E. Participants in the Market
The main participants in the interest rate swaps market are
end users, dealers, and brokers.
1. End Users
a. Typical End Users
End users are typically major corporations, government or
governmental-related entities, investment funds, or other
financial institutions. These end-users typically use interest
rate swaps to combat interest rate movements, express market
preferences through position taking, and/or reduce their cost of
funding. As to the size of an end user, swaps end-user entities
entering into swaps in connection with the conduct of their
business must have assets over $10 million or a net worth over $1
million in order to qualify their swaps for a safe-harbor
exception from most of the regulatory requirements of the
Commodity Futures Trading Commission (CFTC).15
15
A swap must also meet three other requirements in order
to qualify for such an exception. First, the swap may not be
part of a fungible class of agreements which are standardized as
to their material economic terms. Second, the creditworthiness
of any party having an actual or potential obligation under the
swap agreement must be a material consideration in entering into
or determining the terms of the swap agreement. Third, the swap
agreement may not be entered into or traded on a physical or
electronic transaction execution facility in which participants
can simultaneously effect transactions and bind both parties.
-30-
b. End Users’ Uses of Interest Rate Swaps
i. Combat Interest Rate Changes
End users commonly use interest rate swaps to hedge
(minimize) their risk of adverse changes in interest rates.
Interest rate risk is the potential fluctuation in the value of a
financial instrument due to a change in the level of interest
rates. Whereas the market values of fixed-rate loans are exposed
to significant interest rate risk, the market values of
floating-rate loans are not. A fall (or rise) in interest rates
causes the market value of a fixed-rate loan to increase (or
decrease). The fall (or rise) in interest rates leaves the
market value of a floating-rate loan unchanged; the interest
payments on the floating-rate loan fall (or rise) together with
interest rates.
Managing interest rate risk is an important function of
financial managers in entities such as corporations and financial
institutions, and an interest rate swap is a tool with which
financial managers may readily change their exposure to interest
rate fluctuations. Through a swap, an institution may change the
nature of its liabilities from fixed-rate liabilities to
floating-rate liabilities, or vice versa. A company liable on
debt paying a floating interest rate, for example, may guard
against a rise in interest rates by entering into a swap under
which it pays a fixed rate of interest and receives a floating
-31-
rate. The swap transfers to the counterparty the risk of a rise
in interest rates.16 Likewise, a financial manager may need to
increase or decrease the interest rate exposure of an entity’s
liabilities. The financial manager of a corporation, for
example, that has assets which are positively exposed to interest
rate risk (i.e., the value of the assets increases with interest
rates) may seek to match this exposure with liabilities that are
positively exposed to interest rate risk so as to create zero
exposure in the corporation’s net position.
ii. Prosper From Market Forecast
End users also use interest rate swaps to attempt to prosper
from their forecast of the movement in interest rates. For
example, a company that believes that interest rates will fall
may enter into an agreement under which it pays a floating
interest rate. In 1992 and 1993, for example, when interest
rates were at extremely low levels, many companies elected to
issue long-term debt at fixed rates and then enter into
shorter-term swap agreements under which the company paid a
floating rate. The company, in effect, converted the early years
of its financing from a fixed rate to a floating rate.
16
An entity that borrows at a floating rate and then buys a
fixed-for-floating swap of matching maturity and notional
principal is said to have synthetically created a fixed-rate
loan; i.e., the net of the payments on the floating-rate loan and
the swap mirror the payments on a fixed-rate loan.
-32-
iii. Reduce Cost of Funding
End users also use interest rate swaps to reduce the
transaction costs which are a natural consequence of raising
funds. If, for example, a corporation wants to borrow at a fixed
rate but has a shelf registration for commercial paper paying a
floating interest rate, the corporation may be able to minimize
its transaction costs by issuing commercial paper with a floating
rate and then swapping the commercial paper for an obligation
with a fixed rate.
2. Dealers
a. Typical Dealers
Since at least 1992, the swaps market has been almost
entirely intermediated by institutions acting as dealers. Swaps
dealers are generally major financial institutions (e.g.,
securities firms and banks such as FNBC) which hold themselves
out as market-makers; i.e., entities ready and willing to take
either side of a swap transaction for the purpose of earning a
profit by originating new swaps.17 On some occasions, these
institutions enter into swaps in their capacity as swaps dealers.
On other occasions, these institutions enter into swaps in their
capacity as end users to manage the overall structure of their
portfolios to minimize the net exposure to interest rate
17
In performing this market-making function, dealers act
more as principals than as agents in transactions.
-33-
movements. Swaps dealers trade with both end-users and other
dealers.
b. Practice as to Swaps
Swaps dealers maintain a portfolio of swaps on their books
and usually attempt to maintain a neutral, hedged position in the
market. Swaps dealers attempt to maintain a neutral, hedged
position either by: (1) Serving as a counterparty to opposite
sides of two matching swaps or (2) managing the overall structure
of the portfolio so as to minimize the net exposure to interest
rate movements.
c. Price Quotations
Prices in the interest rate swaps market are quoted in the
form of interest rates, and major swaps dealers (e.g., FNBC)
regularly quote the bid and ask prices at which they stand ready
to buy and sell plain vanilla interest rate swaps with standard
maturities of 1, 2, 3, 5, 7, and 10 years. The bid price is the
fixed interest rate that the dealer is ready to pay in exchange
for a specified floating rate. The ask price is the fixed
interest rate that the dealer demands to receive in exchange for
paying a specified floating rate. The ask rate is greater than
the bid rate, and the dealer’s profit when taking the opposite
sides on two identical swaps is the difference between the fixed
rate it receives and the fixed rate it pays.
-34-
Among dealers, it is common to refer to the spread reflected
in the pricing of a swap, and the convention is to quote the
fixed rate on the assumption that the floating rate is LIBOR flat
(i.e., with no spread or premium attached to the floating rate).
A swap, however, may be negotiated with the floating payment tied
to an index plus or minus a spread; i.e., a margin.
d. Role in the Market
When the swaps market first began, every swap generally was
facilitated by a dealer. The dealer was not a party to the
transaction but, generally for a fee, arranged the swap by
introducing the counterparties to each other and helping them to
effect the mechanics of the transaction. With the evolution of
the market, dealers became parties to each swap. In the early
years of the market’s evolution, a dealer would effect a swap
transaction by warehousing the swap (i.e., entering into the swap
without having entered into a matching swap but with the
expectation of hedging the entered-into swap either through a
matching swap or a portfolio of swaps or temporarily in the cash,
securities, or futures market) until the dealer could arrange an
offsetting swap with another counterparty (i.e., match a book).
In the later years of the market’s evolution, the dealer would
simply accept a position opposite the counterparty without
expecting to locate another counterparty transaction to match the
first transaction.
-35-
e. Need for Strong Credit
With the evolution of the interest rate swaps market,
intermediaries could during the relevant years do far more deals
if they were willing to offer themselves as counterparties.
Major commercial banks, as compared to investment banks, were
more highly capitalized and were more willing to assume the
credit risks inherent in acting as a counterparty. The
importance of credit risk was a factor during the relevant years
in the dominance of commercial banks as dealers; e.g., 16 of the
world’s 20 largest swaps dealers in 1993 were commercial banks.
A dealer with a weak credit rating in the swaps market was hurt
in its ability to enter into swaps.
3. Brokers
Swap brokers do not take a position or act as a principal in
a swap transaction, and they do not maintain any exposure with
respect to a swap. Swap brokers simply arrange for dealers to
enter into interdealer swaps by matching dealers who want to
effect a particular swap with other dealers who want to effect a
similar swap. The clientele of a swap broker is limited to
dealers; e.g., an end user may not use the services of a broker
unless the end user is a recognized dealer in the interbank
market. A swap broker is paid a standard fee for its services
based on a percentage of the notional principal amount.
-36-
F. Market for Swaps
1. Types of Markets
a. Primary Market
Interest rate swaps are transacted in the over-the-counter
(OTC) market. That market is highly competitive and includes
many active dealers. Throughout the relevant years, the primary
market for plain vanilla U.S. dollar interest rate swaps between
counterparties of relatively good credit quality was liquid and
as active, deep, and competitive as almost any other market. The
fact that there was an active primary market in benchmark swaps
made it possible for potential counterparties to shop around
quickly for competitive terms for an interest rate swap and agree
on the swap’s value. The appropriate range of terms for a large
interest rate swap between high-quality counterparties was at
least as transparent and easily determined at a moment’s notice
as was the appropriate price for a comparatively large position
in the most liquid equities traded on major U.S. stock exchanges.
b. Secondary Market
No active secondary market exists for swaps, other than in
the case of buyouts (which occur by number of swap transactions
approximately 10 percent of the time in the interbank market) and
to a much lesser extent, assignments. Because of contractual
-37-
restrictions,18 nonstandardized terms, the requirement of bearing
the credit risk of a specific counterparty, and the ability to
buy out a swap at the going market rate, a liquid secondary
market for the assignment of swaps has never developed. When
swaps were sold before maturity, e.g., when a portfolio of swaps
was sold by one dealer to another, the terms were not publicly
available.
2. Brokers’ Dissemination of the Dealers’ Quotations
a. Daily Quotations
During the course of each business day, swap brokers would
contact a large number of swaps dealers (including FNBC) and
request their bid and ask quotes on several plain vanilla swaps.
These swaps were commonly quoted on the convention of semiannual
payments and on the basis of the 6-month LIBOR floating rate and
had standard maturities of 1, 2, 3, 5, 7, and 10 years. These
quotations (as well as the midmarket swap curve (discussed infra
p. 43) assumed that the counterparty was a dealer with a credit
18
For example, a swap may be assigned only upon the consent
of both parties thereto.
-38-
rating of AA.19 No service reported regular and reliable quotes
on swaps negotiated with lower rated counterparties.
Upon receiving these quotations from the dealers, the
brokers disseminated publicly the best interdealer price
quotations by way of electronic broker quotation services such as
Bloomberg, Reuters Monitor Money Rates Service, or Associated
Press/Dow Jones Telerate Service. These services, to which swaps
dealers had access on their “dealer screens”, normally made it
unnecessary for a dealer to shop around when the dealer wished to
enter into a swap transaction because the dealer knew that the
quoted rate was a competitive price. If a dealer wanted to enter
into a specific swap, the dealer could contact a broker, and the
broker would call one or more dealers and confirm their quotes on
the specified swap. The broker then reported back to the first
dealer (the one wanting to enter into the particular swap) on the
best quote that the broker had obtained. If that dealer
ultimately entered into a swap agreement with another dealer
supplied by the broker, the broker received a fee for its
services based on a percentage of the notional amount.
19
Participants in the swaps market generally rated
counterparties using standard credit ratings obtained from
private credit rating agencies such as Moody’s and Standard &
Poor’s (S&P). Each agency had its own set of ratings. The
ratings offered by S&P for long-term debt were (from best to
worst) AAA, AA+, AA, AA-, A+, A, A-, BBB+, BBB, BBB-, BB+, BB,
BB-, B+, B, and B-. (For clarity, we refer only to the S&P
ratings.) In 1992, most swaps dealers had a credit rating of A
or better, and many of those dealers had ratings of AA or AAA.
-39-
b. No Dissemination of Actual Swap Prices
The actual prices at which swaps closed during the relevant
years were not publicly disclosed. The only publicly available
data on swap prices during those years was the quoted bid and ask
rates in the interdealer market as to plain vanilla swaps. Those
quotations were normally the best indicator of the market price
at a particular moment.
c. Spreads Included in Quotations
Swap bid and ask rates in U.S. dollar denominated swaps with
maturities exceeding 1 year were commonly quoted in terms of a
spread to the corresponding U.S. Treasury yield. The table below
lists the U.S. Treasury yield, the bid spreads quoted in the
market, and the resulting bid rates as reported by Bloomberg for
December 31, 1992, for U.S. dollar denominated swaps with
maturities exceeding 1 year.
Maturity U.S. Treasury Yield Bid Spread Swap Bid Rate
2-year 4.57% .24 4.81%
3-year 5.06 .37 5.43
5-year 6.00 .30 6.30
7-year 6.37 .33 6.70
10-year 6.69 .32 7.01
Swap rates reported for U.S. dollar denominated swaps with
maturities of 1 year or less were usually taken directly from the
LIBOR deposit market. The table below lists the LIBOR deposit
rates in the LIBOR deposit market as reported by Bloomberg for
-40-
December 31, 1992, for U.S. dollar denominated swaps with
maturities of 1 year or less.
Maturity LIBOR Deposit Rate
1-day 3.125%
1-month 3.313
3-month 3.438
6-month 3.625
9-month 3.813
1-year 4.062
The LIBOR deposit rates for U.S. dollar denominated swaps
with maturities of 1 year or less were combined with the swap bid
rates for U.S. dollar denominated swaps with maturities exceeding
1 year to obtain a set of bid rates for short and long
maturities. The complete set of bid rates for short and long
maturities was plotted out on a graph to form the swap bid curve.
Swap rates for nonstandard maturities were calculated by
interpolating between the rates on the nearby standard maturity
contracts. The table below illustrates a combination of the swap
bid rates and the LIBOR deposit rates just discussed.
Maturity Swap Bid Rate LIBOR Deposit Rate Swap Bid Curve
1-day --- 3.125% 3.125%
1-month --- 3.313 3.313
3-month --- 3.438 3.438
6-month --- 3.625 3.625
9-month --- 3.813 3.813
1-year --- 4.062 4.062
2-year 4.81% --- 4.810
3-year 5.43 --- 5.430
5-year 6.30 --- 6.300
7-year 6.70 --- 6.700
10-year 7.01 --- 7.010
-41-
The diagram below shows the swap bid curve drawn from these
swap bid and LIBOR deposit rates.
-42-
3. Midmarket Rate
The midpoint (average) of the bid and ask rates for a
specified maturity is known as that maturity’s midmarket rate.
The theoretical midmarket rate is the fixed interest rate for
which the present value of the cashflows from the fixed leg of a
swap equals the present value of the projected cashflows from the
swap’s floating leg. In other words, if a swap was entered into
at the midmarket rate, then the present value of the fixed-leg
payments would equal the present value of the anticipated
floating-leg payments. When any swap with a midmarket rate is
valued also using the same midmarket rate, then the swap has a
theoretical net present value of zero to both counterparties.
A plain vanilla swap with a fixed rate equal to the current
midmarket rate has by definition a market value of zero and is
called a “par swap”. It is also said to be “at-market” as
opposed to “off-market”. If the fixed interest rate is above the
current midmarket rate, the swap is said to be “above-market” and
has positive value to the party that sold the swap and is
receiving the fixed payments. If the fixed interest rate is
below the current midmarket rate, the swap is said to be
“below-market” and has negative value to the party that is
receiving the fixed payments. A swap is a zero-sum contract, so
if it has a positive market value to one counterparty, it has a
negative market value to the other counterparty.
-43-
4. Midmarket Swap Curve
The set of mid-market rates for various maturities is known
as the midmarket swap curve. The midmarket swap curve is drawn
from the averages of the bid and ask prices for swaps of standard
maturities quoted in the interdealer market. At-market swap
rates for all possible maturity dates can be obtained by
interpolation from the midpoints between the bid and ask prices
of the standard maturities as derived from the dealer quotes and
reported by major vendors of financial data.
The midmarket swap curve implies a curve of forward interest
rates and a curve of discount factors.20 One curve implies a
second curve if the values on the second curve can be derived
mathematically from the values on the first curve. The second
curve is said to be implied by the first curve, and, in the case
of interest rates or discount factors, the interest rates or
discount factors on the second curve are said to be implied
interest rates or implied discount factors with respect to the
first curve. Consider, for example, a curve of periodic interest
rates and a corresponding curve of effective annual yields. Each
of these curves is implied by the other. Each point on either
curve can be derived by a mathematical formula from the
corresponding point on the other curve. This implied concept is
20
A discount factor states the value today of $1 to be
received on a future date.
-44-
different from interpolation. Interpolation is a process by
which the gaps between separated points are estimated and filled
in to produce a complete curve.
The midmarket value of a swap is calculated using a
mathematical model that extracts the market’s forecasts for
future interest rates (implied forward interest rates) from the
current midmarket swap curve to determine the floating-rate
payments that will be due or payable under the swap agreement.21
The implied forward interest rates are used to project the
floating-rate payments into the future. The implied discount
factors are used to discount the fixed-rate payments and the
projected floating-rate payments to their present value.
5. ISDA Form Agreements
The International Swaps and Derivatives Association, Inc.
(ISDA), formerly known as the International Swaps Dealers
Association, Inc., is a trade body that comprises swaps dealers
and other participants in the OTC derivatives market. The ISDA
prescribed customized ISDA form agreements for swap transactions,
and these form agreements were in widespread use during the
relevant years. The ISDA form agreements generally provided a
21
As discussed infra p. 60, the midmarket value of a swap
also can be calculated as the difference between the value of two
specific bonds, both of which have a principal amount equal to
the notional amount of the swap. The first bond is a
floating-rate bond. The second bond is a fixed-rate bond paying
a fixed interest rate equal to the fixed interest rate of the
swap.
-45-
statement of the general conditions governing all swap contracts
between counterparties to the agreements. Customized individual
payment terms could be negotiated by the parties to a particular
swap, and those terms would be memorialized in the form of a
confirmation letter. During the relevant years, many dealers,
including FNBC, required that each of their swaps have a
confirmation.
The ISDA had two form agreements (collectively, ISDA form
agreements); namely, the 1987 ISDA interest rate swap agreement
and the 1992 ISDA master agreement (1992 ISDA form agreement).
The ISDA form agreements contained a number of standard terms but
also allowed the parties a great deal of flexibility in
structuring specific transactions. The ISDA form agreements were
relied upon in the industry as uniform and accepted contracts
with easily understood terms.
Under the ISDA form agreements, a party thereto had the
unilateral right to terminate a swap agreement before maturity
only in the case of default. The ISDA form agreements also
allowed a swap contract to be terminated before maturity in the
case of certain events generally not within the control of either
party; e.g., if a law was enacted that made it illegal for one or
both parties to the contract to perform under the contract. A
swap could also be terminated if it contained a credit trigger
calling for early termination upon a credit downgrade or other
-46-
credit event. The 1992 ISDA form agreement also provided that
the parties to a swap governed by that agreement could specify
any other event as a termination event in the schedule or
confirmation.22
The ISDA form agreements generally prohibited each party
thereto from selling or transferring its swap position to a third
party without the consent of the counterparty. The swap
contract, however, could be transferred to another in the case of
an amalgamation, consolidation, merger, or transfer of assets. A
nondefaulting party also could transfer any payment owed to it by
a defaulting party. The ISDA form agreements also permitted one
counterparty to transfer its swap agreement to one of its
branches or to an affiliate in order to avoid a termination
event. In that case, the other counterparty could not withhold
its consent to the transfer if its existing policies would permit
it to enter into transactions with the transferee on the terms
proposed.
The ISDA form agreements provided that where there was an
early termination due to the default of one party, the payment
would be ascertained by reference to quotations from leading
22
Notwithstanding the terms of a particular swap, a party
thereto could synthetically terminate any swap by entering into
an offsetting or mirror swap; i.e., a new swap with terms
identical to those in the remainder of an existing swap, but with
the payments reversed. The parties also could mutually agree to
terminate a swap with one party paying the other in a buyout.
-47-
dealers for the replacement costs of the relevant terminated
transactions. Neither of the ISDA form agreements provided
specifically for the addition of a surcharge, or discount, for
administrative costs adjustments when computing the amount paid
on early termination due to the default of one party.
6. Assignments and Buyouts of Swaps
A party to a swap agreement seldom assigned its interest in
the swap. In the rare case of an assignment, a third party was
substituted for one of the two original counterparties. The
third party usually made or received an upfront payment
approximately equal to the market value of the swap. In these
cases, the market value of the swap generally equaled the
difference in the present value of the anticipated net cashflow
from each of the swap’s legs.
If a swap counterparty wanted to withdraw from a
transaction, it usually terminated the transaction through a
buyout. In a buyout, one counterparty terminated the swap by
paying the other counterparty a lump-sum amount approximately
equal to the swap’s market value. In these cases, the market
value of the swap generally equaled the difference in the present
value of the anticipated net cashflow from each of the swap’s
legs.
Buyouts of swaps were frequent during the relevant years,
and they occurred in the case of both interdealer and end-user
-48-
swaps. The reasons for buyouts were generally that one of the
counterparties had a business need to terminate the transaction
or was in distress. Swaps were bought out (and initially entered
into) on a swap-by-swap (rather than portfolio) basis.
G. Risks Assumed by Dealers
1. Types of Risks
Dealers entering into interest rate swaps assumed at least
two types of risk; namely, a credit risk and a market risk.
Credit risk was the risk of loss from the possibility that the
counterparty would not perform and would default on its payment
obligations. Market risk was the risk that changes in the market
would affect the value of an instrument. The most common form of
market risk was interest rate risk.
2. Techniques Used To Minimize Credit Risk
During the relevant years, the practice of rationing credit
risk exposure to specific counterparties through credit
enhancements was widespread and was an important part of credit
risk management. In addition to placing limitations on the tenor
and principal amount of a swap, swaps dealers such as FNBC
required counterparties with lower credit quality to post
collateral to support the counterparties’ obligations under the
contracts. Dealers such as FNBC (and end users) also sometimes
inserted provisions in the underlying contracts requiring
maintenance of a specified debt-equity ratio, a net worth
-49-
requirement, or a certain credit rating which, unless met, would
trigger an early termination of the contract or the posting of
collateral in support of the counterparty’s obligations under the
contract. Dealers during the relevant years generally did not
adjust interest rates to account for credit risk, nor did they
quote different bid and ask rates on the basis of credit rating.
3. Techniques Used To Minimize Market Risk
The market risk of interest rate swaps arose from the high
level of volatility in the value of interest rate swaps. A small
movement in interest rates, for example, could have a large
impact on the value of an interest rate swap. Swaps dealers
attempted to reduce or eliminate market risk by hedging their
portfolios so that a portfolio’s value would not change
significantly with either a rise or fall in interest rates.
In the early days of the swaps market, dealers employed
simple hedging strategies. Transactions designed to meet a
customer’s requirements were immediately hedged by entering into
an offsetting transaction, such as a matched swap. In the later
years, many dealers (including FNBC) adopted more sophisticated
portfolio strategies for hedging market risks. Under this
approach, all of the dealer’s transactions were broken down into
their component cashflows to yield a measure of the net
(residual) market exposures arising from all of the dealer’s
positions. The residual market exposures were then hedged in
-50-
various ways such as by taking positions in the cash market
(e.g., holding or selling short U.S. Treasury securities), by
using interest-rate futures (which are traded on public
exchanges), or by entering into swaps.
H. Dealer Spreads
1. Bid-Ask Spread
The bid-ask spread is the difference between the bid and ask
interest rates which are quoted on the interdealer market. The
market bid is typically the highest among a set of dealers
surveyed. The market ask is typically the lowest. The market
bid and market ask need not come from the same dealer’s bid and
ask quotations. A particular dealer’s quoted bid and ask rates
will often deviate from the market bid and ask rates so that the
dealer’s mid-rate is not necessarily the midmarket rate.
2. Bid-to-Mid Spread
The spread from midmarket (also known as the bid-to-mid
spread) is the difference between the fixed interest rate that is
quoted on the interbank market and the midmarket rate for a swap.
The bid-to-mid spread equals one-half of the bid-ask spread.
3. Example
Assume that the market quotes a bid price of 6.5 percent
(the fixed rate it is willing to pay) and an ask price of 6.54
percent (the fixed rate it is willing to receive). The bid-ask
-51-
spread is 4 basis points,23 and the midmarket rate is 6.52
percent. If the dealer’s bid price is accepted and the dealer
enters into a swap under which it is paying a fixed interest rate
of 6.5 percent, then the spread from midmarket is 2 basis points.
4. Significance of Spreads
The spread from midmarket that a dealer is able to obtain
when it negotiates a swap provides it with the revenue necessary
to cover its costs connected with the swap and, it hopes,
generate a profit. When a dealer buys a swap, the dealer
captures the difference between its bid on the transaction and
the midmarket rate. When a dealer sells a swap, the dealer
captures the difference between its ask on the transaction and
the midmarket rate.
In general, a dealer did not enter into a swap unless it
expected to make a profit. As two exceptions to this rule,
dealers entered into swaps without profit to develop a
relationship with a particular customer or to hedge their
portfolio.
Dealers typically charged smaller spreads to other
dealer/counterparties than to end users. A dealer that entered
into an interdealer swap usually contemporaneously entered into a
similar swap with an end user. The dealer typically earned a
profit on the end-user swap by negotiating a bid or ask rate that
23
A basis point is 0.01 percent.
-52-
was different than the rate that the dealer had negotiated on the
interdealer swap.
5. Decline in Interdealer Spreads
For interdealer spreads as of December 20, 1993, the
following table shows (in basis points) the bid, ask, and
midmarket rates, and the bid-to-mid spreads for nine common swap
maturities:
Maturity Bid Ask Midmarket Bid-to-Mid Spread
2-year 13.000 15.666 14.333 1.333
3-year 22.333 25.000 23.666 1.333
4-year 24.333 27.000 25.666 1.333
5-year 20.000 23.000 21.500 1.500
6-year 26.666 29.666 28.166 1.500
7-year 39.666 43.000 41.333 1.667
8-year 32.000 34.666 33.333 1.333
9-year 32.333 35.000 33.666 1.333
10-year 32.333 35.000 33.366 1.333
By 1993, the swap bid-ask spreads had narrowed from earlier
years because in part of competition. Average bid-ask spreads
for fixed-for-floating interest rate swaps with 2-, 5-, and
10-year tenors narrowed from 4 to 4.5 basis points in July 1991
to 2.5 to 3 basis points in July 1993.
III. Valuing Swaps
A. Relevant Valuation Standards
The three relevant valuation standards are fair market
value, market value, and fair value.
-53-
1. Fair Market Value
The term “fair market value” is typically used in the
economics and business/tax worlds. The term is generally
understood in its simplest form to mean the price at which
property would change hands between a willing buyer and a willing
seller, neither being under any compulsion to buy and sell and
both having reasonable knowledge of relevant facts.
2. Market Value
The term “market value” is a term of art in the swaps
industry. This term is generally understood in its simplest form
to mean the present value of the anticipated cashflows,
calculated according to a series of generally accepted
conventions for using market data and using midmarket swap rates.
The market value of a swap is typically calculated the same way
for all swaps, without regard for the credit rating of the
counterparty and without incorporating an extra adjustment for
credit risk or future administrative costs.24
3. Fair Value
The term “fair value” is typically used in the accounting
world and is directed to the needs of financial statement
24
The common industry practice of valuing swaps does not
consider differences in the credit ratings of investment grade
counterparties.
-54-
users.25 The meaning of this term is similar to, but is not
necessarily the same as that of, the term “fair market value”.
“Fair value” is broader than and may include “fair market value”.
The objectives of each of these two concepts also are distinct.
B. Mark-to-Market Accounting
Swaps dealers generally attempted during the relevant years
to mark their swap positions to market daily. The concept of
mark-to-market accounting requires that the market value of an
asset such as a swap be recorded on the balance sheet at each
financial reporting date and that any changes in market value
from one reporting date to the next be currently reflected in
income or loss.
C. Devon System and the Devon (Midmarket) Value
1. Devon System
FNBC and most other dealers used the Devon system in order
to ascertain their valuations for their mark-to-market accounting
systems. The Devon system was developed and marketed by an
independent software company named Devon Systems International,
Inc.26 The Devon system was during the relevant years the most
25
Most State statutes also usually define the term for
purposes of valuing dissenting stockholders’ appraisal rights
and, sometimes, for purposes of valuing property in cases of
marital dissolution. As discussed below, that definition is not
applicable here.
26
SunGard Systems International, Inc., a subsidiary of
SunGard Data Systems, Inc., acquired Devon Systems International,
(continued...)
-55-
commonly used commercially provided integrated front and back
office processing and risk management system for financial
derivatives. One of the Devon system’s important functions was
to take real time feeds of market rates and provide pricing of
various securities and instruments.
2. Devon (Midmarket) Value
The Devon system calculated each swap’s mid-market value by
reference to zero-coupon yield curves. The Devon system used the
two following types of inputs to calculate the midmarket value of
a swap: (1) Transaction information and (2) market information.
The transaction information was generally the information set
forth in the trade ticket and was typically provided in the
confirmation letter.27 The transaction information included the
notional amount, the tenor, the fixed interest rate, the floating
interest rate, the payment dates, and the payment formulas. The
26
(...continued)
Inc., in 1987. Devon Systems International, Inc., changed its
name to SunGard Capital Markets, Inc., in 1992. On Jan. 2, 1998,
SunGard Data Systems, Inc., acquired Infinity Financial
Technology, Inc. (IFT), a financial derivatives trading and risk
management company. SunGard Data Systems, Inc., merged IFT and
its existing related Renaissance Software and SunGard Capital
Markets to form a new operating group named Infinity, A SunGard
Company. Infinity now maintains and licenses the Devon software.
27
Each FNBC trader filled out a “trade ticket” for each
transaction in which he or she had responsibility. This ticket,
which listed all of the essential facts of the transaction, was
then transmitted to the back office to input those facts into
FNBC’s Devon system and to prepare the related confirmation
letter.
-56-
market information was data on the sets of interest rates
prevailing in the financial markets on the valuation date.
The Devon system calculated a swap’s midmarket value in two
steps. First, the system used the market data to calculate a set
of discount factors and forward rates. Second, the system
ascertained the present value of the net cashflows over the life
of the swap. The forward rates were used to translate the
uncertain future cashflows on the floating side of a swap into
expected future cashflows. The discount factors were used to
reduce the fixed and expected floating cashflows to their present
values. Summing the present values of the various cashflows
produced the swap’s total present value.
During the relevant years, midmarket values could be
calculated under the Devon system with precision and agreement,
and midmarket values were readily agreed upon for those swaps for
which sufficient information was provided. The calculation of
midmarket value was critically dependent on the assumptions made
about future interest rates.
3. Yield Curve
a. Overview
The yield curve defined the yield (interest rate) available
in the market for a given maturity on an instrument that met the
definitions used in the construction of the yield curve. The
yield curve, which was usually a zero-coupon yield curve
-57-
appropriate to the index on which the swaps were based (e.g.,
LIBOR-based swaps required LIBOR yield curves), (1) forecast the
floating interest rates on each date relevant to a swap agreement
and (2) determined the discount rate that should be used to
compute the present value of each payment (fixed and floating)
due under the swap agreement.
b. Constructing the Curve
In order to construct a yield curve, a user had to make at
least three critical decisions. First, the user had to decide
among the large amounts of available market information, such as
LIBOR deposit rates, Eurodollar futures prices, swap bid and ask
quotes, and yields on U.S. Treasury securities. The user had to
choose, for example, whether the 1-year point on the yield curve
would be based on LIBOR rates, Eurodollar future rates, or some
other rate. Because these rates fluctuated during the day, the
user then had to decide the time of day at which the rates would
be collected, for example, at 11 a.m. or 2 p.m. Because the
market data produced only a series of points corresponding to the
maturities available in the market, the user then had to decide
on a model that connected the dots in order to interpolate where
the floating interest rate would be on the particular dates
specified in each swap agreement.
-58-
c. Imprecise Measure
The midmarket value computed using dealer-constructed yield
curves was a constructed, rather than an observed, number and was
not absolutely precise. Two dealers could calculate different
midmarket values for the same swap, although the differences
should not have been that large. Disparities could have
resulted, for example, because (1) the dealers relied on
different market indicators (e.g., one relied on futures prices
while the other relied on LIBOR), (2) the dealers used different
software with different interpolation techniques, or (3) the
dealers relied on prices quoted at different times during the
day. As to the latter, a small movement in interest rates of
just one basis point during a day could affect the midmarket
values, and the price of a swap could change within a few hours.
During the first quarter of 1990, for example, it was not unusual
for interest rates to move 10 basis points or more in a single
day.
D. Market Value
1. Net Present Value-–Forward Rate Pricing
The market value of a swap is equal to the net present value
of the expected net cashflows. The forward rate pricing approach
calculates this net present value in two steps. First, the
expected net cashflows are determined. Second, these expected
cashflows are discounted to produce a present value.
-59-
a. Expected Cashflows
The table below shows the forecasted future cashflows as of
December 1, 1992, on the swap illustrated supra p. 27. The
implied forward rate of 4 percent used for the first floating
payment is specified when the swap is originated. The remaining
implied forward rates are derived from the midmarket swap curve.
The forecasted cashflows for the floating side are calculated by
multiplying the implied forward rate by the notional principal
and then multiplying the product by a ratio that equals the
number of days in the payment period divided by 360.
Number Forecasted
of Forecasted Net Cash
Payment Days in Fixed Implied Forward Floating Flow
Dates Period Payment Rate Payment From (To) FNBC
12/1/1992
6/1/1993 182 $25,278 4.000% $20,222 ($5,056)
12/1/1993 183 25,417 4.262 21,664 (3,753)
6/1/1994 182 25,278 5.098 25,772 494
12/1/1994 183 25,417 5.813 29,549 4,132
6/1/1995 182 25,278 6.379 32,250 6,972
12/1/1995 183 25,417 6.921 35,180 9,763
b. Discounting Expected Cashflows
The table below shows the calculation of the present value
of the forecasted future cashflows of the swap. The second
through fourth columns show the forecasted fixed, floating and
net cashflows on the swap just discussed. The fifth column shows
the discount factors for each cashflow. The total present value
of the swap is $10,148 as of December 1, 1992.
-60-
Forecasted Present Value
Net Cash Floating Net Cash
Payment Fixed Payment Floating Payment Flow Discount Fixed Payment Payment Flow
Dates (from FNBC) (to FNBC) (to FNBC) Factor (from FNBC) (to FNBC) (to FNBC)
6/1/1993 $25,278 $20,222 ($5,056) .9852 $24,903 $19,922 ($4,981)
12/1/1993 25,417 21,664 (3,753) .9643 24,509 20,890 (3,619)
6/1/1994 25,278 25,772 494 .9401 23,762 24,227 465
12/1/1994 25,417 29,549 4,132 .9131 23,207 26,980 3,773
6/1/1995 25,278 32,250 6,972 .8845 22,359 28,526 6,167
12/1/1995 25,417 35,180 9,763 .8545 21,718 30,061 8,343
Total —-- --- --- --- 140,458 150,606 10,148
2. Floating-Rate Note Method
An alternative approach finesses the need to forecast
expected cashflows. It works on the analogy between the swap and
a pair of bonds, one of which has a fixed rate and the other of
which has a floating rate. This method relies on the assumption
of which the floating-rate bond is worth its face value on the
effective date or on any reset date. Since the market value of
the swap is equal to the difference between the value of the
floating leg and the value of the fixed leg, and since the value
of the floating leg is known, the problem is to determine the
value of the fixed leg. This does not require the use of a
forward curve.
The floating-rate note method is useful when (1) the terms
of the swap are plain vanilla and (2) the valuation date is a
reset date. In other cases, a correct implementation of the
floating-rate note method requires additional steps which are
comparable to those employed in the forward rate pricing
approach. The two approaches yield the same result in all
events.
-61-
3. Value at Origination
Swaps generally originate close to par, at a rate
approximately equal to either the prevailing market bid or ask,
depending upon which side of the swap the dealer is on. The
small initial divergence from par is the dealer’s profit on
making the market. When a dealer buys a swap at the prevailing
market bid rate, it will have a positive value. The dealer does
not typically pay this positive market value to the counterparty
but keeps it as the profit on origination. Similarly, when a
dealer sells a swap at the prevailing market ask rate, it will
also have a positive value which is the dealer’s profit on
origination.
Whereas dealers generally originated swaps at prices near
the prevailing market bid and ask rates, a particular dealer at
any given time could set a higher or lower bid or ask rate for a
given maturity swap, thereby producing a higher or lower profit
on that swap. The dealer’s ability to set the higher or lower
rate depended upon the dealer’s own business situation, on the
risk structure of the dealer’s entire portfolio, on the profile
of the dealer’s full set of counterparties, and/or upon other
commercial considerations. Dealers seldom agreed to a rate on a
swap which gave the swap a negative value at origination, unless
the dealer was seeking to develop a client relationship and was
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ready to incur an upfront cost in pursuit of longer term sources
of profit.
4. Change in Market Value
A swap may originate at par and become an above-market swap
on account of a fall in interest rates. A swap also may
originate at par and become an above-market swap without a fall
in interest rates. The latter occurs if the term structure is
upward sloping so that short-maturity swaps are negotiated with a
lower fixed rate than long-maturity swaps. Because the fixed
rate is typically constant over the life of the swap, a decline
in the swap’s remaining maturity means that the swap’s fixed rate
is above the at-market rate for a newly originated swap with the
identical remaining maturity. Assume, for example, that the
2-year swap rate is 5 percent, the 3-year swap rate is 6 percent,
and the 4-year swap rate is 7 percent. Assume further that a
4-year swap is initiated at par (i.e., at a fixed rate of 7
percent). Assuming that the swap rates remain the same at the
end of the first year, at the beginning of the second year, the
7-percent fixed rate on the remaining 3-year swap now exceeds the
6-percent rate for a newly originated 3-year swap. The swap is
considered above-market relative to newly originated swaps which
have a par rate of 6 percent.
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E. Primary Financial Reporting Methods
1. Overview
The primary financial reporting alternatives for valuing
nonhedging swaps are amortized cost, current market value, and
lower of cost or market value (lower of cost or market). The
latter two alternatives use market value information and allow
unrealized gains and losses to be either (1) recognized as
current income on the income statement or (2) accumulated on the
balance sheet in a separate component of shareholders’ equity
until realized.
2. Amortized Cost
Under the amortized cost method, the initial cost of a
typical interest rate swap is zero; swaps generally have no
cashflow at inception. On each financial reporting date, income
or loss on the swap is accrued in an amount equal to the portion
of the next scheduled cashflow that reflects the elapsed time as
of the reporting date. An offsetting entry is made to a
receivable or payable, which is the only balance sheet evidence
of the swap. On cashflow dates, entries are made to record the
cash received or paid, reverse the receivable or payable, and
record the balance as income or loss. Income over the life of
the swap equals the total cashflows.
-64-
3. Current Market Value
Under a current market (or mark-to-market) valuation,
entries are made to record the market value of the swap on the
balance sheet at each financial reporting date. Changes in
market value are reflected in income or loss, as are cashflows.
Because the sum of changes in market value over the life of the
swap must be zero, the income over the life of the swap again
equals total cashflow.
4. Lower of Cost or Market
Entries under the lower of cost or market generally follow
the entries made under the amortized cost method, with the added
step that, at each financial reporting date, the swap’s amortized
cost value (if any) is compared with its market value. If
current market value is below the amortized cost value, an entry
is made to adjust the recorded value to an amount equal to the
market value. All adjustments to or from market value are
treated as income or loss. The lower of cost or market method
recognizes losses in market value below the amortized cost value,
and gains to the extent that they recoup previously recognized
losses. The lower of cost or market does not recognize gains in
market value above the amortized cost value.
-65-
F. Relevant Standards of the FASB
1. The FASB and GAAP
The Financial Accounting Standards Board (FASB) is the
professional organization primarily responsible for establishing
financial reporting standards in the United States. The FASB’s
standards are known as Generally Accepted Accounting Principles
(GAAP).
2. Initial Role of Market Values in GAAP
Under GAAP, market values initially played a limited role in
shareholder reporting. GAAP uses predominantly transaction-based
valuation; i.e., valuation established in an actual transaction
by the reporting entity. The primary advantage of
transaction-based valuation is reliability; accountants view
values established in arm’s-length transactions as less
subjective and more easily verified than values produced without
such transactions. The primary disadvantage of transaction-based
valuation is that values can become outdated, thus rendering the
information less relevant to investors. If a company issued a
bond at par, for example, transaction-based valuation would
report the bond on the company’s financial statements at its
issue price. If interest rates fell, the market value of the
bond, and thus the market value of the company’s liability, would
rise. This rise in value would not be recognized in the
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company’s transaction-based reports, although it would most
likely be an important factor in valuing the company.
3. SFACs
From the late 1970s through the mid-1980s, the FASB issued a
series of statements known as “Statements of Financial Accounting
Concepts” (SFACs) in an effort to define a conceptual framework
within which accounting standards could be developed. These
statements did not discuss mark-to-market accounting explicitly.
However, SFAC No. 5, issued in December 1984, allowed for the
possibility that assets and liabilities could in certain cases be
revalued on the basis of current market value in the absence of a
new transaction. These cases could occur if the current price
information was “sufficiently relevant and reliable to justify
the costs involved”.
Though the transaction-based approach remained dominant, the
SFAC No. 5 criterion for using current market value allowed a
wide range of practice. The FASB listed three examples of
valuation at current market value from then-current practice:
(1) Some investments in marketable securities, (2) assets
expected to be sold at prices less than previous carrying
amounts, and (3) some liabilities that involved marketable
commodities or securities, such as obligations of writers of
options. These examples were limited to circumstances where
either (1) shareholders had suffered a decline in value from the
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historical transaction-based valuation or (2) the item had a
ready market in the form of an organized exchange so that the
cost of obtaining objective and verifiable pricing information
was minimal, as was the uncertainty about whether the reporting
entity could find a buyer.
4. Change in Accounting Treatment
Until recently, accounting for non-exchange-traded financial
assets had typically been on the basis of amortized cost. For a
traditional fixed-rate loan, for example, the amortized cost
value of the loan would be (1) the original amount lent, net of
any repayments, plus (2) accrued interest at the contractually
specified rate. With the exception of actual default, amortized
cost valuation was not sensitive to changing market conditions
such as changes in interest rates or changes in the asset’s
credit risk.
Financial innovation during the 1980s and 1990s created a
need for better information than reported by the traditional
transaction-based system. With encouragement from the Securities
and Exchange Commission (SEC), the FASB began in the early 1990s
to consider greater use of market values in accounting for
financial instruments.28 One concern with the transaction-based
28
Before 1990, financial accounting standards mentioned
swaps only in the context of hedging. Statement of Financial
Accounting Standards (SFAS) No. 52 mentions currency swaps used
as hedges to reduce risk from currency fluctuations and discusses
(continued...)
-68-
system was that new financial instruments created potentially
large risks not reported on the balance sheet. Forward
contracts, for example, typically require no exchange at
inception, so the transaction-based value would be zero at
inception and would remain zero until maturity. At maturity, the
cash settlement would determine income or loss, without any value
ever appearing on the balance sheet.
A second concern with the transaction-based system was that
firms could sell appreciated on-balance-sheet investments to
report gains and leave investments that had declined in value
reported on the balance sheet at their original cost. A third
impetus for increasing the use of market value information in
financial reports was the greater acceptance of theoretical
models and the wider availability of financial data to support
more reliable and informative reports. For example, although
models of option pricing existed in the academic finance
literature in the 1970s, their acceptance in accounting practice
began only in the mid-1980s.
5. SFASs
From in or about March 1990 through June 1998, the FASB
worked on its financial instruments project. As part of that
28
(...continued)
the appropriate accounting for such hedges. SFAS No. 52 does not
discuss the appropriate accounting for nonhedging swaps such as
those at issue.
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project, the FASB issued four statements each known as a
“Statement of Financial Accounting Standards” (SFAS).
a. SFAS No. 105
In March 1990, the FASB issued SFAS No. 105, “Disclosures of
Information about Financial Instruments with Off-Balance-Sheet
Risk and Financial Instruments with Concentrations of Credit
Risk”. SFAS No. 105 required the footnote disclosure of the
extent, nature, and terms of financial instruments such as swaps
which had off-balance-sheet risk. SFAS No. 105 did not require
disclosure of the related market values.
b. SFAS No. 107
In December 1991, the FASB issued SFAS No. 107, “Disclosures
about Fair Value of Financial Instruments”, effective for fiscal
years ended after December 15, 1992. SFAS No. 107 required
footnote disclosure of the fair value of financial instruments
for which it was practicable to estimate fair value but did not
require formal recognition in the financial statements. SFAS No.
107 defined the fair value of a financial instrument as
the amount at which the instrument could be exchanged
in a current transaction between willing parties, other
than in a forced or liquidation sale. If a quoted
market price is available for an instrument, the fair
value to be disclosed for that instrument is the
product of the number of trading units of the
instrument times that market price.
SFAS No. 107 stated that the amounts computed as “market value,
current value, or mark-to-market” value under the then-existing
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requirements satisfied the fair value requirements of SFAS No.
107.
As relevant herein, the FASB allowed a variety of
methodologies for estimating fair values, including the use of
midmarket values if any adjustments thereto were likely to be
negligible or not cost effective to estimate reliably. The FASB
recognized in SFAS No. 107 that quoted market prices did not
exist for custom-tailored instruments such as swaps and
recommended that “an estimate of fair value might be based on the
quoted market price of a similar financial instrument, adjusted
as appropriate”. In illustrating an acceptable disclosure under
SFAS No. 107, SFAS No. 107 gives the following description of
swap valuation: “The fair value of interest rate swaps * * * is
the estimated amount that the Bank would receive or pay to
terminate the swap agreements at the reporting date, taking into
account current interest rates and the current creditworthiness
of the swap counterparties.”
c. SFAS No. 119
In October 1994, the FASB issued SFAS No. 119, “Disclosures
about Derivative Financial Instruments and Fair Value of
Financial Instruments”. SFAS No. 119 required footnote
disclosure of the nature, terms, and fair values of financial
derivative instruments. SFAS No. 119 was not effective for any
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of the relevant years, and it did not prescribe specific methods
for arriving at fair value.
d. SFAS No. 133
In June 1998, the FASB issued SFAS No. 133, “Accounting for
Derivative Instruments and Hedging Activities”. SFAS No. 133
required non-hedging derivative instruments such as swaps to be
reported at fair value on the balance sheet, with gains and
losses included in current earnings. SFAS No. 133 was not
effective for any of the relevant years, and it did not prescribe
specific methods for arriving at fair value.
G. Methods of Valuing Swaps
During the relevant years, the three main methods which
dealers used to value their swaps portfolios were the bid-ask
method, the midmarket method, and the adjusted midmarket method.
1. Bid-Ask Method
The bid-ask method was essentially a market comparables
approach to valuation. Some dealers used this method, and it was
recognized as a valid method by the Group of Thirty (G-30)
(discussed infra p. 76) and the OCC. Under the bid-ask method,
each swap generally was valued by (1) identifying the generic
swap to which it was most comparable, (2) ascertaining the bid or
ask price for that generic swap, and (3) adjusting the
ascertained price to reflect any differences between the generic
swap and the swap being valued. Bid prices were used to value a
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long position (swaps where the dealer received the fixed rate),
and ask prices were used to value a short position (swaps where
the dealer paid the fixed rate). The bid and ask prices were
both interdealer published quotes rather than the dealer’s own
quotes.
2. Midmarket Method
The industry practice from 1990 through 1993 was to use the
midmarket value to value portfolios and to report separately the
adjustments described below.29 As discussed above, the midmarket
value was the net present value (positive or negative) of the
anticipated cashflows which the parties had agreed to exchange.
A positive value meant that the dealer expected to be a net
receiver of future payments. A negative value meant that the
dealer expected to be a net payer.
3. Adjusted Midmarket Method
During the relevant years, the adjusted midmarket method was
a common method used by dealers to value their portfolios, and it
was recognized as a valid method by the G-30. Under this method,
a dealer calculated the midmarket value of the swaps in its
portfolios and then made certain adjustments. The type of these
adjustments varied between and among dealers. Depending on the
dealer, adjustments were made for factors which included credit
29
Most people in the industry during the relevant years
referred to the midmarket value of a swap as its “market value”.
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risk, future administrative costs, hedging costs, investing and
funding costs, closeout costs, and liquidity (each discussed
infra p. 81). During the relevant years, there was no standard
practice in the market as to the specific adjustments taken by
dealers.
H. Nontax Purposes for Which Dealers Value Swaps
1. Overview
Swaps are valued for a number of nontax purposes. These
purposes include regulatory reporting, risk management,
management reporting, financial reporting, and pricing.
2. Regulatory Reporting
National banks such as FNBC had to value their financial
derivative portfolios in reports submitted to their principal
regulator, the OCC. During the relevant years, the primary focus
of an OCC examination of a bank dealer department was to
determine whether the risk management systems employed by the
bank assured timely recognition of risk-taking and losses and did
not permit an overstatement of income. In contrast with the
Commissioner’s audits of a taxpayer’s Federal income tax return,
OCC examinations did not focus on understatements of income or of
value. OCC examiners were instructed to examine closely the
recognition of income associated with financial derivatives
positions to ascertain that the bank under examination had not
overstated its income. The OCC preferred valuation methodologies
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and income reporting that resulted in a bank’s taking significant
reserves, deferring income recognition, and using conservative
carrying values for swaps. The OCC’s role as regulator of the
bank was to oversee the risk management systems employed by the
bank.
The OCC endorsed valuing financial derivative portfolios at
adjusted midmarket values and considered the adjustments
“holdbacks” (i.e., reserves) designed to provide for likely
future costs and to attribute trading income to the appropriate
source of income. This endorsement reflected the OCC’s
acceptance of a 1986 recommendation of the Basel Committee on
Banking Supervision (Basel Committee) that banks should build a
cautious bias into their estimates of the replacement costs of
off-balance-sheet instruments. Neither the OCC nor the Basel
Committee provided specific guidelines for calculating midmarket
value adjustments. The OCC did require banks to take into
account changes in counterparty credit quality in swap
revaluations. In making credit adjustments to midmarket values,
it was the view of the OCC that the credit adjustment was
typically calculated by formulas based on the counterparty credit
rating, maturity of the transaction, collateral, netting
arrangements, and other credit factors.
In 1994, the FRB expressed concerns about the potential for
income manipulation by use of midmarket adjustments.
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3. Risk Management
Swaps dealers needed to value financial derivatives to
measure the performance of their financial derivatives trading
operations and to measure and to ascertain how to hedge the
market risks in their portfolios. Traders were responsible for
maintaining the portfolios they managed within various risk
limits. The traders needed to know their exposure to long-term
and short-term interest rate movement positions in order to
assure that they did not take on unacceptable levels of risk.
Swaps dealers such as FNBC used midmarket values for daily
risk management purposes. The purpose of these valuations was to
measure the day-to-day change in the value of the portfolio and
to quantify the impact that particular interest rate movements
would have on the value of the portfolio. These calculations
were used to monitor risk positions (i.e., how much unhedged
market risk a trader could assume) and to identify where hedging
was needed. Swaps dealers such as FNBC did not rely upon their
credit adjustments to risk-manage their swaps and did not use
their administrative costs adjustments for risk management.
4. Management Reporting
Each month, swaps dealers such as FNBC prepared a management
report for the financial derivatives profit center that included
interest rate swaps. The monthly management reports contained a
profit-and-loss statement and a balance sheet. On its balance
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sheets, FNBC valued its swaps at midmarket values and reflected
its credit and administrative costs adjustments in a reserve
account. Copies of these reports were sent to senior management,
the OCC, and the FRB.
FNBC’s upper management did not rely upon any of the
adjustments used for tax purposes. In making presentations to
its Board Examining Committee on the profitability and status of
its swaps business, FNBC relied on midmarket values. FNBC
reported to its Board Examining Committee that it made a
reasonable profit from the difference between the swaps market
and the customer.30
5. Financial Reporting and Pricing
Swaps dealers such as FNBC valued their swaps for financial
reporting and pricing purposes. FNBC did not rely upon its
credit adjustments in pricing its swaps.
I. The G-30
1. Overview
The G-30 is a private, nonprofit international body that
comprises very senior representatives of the private and public
sectors and academia. It was organized to deepen understanding
of international economic and financial issues and to examine the
choices available to market practitioners and policymakers. It
30
FNBC also did not rely upon its credit adjustments to set
employee bonuses.
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is supported by contributions from private sources such as banks
and nonbank corporations. During the relevant years, the
chairman of the G-30 was Paul Volcker.
2. G-30’s Review of Industry Practices
The G-30 establishes study groups, committees, and
subcommittees to study various matters of interest to the
international financial community. In 1992, the G-30
commissioned an authoritative review of industry practices and
performance with respect to financial derivatives. The G-30 did
so in order to define a set of sound risk management practices
for dealers, end users, and regulators. Later that year, the
G-30 established a Derivatives Project Steering Committee, which,
in turn, created a working group of specialists (working group)
in the financial derivatives field.
The working group conducted a comprehensive study of
financial derivatives and financial derivatives markets drawn
from the experience of market participants. In July 1993, the
working group issued its report (G-30 report), entitled
“Derivatives: Practices and Principles”. The G-30 report
focused on bank regulatory concerns and generally defined a set
of sound risk management practices for dealers and end users.
The working group followed that report with various surveys
published in 1994 as to industry practices. These surveys were
incorporated into the G-30 report.
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3. G-30 Report
The G-30 report set forth an unofficial but authoritative
review of industry practices and performances, mainly for the
benefit of the risk management activities of dealers and end
users. The G-30 report included a primary section on
recommendations and the following additional and integral parts:
Appendix I Working Papers, dated July 1993
Appendix II Legal Enforceability, Survey of Nine
Jurisdictions, dated July 1993
Appendix III Survey of Industry Practices, dated
March 1994
Follow-up Surveys of Industry Practice, dated December
1994
As to the valuation of financial derivatives, Recommendation
3 of the G-30 report stated:
Recommendation 3: Market Valuation Methods
Derivatives portfolios of dealers should be valued
based on mid-market levels less specific adjustments,
or on appropriate bid or offer levels. Mid-market
valuation adjustments should allow for expected future
costs such as unearned credit spread, close-out costs,
investing and funding costs, and administrative costs.
The G-30 report explained as to this recommendation:
Marking to mid-market less adjustments specifically
defines and quantifies adjustments that are implicitly
assumed in the bid or offer method. Using the mid-
market valuation method without adjustment would
overstate the value of a portfolio by not deferring
income to meet future costs and to provide a credit
spread.
Two adjustments to mid-market are necessary even for a
perfectly matched portfolio: the “unearned credit
spread adjustment” to reflect the credit risk in the
portfolio; and the “administrative costs adjustment”
for costs that will be incurred to administer the
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portfolio. The unearned credit spread adjustment
represents amounts set aside to cover expected credit
losses and to provide compensation for credit exposure.
Expected credit losses should be based upon expected
exposure to counterparties (taking into account netting
arrangements), expected default experience, and overall
portfolio diversification. The unearned credit spread
should preferably be adjusted dynamically as these
factors change. It can be calculated on a transaction
basis, on a portfolio basis, or across all activities
with a given client.
Two additional adjustments are necessary for portfolios
that are not perfectly matched: the “close-out costs
adjustment” which factors in the cost of eliminating
their market risk; and the “investing and funding costs
adjustment” relating to the cost of funding and
investing cash flow mismatches at rates different than
the LIBOR rate which models typically assume.
The Survey reveals a wide range of practice concerning
the mark-to-market method and the use of adjustments to
mid-market value. The most commonly used adjustments
are for credit and administrative costs.
The G-30 report does not provide an objective standard as to
the calculation, measurement, or testing of either the unearned
credit spread (i.e., the credit adjustment) or the administrative
costs adjustment.
4. BC-277
Later in 1993, shortly after the G-30 report was issued, the
OCC released Banking Circular 277 (BC-277), entitled “Risk
Management of Financial Derivatives”. This document addressed
the valuation of financial derivatives and was sent to the chief
executive officer of every national bank. In relevant part, it
stated on the cover page:
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PURPOSE
This banking circular provides guidance on risk
management practices to national banks and federal
branches and agencies engaging in financial derivatives
activities. The guidelines in this circular represent
prudent practices that will enable a bank to conduct
financial derivatives activities in a safe and sound
manner. National banks engaged in financial
derivatives transactions are expected to follow these
guidelines. * * *
* * * * * * *
SCOPE
Financial derivatives transactions currently represent
a relatively small portion of the total credit, market,
liquidity, and operational risk to which most banks are
routinely exposed. However, because of their
complexity, many banks involved in financial
derivatives transactions have developed sophisticated
approaches in managing those traditional types of risk.
These guidelines reflect such approaches and,
therefore, represent sound procedures for risk
management generally. Therefore, to the extent
possible, they should be applied to all of a bank’s
risk-taking activities.
As to the valuation of derivatives, BC-277 stated:
4. Valuation Issues
Banks that engage in financial derivatives activities
should ensure that the methods they use to value their
derivatives positions are appropriate and that the
assumptions underlying those methods are reasonable.
Dealers and active position-takers should have systems
that accurately measure the value of their financial
derivative portfolios. The pricing procedures and
models the bank chooses should be consistently applied
and well-documented. Models and supporting statistical
analyses should be validated prior to use and as market
conditions warrant.
The best approach is to value derivatives portfolios
based on mid-market levels less adjustments.
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Adjustments should reflect expected future costs such
as unearned credit spreads, close-out costs, investing
and funding costs, and administrative costs. Most
limited end-users (and some traders) may find it too
costly to establish systems that accurately measure the
necessary adjustments for mid-market pricing. In such
cases, banks may price derivatives based on bid and
offer levels, provided they use the bid side for long
positions and the offer side for short positions. This
procedure will ensure that financial derivatives
positions are not overvalued.
Banks adopting mid-market pricing should recognize that
mid-market prices are not observable for many
instruments. In those cases, banks should derive
unbiased estimates of market prices from prices in
similar markets or from sources that are independent of
the bank’s traders. The bank’s operations staff should
develop procedures to verify the reasonableness of all
pricing variables or, if that is not possible, should
limit the bank’s exposure through position or
concentration limits and develop appropriate reporting
mechanisms.
Traders may review and comment on prices. When
material discrepancies occur, senior management should
review them. If, in an extenuating circumstance,
senior management overrides a back office estimate, it
should prepare a written explanation of the decision.
IV. Adjustments to Midmarket Value
A. Overview
The credit adjustment and the administrative costs
adjustment are the primary adjustments in dispute. The total of
these adjustments in the industry exceeds $1 billion per year.
Dealers during the relevant years also reported adjustments to
midmarket value for the following: (1) Provision for current
closeout costs of net open positions, (2) provision for future
hedging costs (portfolio rebalances), (3) adjustment for odd
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cashflows, (4) adjustment to reflect borrowing and lending rates
for in- or out-of-the-money positions, (5) liquidity, and
(6) model risk. We discuss the adjustments recognized by the
parties and/or experts.
B. Administrative Costs Adjustment
1. Overview
The adjustment for administrative costs represented those
expenses which a dealer expected to incur in the future in
holding, managing, and administering its existing swap portfolio
to maturity. The adjustment reflected the dealer’s operation,
maintenance, and staffing of the support functions and limited
trading personnel, including the personnel needed to execute swap
transactions to service the existing portfolio, process payments
on the swaps, determine and execute the appropriate hedges as to
the swaps, and monitor the credit standing of counterparties.
The adjustment reflected the appropriate data feeds, software
licenses, activities needed to support the trading floor, and
associated space costs.
2. Dealers’ Practice
Dealers did not take administrative costs into account for
purposes such as pricing and trading. Negotiations among dealers
were over the total price of a swap, and dealers did not
separately negotiate an administrative costs component of the
spread from midmarket value.
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3. Use of Dealer’s Own Costs
Dealers calculated their administrative costs adjustments on
the basis of their own internal estimates of future costs. There
was neither a market standard for administrative expenses related
to swaps, nor a market standard (or market data) for an
administrative costs adjustment whether on a swap-by-swap or
portfolio basis.
Dealers did not know the level of administrative (or other)
costs experienced by other dealers. That information was
generally regarded as proprietary and was not public.
C. Adjustment for Counterparty Credit Risk
1. Overview
A party to a swap was exposed to credit risk. The party’s
credit risk was the potential change in the market price of the
party’s position in the swap due to the credit quality of the
counterparty. The event of a default by the counterparty lowered
the market price of that position, and the danger of default was
the ultimate source of credit risk. Short of an actual default,
a downgrade in the counterparty’s credit rating could also affect
the market price of the party’s position in the swap. Credit
risk included the danger that the market price of the party’s
position in a swap would fall because of a downgrade in the
credit rating of the counterparty.
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Although the notion of midmarket adjustments for credit risk
was recognized in the swaps market, there was no publicly
available data as to the impact that credit quality had on swap
prices. The publicly reported bid and ask rates were commonly
considered valid for counterparties rated AA, and counterparties
with other ratings that negotiated around these quotes did not
publicly report the prices which they negotiated. Those
negotiated prices, therefore, could not be distilled into a set
of swap curves for different credit qualities.
2. Common Method of Calculating Adjustment
There was no consensus during the relevant years about
either the model or the methodology that should be used to
calculate a credit adjustment on swaps. Many bank dealers
calculated their credit adjustments on the basis of a formula
that referenced (1) each counterparty’s credit rating, (2) the
bank’s estimate of expected losses for that credit rating, and
(3) a loan equivalency amount.
a. Counterparty Credit Rating
Most bank dealers had well-established internal credit
risk-rating systems which were developed for purposes other than
calculating a credit adjustment on a swap. Many dealers applied
these credit ratings to ascertain their credit adjustments for
swaps.
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b. Expected Loss Factor
On the basis of historical experience, bank dealers
generally ascertained a loss factor for each credit rating. The
loss factor represented the bank’s estimate of its credit losses
for each dollar of credit exposure in that credit rating. The
loss factors were generally derived from the bank’s experience
with loans to borrowers with the respective credit ratings.
c. Loan Equivalency
i. Overview
A bank would typically establish a credit limit for each
customer, and the loan equivalency measurement of credit exposure
was used by banks in applying credit limits. The loan
equivalency amount focused on the bank dealer’s expected credit
exposure from a specific counterparty with which it had entered
into one or more swaps. The loan equivalency amount represented
the amount of the counterparty’s credit limit, as established by
the bank, that was consumed by each swap. In other words, the
exposure model determined the number of swaps that the bank could
enter into with the counterparty and stay within the prescribed
credit limit.
ii. Types of Credit Exposure
The concept of credit exposure was broken into current
credit exposure and potential credit exposure. There also is a
third type of credit exposure known as “expected exposure”.
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A. Current Credit Exposure
A bank dealer’s current credit exposure on any day was the
net present value of the amount that the bank expected to receive
under a swap agreement as ascertained from current interest rate
projections. In other words, a bank’s current credit exposure
was the midmarket value of a swap, to the extent that the
midmarket value was positive.
B. Potential Credit Exposure
A bank dealer’s potential credit exposure was the most that
it could lose on a swap. Although it was possible to ascertain
the amount that a bank would lose if interest rates reached
unthought-of heights such as 20 percent or higher (or, in other
words, a bank’s “maximum exposure”), banks generally did not
consider their maximum exposure because they did not believe that
interest rates would rise to those unexpected levels. The
concept of potential credit exposure was reformulated to measure
the most that a bank could lose with a set level of confidence
(e.g., a 95-percent certainty). The degree of conservatism
increased with an increase in the number used as the confidence
level; e.g., the use of a 20-percent confidence level was less
conservative than the use of a 50-percent confidence level.
The G-30 report recommended that potential credit exposure
be calculated using broad confidence intervals (e.g., two
standard deviations) over the remaining terms of the
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transactions. An interval of two standard deviations corresponds
to a 95-percent confidence level.
C. Expected Exposure
Expected exposure is the mean exposure which is used for
valuing credit risk.
iii. OCC’s Position
BC-277 stated that for risk management purposes every bank
should have a system to quantify “current exposure (‘mark-to-
market’) as well as potential credit risk due to possible future
changes in applicable market rates or prices (‘add-on’).” BC-277
stated further that “This methodology should produce a number
representing a reasonable approximation of loan equivalency, that
is, the amount of credit exposure inherent in a comparable
extension of credit.”
iv. Methods Used To Calculate
Complex models were used to measure credit exposure for
interest rate swaps. Initially, some swaps dealers measured
potential exposure using a scenario approach. They would analyze
a limited number of future interest rate scenarios and track the
value of the swap over time to determine the maximum amount at
risk if the counterparty were to default. Under this approach,
the worst case scenario was regarded as the potential exposure.
This approach had many deficiencies, and, by the 1990s, most
dealers were trying to develop more sophisticated tools.
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One common approach during the relevant years for estimating
credit exposure was a Monte Carlo simulation. The basic idea of
this approach was to construct a mathematical model to simulate
thousands of variations of future movements of a certain interest
rate (e.g., 6-month LIBOR rate) and, for each variation, to
calculate the credit exposure at numerous points (e.g., every 3
months over the life of the swap). The model generated a
probability distribution of exposure amounts for each swap, which
was used to calculate maximum exposures for multiple confidence
intervals.
3. Market Data for Pricing Credit Risk of Bonds
The credit quality of an issuer of bonds affects the fair
market value of the bonds. If a bond is traded, this
relationship can be directly observed in the price of the bond.
Data on the market prices of traded bonds can be used to
estimate the fair market value of nontraded bonds, inclusive of
any premium or discount that should be applied for credit risk.
Public databases exist which gather information on the traded
prices and yields for bonds with different credit ratings and at
different maturities. This information is gathered, and an index
of yields is constructed. The value of a nontraded bond is
calculated by discounting the promised cashflows at the yield for
the index of comparably rated bonds with the same maturity.
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The observable quality spread in the bond markets makes it
possible to calculate an appropriate adjustment for credit
quality. Assume, for example, that a U.S. Treasury bond priced
at $101.25 would have an estimated fair market value of $99.83
if, instead, it was a like bond issued by an AAA-rated
corporation. The $1.42 difference between the two bonds is the
credit adjustment for an AAA-rated bond issuer. If the same bond
would have had an estimated fair market value of $98.91 if it had
been a like bond issued by an A-rated corporation, the $2.34
difference between the price of the Treasury and A-rated bonds is
the credit adjustment for an A-rated bond issuer. The 92-cent
difference between the estimated fair market values of the
AAA-rated bond and the A-rated bond is the incremental credit
adjustment as of the date of valuation.31
D. Other Adjustments
1. Investing and Funding Costs
The G-30 report recommended an adjustment for investing and
funding costs for portfolios that are not “perfectly matched”.
This adjustment, the G-30 report stated, relates to “the costs of
funding and investing cashflow mismatches at rates different from
the LIBOR rate which models typically assume”. This adjustment
is also mentioned in BC-277.
31
The market price of credit risk fluctuates over time.
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2. Closeout Costs (Liquidity)
The G-30 report recommended an adjustment for closeout
costs. The closeout costs (liquidity) adjustment reflects the
cost to buy out, assign, or otherwise unwind one or all of the
reporting entity’s swaps.
The need for a closeout costs adjustment is relatively
strong in some cases. Midmarket pricing from models based on the
prices of benchmark instruments that are liquid overstates the
pricing of assets that are exotic, or infrequently traded, or
have a limited set of potential buyers. Such assets should be
marked down for their liquidity.
During the relevant years, no sound or implementable
approaches existed as to close out costs adjustments. Nor did
many entities (including FNBC) make closeout costs adjustments
during those years.
3. Dealer Margin
The fair market value of a swap (inclusive of profit) is not
normally zero at inception. Dealers capture profits on the
origination of swaps, especially swaps with end users. As a
result, the fair market value of a swap between a dealer and an
end user is generally positive at origination. The midmarket
value of a swap at origination often includes the present value
of the dealer’s expected profit on the transaction.
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The adjusted midmarket method generally did not include an
adjustment for the dealer’s profit margin. Nor did FNBC’s
implementation of that method include such an adjustment.
V. Los Alamos Project
In 1994, the Commissioner entered into a contract with the
Los Alamos National Laboratory under which the Los Alamos
scientists (including quantum physicists and mathematicians) were
to develop in the form of software a sophisticated model to
assist the Commissioner in valuing interest rate swaps, currency
swaps, and other financial derivative products for which mark-to-
market reporting was required under section 475. This software
was intended to produce a narrow range of values for swaps that a
revenue agent could use as a litmus test for ascertaining whether
a more thorough audit would be necessary as to a dealer’s
valuation of its swaps. The Commissioner contemplated that a
more detailed audit would be required if the dealer’s valuation
fell outside the range of values.
The Los Alamos team was to address during the first 12
months of the project the following nine issues:
1. Address security and disclosure issues. –- Some of
the data required in the model development must
use sensitive unclassified information about
taxpayers’ market transactions. Procedures must
be put in place to handle these requirements.
2. Determine how the various forms of tax information
data are handled and its impact on models. –- For
example much of the data on transaction is only
available in paper format. In this case
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statistical methods need to be used to account for
the transactions; this will need to be allowed for
in the models.
3. Many of these models will require historical data
on price, interest rates, economic indicators,
company reports and analyst estimates. This data
is available from several vendors who need to be
identified and form of feeds established.
4. Develop pricing models for interest rate and
currency swaps, allowing proper determination of
zero coupon rates and pricing based on the
floating and fixed rate side. Perform
benchmarking.
5. Identify list of other significant derivatives for
which to begin modeling efforts. –- Discuss with
the IRS which of the many derivative securities
should be focused on. This activity will help set
the framework for model development of subsequent
securities.
6. Determination of platform to use in the field. It
is strongly recommended that this be a windows
driven system. Many of the models developed will
require a large computing platform. The way to
handle this is to have a software package on the
field agent’s computer that would remotely log
into the larger machines.
7. Non-linear models for interest rate yield curve
predictions. –- Yield curve models are central to
the valuation of these securities, issues
associated with these must be addressed early in
the game.
8. Credit risk models and their incorporation into
swap pricing. -- In a similar fashion to yield
curve models credit risk or the risk of defaulting
on a contract must be addressed.
9. Implement a working system that has a basic set of
models with the look and feel of future systems.
-- Test in house a beta version of system to be
implemented.
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The Los Alamos team spent the most time for the software
project on developing strong foundations for pricing plain
vanilla swaps, which were the bulk of instruments traded in the
market. The Commissioner believed that strong foundations for
building models in these instruments had to be established first
before models could be built for the more complicated nongeneric
products.
After having spent more than 3 years and at least $2.6
million on the Los Alamos Project, the Commissioner suspended the
project in late 1997 primarily because of budgetary constraints.
There were internal concerns about computer spending during this
time and a particular concern about additional funding for the
project because any product that was developed would require
subsequent budgeting for costs connected to Los Alamos’s need to
fine-tune the product.
VI. FNBC’s Swaps Business
A. Overview
FNBC began dealing in interest rate and currency swaps in
1983 and began dealing in commodity swaps in 1989. To date, FNBC
has traded in at least 17 currency markets, including U.S.
dollars, Canadian dollars, Australian dollars, deutschmarks,
sterling, yen, Swiss francs, ECU’s, and pesetas. FNBC is an
innovator of interest rate products and is a leading provider in
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commodity derivatives including commodities such as oil, zinc,
copper, and natural gas.
On the basis of notional principal amounts outstanding, FNBC
was the 16th largest swaps dealer in the world in 1993. On a
consolidated basis, the notional principal amounts of FNBC’s
outstanding swaps at the end of 1990, 1991, 1992, and 1993
totaled $59.4 billion, $78.8 billion, $84.5 billion, and $114.9
billion, respectively. For all of FNBC’s worldwide interest rate
derivative business, its return on equity for global derivative
products in 1992 and 1993 was 30 percent and 33.9 percent,
respectively.
During the relevant years, FNBC entered primarily into
interest rate swaps. As of July 31, 1993, approximately 95
percent of the total number of deals in FNBC’s portfolio were
plain vanilla swaps and options.
B. Trading Desks
During the relevant years, FNBC had swap trading desks in
Chicago, London, Tokyo, and Sydney. The swap traders at the
Chicago trading desk handled primarily interest rate swaps
denominated in U.S. or Canadian dollars and, to a lesser extent,
currency swaps, commodity swaps, and combination swaps. The
Chicago office also traded many products other than swaps
including, but not limited to, interest rate guarantees, FRAs,
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Government securities, municipal bonds, high yield debt, and
asset-backed securities.
The Chicago office booked (i.e., held and risk-managed) all
swaps the notional principal amounts of which were denominated in
U.S. or Canadian dollars. Swaps booked in Chicago but
originating outside of FNBC’s Chicago office (e.g., at the London
office32) were known as “linked deals”. Linked deals are a type
of internal contract that transfers the external exposure on a
swap, as well as the responsibility for cashflows and market
risk, from one FNBC trading office to another. In order to book
in Chicago a deal originating in another office (e.g., London),
FNBC entered into a mirror swap with the origination office to
transfer the swap from the origination office to Chicago.
Carveouts for linked deals were claimed at the linked office;
i.e., the office that held and risk-managed the swap.
C. Swaps Operations Personnel
1. Overview
During the relevant years, FNBC’s swap operation was divided
into a front office and a back office. The front office
consisted of (1) traders, (2) marketers, (3) financial engineers
who designed new instruments and structured transactions, and
(4) the support staff for the first three categories of
32
The London office specialized in the trading of European
and Asian currencies.
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employees. The back office (also known as the swaps operations
group) ensured the integrity of the paperwork on FNBC’s swaps and
other multiple trading products. The back office, among other
things, verified that swap master agreements were executed, that
confirmations on swap transactions were received, and that
periodic payments on swaps were properly transacted.
2. Traders
a. Function
FNBC’s traders were the individuals who on behalf of FNBC
negotiated and entered into swap transactions with other dealers
or brokers. In order to effect these transactions, FNBC’s
traders usually dealt directly with the brokers or with their
(FNBC’s traders’) counterparts at the other dealers. In swaps
with other dealers, including brokered transactions and those
swaps which a dealer entered into for its own use (e.g., to hedge
its own books), the FNBC trader usually determined the final
price for the swap and was authorized to enter into the
transaction without specific credit approval if sufficient credit
limits had already been established for the counterparty/dealer.
If the counterparty was strictly an end-user, as opposed to a
dealer acting either as a dealer or as an end user, the FNBC
trader would not deal directly with the counterparty. Rather, a
marketer would handle negotiations with the counterparty after
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checking with the trader as to the potential pricing of the
transaction.
During the relevant years, FNBC generally required its
traders to use ISDA documentation for its swaps, and its swaps
were subject to ISDA conventions.
b. Number Employed in Chicago
FNBC’s Chicago swap operation employed three traders of
interest rate swaps and one other individual, the head of the
trading desk, who supervised these three traders. Two of the
three traders traded U.S. dollar denominated interest rate swaps,
and the third trader traded Canadian dollar denominated interest
rate swaps. One of the two traders of U.S. dollar denominated
interest rate swaps traded short-term swaps, and the other traded
long-term swaps.
c. Practice as to Quotations
FNBC’s traders typically quoted the same bid and ask rates
for all potential counterparties rated A- or better. FNBC’s bid
and ask quotes were driven by the market bid and ask quotes and
the risk position of FNBC’s portfolio. FNBC’s traders agreed to
the terms of a plain vanilla interest swap in a matter of
seconds.
In pricing potential swap transactions, FNBC’s traders
attempted to determine where the market was at that time and,
given their views on interest rate movement, price their swaps on
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the basis of supply and demand. They gauged the market by
looking at various sources (e.g., yields on Treasury securities,
broker quotes of swap spreads over relevant Treasury instruments,
and Eurodollar futures prices) to determine points on the
interest rate yield curve. Some of the requisite information
underlying these sources was reflected in FNBC’s Devon system.
FNBC’s traders often used the information provided by the Devon
system as a starting point in pricing.
d. Risk Management Responsibility
Each FNBC trader was responsible for maintaining his or her
aggregate positions within various market risk parameters. The
traders risk-managed their portfolios subject to the trading
limits set by those market risk parameters. In risk-managing
their portfolios, the traders used daily risk profiles and
Devon-system-generated daily profit and loss statements for
swaps. These profiles and statements listed midmarket values and
did not include administrative costs adjustments or credit
adjustments. FNBC’s traders were limited on the amount of
interest rate exposure that they could assume on behalf of FNBC
by a risk point system. That risk point system was based upon
the profit/loss estimates that FNBC’s Devon system provided given
a certain basis point movement in interest rates.
Whenever FNBC and a counterparty reached agreement on the
price of a new swap, the trader would begin the process of
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attempting to hedge some or all of the market risk taken in the
transaction. The trader usually hedged its swaps with other
swaps as well as with futures and Government securities such as
Treasury securities. In some cases, the trader decided to leave
a position unhedged for a period of time or did not enter into a
specific hedging transaction. In those cases, the transaction
was already adequately balanced, in whole or in part, by other
transactions in the trader’s portfolio or was entered into to
balance the existing portfolio.
3. Marketers
a. Function
FNBC’s marketers were the individuals who on behalf of FNBC
negotiated and entered into swaps with nondealer end users. In
order to effect these transactions, FNBC’s marketers dealt
directly with the nondealer end users, but only after checking
with a trader as to the potential pricing of the transaction.
The marketers were assigned groups of customers (e.g., financial
institutions) and were responsible for locating nondealer
customers that wanted to enter into swaps. The marketers
promoted FNBC’s swaps business to its end-user customers and
educated potential clients on the products FNBC offered and how
the products could help the clients.
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b. Practice as to Quotations
FNBC’s marketers negotiated the best price (within the
limits set by a trader) for any swap with a nondealer end-user
but needed the approval of an FNBC trader for any negotiated
price as to the swap. The marketer would communicate to an FNBC
trader the terms of a proposed swap for a nondealer end-user
customer and obtain a price quote. The marketer could build in
an additional spread but could not decrease the price quoted by
the trader without the trader’s approval.33 The trader had to
sign the trade ticket and, in so doing, took on all
responsibility for risk-managing the swap. The marketer had no
responsibility for risk management.
4. Relationship Managers
Each customer of FNBC had an assigned FNBC relationship
manager who was responsible for generating business from the
customer and overseeing FNBC’s dealings with the customer. The
relationship manager was not part of the group that included swap
traders and marketers. Marketers worked with the relationship
managers to explain to customers how they could benefit from
using FNBC’s swap products. Relationship managers had overall
responsibility for all of the customers’ transactions (e.g., bond
33
A client that received many services from an FNBC
marketer might allow the marketer to add to the spread to pay for
the services.
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issuances, letters of credit, loans, financial derivative
transactions).
5. Credit Officers
An FNBC credit officer was assigned to each swap
counterparty. Before a swap could be entered into with that
counterparty, the credit officer had to approve the
counterparty’s credit and give the counterparty a credit exposure
limit (credit line). Credit officers did not work in the swap
department and were not part of the group that included swap
traders and marketers. Nor was the credit approval process a
function of the swap traders and marketers.
The credit line for financial derivative products was known
as the variable exposure product (VEP) limit (VEPL). If a VEPL
had already been established for a counterparty, and a new swap
was within that limit, then no additional credit approval was
needed. If the credit exposure of a swap exceeded the available
VEPL, or if no VEPL had been approved, then the trader had to
obtain credit approval from the credit officer.
D. Weak Credit Rating
FNBC was a major participant in the swaps market during the
relevant years but was considered in that market to have weak
credit. FNBC’s credit rating was downgraded to A- in or about
the fall of 1990. This downgrade was generally viewed poorly
among persons or entities dealing with or considering dealing
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with FNBC, and it hurt FNBC’s ability to enter into new swaps.
FNBC’s end-user customers were worried about having periodic
payments that would be due to them from a lower rated dealer.
Some banks required collateral provisions in their swap
agreements with FNBC because they were a better credit risk than
FNBC and were not allowed to take on any risk.
E. Quoting a Price
FNBC’s practice at the start of each business day was to
announce to brokers its bid and ask quotations on interdealer
generic swaps. During the course of the day, FNBC’s traders
would receive calls from brokers informing the traders that the
brokers had a particular dealer that wanted to enter into a swap
at one or more of FNBC’s quoted rates. The broker would not
identify the other dealer until FNBC agreed in principle to the
terms of the swap. Once FNBC learned the other dealer’s
identity, it would decide whether to go forward with the swap, in
view of the other party’s credit rating and the credit limit that
FNBC had established for the counterparty.
FNBC generally went through two steps in deciding what price
to quote on a specific swap (whether with a dealer or an end
user). First, FNBC calculated (usually on its Devon system) the
midmarket rate that would result in both legs of the swap having
the same present value. Second, FNBC added (or subtracted) a
spread to arrive at its ask (or bid) price. In pricing a swap,
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the spreads which FNBC factored into its traders’ bid and ask
quotes were constrained by competition. On most transactions,
particularly those with other financial institutions and large
corporations, the customer obtained quotes from many different
dealers, and FNBC was unlikely to get the business if another
dealer offered better terms. Where FNBC dealt with an end user
on a transaction that was particularly customized, or where the
customer was not likely to obtain prices from other sources,
FNBC’s marketers sometimes sought to realize additional profit on
the transaction by quoting a larger spread. FNBC’s marketers
usually were not able to get a larger spread from FNBC’s end
users. In the rare cases where they were able to get a larger
spread, it was in the nature of a fee for the cost of explaining
swaps to the customer or for other services.
F. Buyouts
FNBC’s interest rate swaps were easily terminated during the
relevant years by way of buyouts. FNBC regularly and
continuously sought to, and did, buy out swap transactions in
which it was a party.
Both end users and dealers came to FNBC to buy out their
swaps with FNBC. FNBC’s traders and marketers were asked to (and
did) quote prices for early termination of swaps by way of
buyouts. FNBC marketed its swaps to customers as financial
instruments that could be easily bought out or terminated at
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market value; i.e., the difference in the present value of the
anticipated net cashflows from each of the swap’s legs. FNBC
required as a matter of practice that the buyout price be at
least the midmarket value. FNBC was willing to enter into
buyouts at the midmarket value even if there was not a profit to
FNBC.
Approximately 12 percent of FNBC’s swaps business in March
1993 was buyouts. Approximately 23 percent of FNBC’s swaps
business in June 1993 was buyouts.
G. Swaps Outstanding at Yearend
Without consideration of any swaps booked in the London
branch, FNBC had 1,020 interest rate swaps (without an embedded
feature) outstanding at the end of 1991; 1,290 at the end of
1992; and 1,147 at the end of 1993. Without consideration of any
swaps booked in the London branch, FNBC had 19 commodity swaps
outstanding at the end of 1991; 19 at the end of 1992; and 52 at
the end of 1993.
H. Swaps in Issue
The parties have settled all pleaded issues with respect to
swaps booked through FNBC’s London branch, and no issues have
been raised as to swaps booked through the Tokyo or Sydney
office. The swaps at issue originated at the Chicago trading
desk or were booked through FNBC’s other desks and linked to the
Chicago desk. The disallowed amounts encompass all adjustments
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on all swaps which were on the books of FNBC’s Chicago office at
each yearend and all adjustments used to reduce FNBC’s swaps
income.
With respect to all of FNBC’s swaps which it designated as
interest rate swaps, 95 percent of them were plain vanilla U.S.
dollar denominated interest rate swaps with standardized terms.
The remaining 5 percent were mainly exotic swaps that included:
(1) Amortizing or accreting swaps; (2) constant maturing swaps
(i.e., an interest rate swap in which the floating rate is tied
to a long-term constant maturity Treasury bond yield); (3) basis
swaps; and (4) forward-start swaps (interest rate swaps that
specify a future start date). The remaining 5 percent also
included Canadian dollar denominated interest rate swaps, all of
which, during the relevant years, were plain vanilla. During
1993, FNBC generally entered into fewer than 10 Canadian dollar
denominated interest rate swaps a week.
During 1990 and 1991, the counterparties to FNBC’s interest
rate financial derivative products were from the following
categories:
1990 1991
Bank dealers 33% 32%
Bank end users 16 21
Corporate end users 30 26
FCC, FNBC and its branches,
its affiliates, and its own
subsidiaries 21 22
100 100 (rounded)
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VII. FNBC’s Financial Accounting Practice
During the relevant years, FNBC’s financial accounting
practice with respect to the pricing and valuation of commodity
swaps, currency swaps, and combination swaps did not differ
significantly from its financial accounting practice with respect
to interest rate swaps. FNBC used a three-step process to
determine the value of its swaps for financial accounting
purposes. First, on a swap-by-swap basis, FNBC generally
calculated each swap’s midmarket value (usually from the Devon
system but sometimes from the midmarket swap curve) and
recalculated these midmarket values daily. Second and third,
FNBC calculated credit and administrative costs adjustments as to
the swaps. FNBC’s administrative costs adjustments (which were
computed on a portfolio basis) included an adjustment for hedging
and may have included an adjustment for funding and cost of
capital. FNBC did not take an adjustment for the cost to close
out (liquidate) its swaps.
VIII. FNBC’s Practice as to Its Valuation of Its Swaps
A. Financial Reporting Position
The 1993 Annual Report of FNBC and its parent FCC described
their accounting policy for financial derivative instruments as
follows:
Accounting for Derivative Financial Instruments
Derivative financial instruments used in trading and
venture capital activities are valued at prevailing
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market rates on a present value basis. Realized and
unrealized gains and losses are included in noninterest
income as trading account profits, foreign exchange
trading profits and equities securities gains. Where
appropriate, compensation for credit risk and ongoing
servicing is deferred and taken into income over the
term of the derivatives. Any gain or loss on the early
termination of an interest rate swap used in trading
activities is recognized currently in trading account
profits.
This description related exclusively to the income
statements and the balance sheets. It is different from the
description used for the fair value disclosure in the footnotes,
which omitted any reference to adjustments for administrative
costs and/or credit risk. FNBC used midmarket values for SFAS
No. 107 footnote disclosure purposes, and it used adjusted
midmarket values for other financial reporting purposes.
B. Uses of Valuation
FNBC was required to value its swaps in conformance with
regulatory accounting principles (RAP), GAAP, and Federal income
tax laws. Tax considerations were not a factor when FNBC
determined how it would calculate the value of its swaps, and
FNBC did not consult with anyone to ascertain whether its
adjustments were appropriate for section 475 purposes. Tax
considerations were not mentioned when the valuation methodology
was presented to FNBC and its parent’s board of directors.
Midmarket values were used in the presentation to the board.
There is no line item on any report that FNBC filed with the
OCC that set forth, or specifically identified, the amount of
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administrative costs or credit adjustments FNBC reported for
regulatory purposes.
C. RAP/GAAP
In some cases, RAP can differ from GAAP, with RAP/GAAP
differences referring to the differences between the reporting
required for regulatory purposes and the reporting required for
GAAP. FNBC conducted RAP/GAAP reconciliations.
IX. FNBC’s Calculation of Midmarket Value
A. FNBC’s Devon System
1. Overview
FNBC first used the Devon system in 1989. FNBC was one of
the first users of the Devon system, and Devon modified its
system specifically for FNBC. FNBC’s customization of its Devon
system changed repeatedly from 1989 through February 1993.
FNBC’s Devon system never took into account the bilateral nature
of swaps or FNBC’s relatively weak credit rating for a dealer in
the interdealer swaps market.
FNBC needed the Devon system to handle the thousands of
transactions it had on its books. FNBC used the Devon system to
calculate a midmarket value for each of its swaps. FNBC also
used its Devon system to value all of its other financial
derivatives. In the relevant years, FNBC’s Devon system used
discount factors for entities with the equivalent of AA credit
ratings. The Devon system’s use of a discount rate applicable to
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an AA-rated entity took into account the risk of nonpayment of
the cashflows by an AA-rated entity.
2. Role of FNBC’s Devon System
The Devon system had a critical role in FNBC’s risk
management and hedging operations. The Devon system was used by
FNBC’s Chicago office traders to risk-manage and to hedge their
swaps. The Devon system calculated not only the current
mid-market value for the book, but also how much the value would
change with particular interest rate movements.
B. Accounting for Devon Value
At least monthly, FNBC recorded the change in the midmarket
value of a performing swap in two pieces.34 The first piece,
described by FNBC as the accrual,35 reflected a proportion of the
next scheduled net cashflow. This accrual of interest was
computed by multiplying the amount of the net interest payment by
a fraction. The fraction’s denominator was the number of days in
the payment period (the period between the scheduled cashflows or
34
FNBC removed “nonperforming VEP transactions” (discussed
infra p. 148) from its trading portfolio and valued these swaps
at a “modified lower of cost or market”.
35
In the accounting sense, an “accrual” is the process of
recognizing noncash events or circumstances as they occur, not
necessarily when cash is paid or received. Accrued assets or
liabilities and the related revenues, expenses, gains, or losses
represent amounts expected to be received or paid in the future.
Common examples of accruals include (1) purchases and sales of
goods or services on account and (2) unpaid but incurred amounts
of interest, rent, wages, salaries, and taxes.
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from the start of the swap to the first scheduled cashflow, if
that was the first period). The fraction’s numerator was the
number of days in the accrual period. If the next scheduled net
cashflow was a cash receipt, then FNBC basically recorded an
increase in a receivable and a corresponding entry for realized
trading income. If the next scheduled net cashflow was a cash
payment, then FNBC basically recorded an increase in a payable
and a corresponding entry to realized trading loss. FNBC reduced
the receivable (or payable) when the scheduled net cashflow was
received (or paid).
The second piece, described by FNBC as the revaluation,
recorded the change in the midmarket value minus the accrual just
discussed. The sum of the two pieces equaled the change in the
midmarket value. At the first valuation date after the start of
the swap, the change in midmarket value equaled the midmarket
value (i.e., the previous value was zero). If the change in the
midmarket value minus the accrual was an increase, then FNBC
recorded an increase in its asset balance for swaps and a
corresponding entry for unrealized trading income. If the change
in the midmarket value minus the accrual was a decrease, then
FNBC recorded a decrease in its asset balance for swaps and a
corresponding entry for unrealized trading loss.
An effect of this manner of accounting for the midmarket
value was that no single account recorded the midmarket value of
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a swap. Rather, the midmarket value was the cumulative sum of
accruals plus revaluations which related to the swap.
C. Early Closing Date
FNBC did not value its swap portfolio as of its yearend (or
its last business day) but as of a date slightly before yearend
(early closing date). Typically, the early closing date was on
or about the 20th day of the month; e.g., FNBC determined the
value of its portfolio as of December 31, 1993, on the basis of
the midmarket values on December 20, 1993.36 FNBC adjusted its
books for periodic payments made during the period between the
early closing date and yearend, but did not adjust its books for
changes in valuation from the early closing date to yearend.
FNBC did not consider those changes in valuation material from
the viewpoint of the entire operations of FNBC (and not just from
the viewpoint of FNBC’s swaps operation).
FNBC had an internally imposed accounting schedule that
dictated its use of the early closing date. FNBC had a rigid
deadline under which it would close its books on the second
business day after the end of a month. In the early 1990’s, FNBC
attempted to value its swaps as of the last day of the month but
36
Significant valuation changes occurred from the close of
business on Dec. 20, 1993, through the close of business on
Dec. 31, 1993. In the case of one swap, for example, FNBC
reported that the midmarket value for that swap was $104,233 as
of Dec. 20, 1993. The swap had a midmarket value of $97,721 as
of Dec. 31, 1993, or, in other words, a decrease of 6.2 percent
in the 11 days.
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encountered problems under which it had difficulty meeting its 2-
business-day deadline. The Devon system, for example, did not
automatically post to the general ledger, and thousands of
entries had to be entered manually each month. Because FNBC was
unable to enter all of these entries correctly within 2 business
days after the close of the year, it established the early
closing date.
FNBC’s use of its early closing date was approved by FNBC’s
chief accounting officer, and the stub period adjustments (those
adjustments for the period extending from the early closing date
until the yearend date) were discussed with FNBC’s outside
auditors. FNBC’s auditors concluded that FNBC’s financial
statements presented fairly, in all material respects, FNBC’s
financial position at yearend.
X. FNBC’s Administrative Costs Adjustment
A. Overview
FNBC made an internal forecast of future administrative
costs which it expected to incur in administering its existing
swap portfolio to maturity. For Federal income tax purposes,
FNBC considered the present value of these costs an adjustment to
the midmarket value of its swaps. FNBC ascertained its forecast
by (1) projecting future costs to manage the current portfolio of
swaps and interest rate guarantees; (2) reducing the projected
costs in each future year by the proportion of the current
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portfolio that would mature before the start of the future year,
as ascertained from a “rolloff” schedule; (3) discounting the
future costs to present value; and (4) assigning 30 percent of
future costs to interest rate guarantees and the remaining 70
percent to swaps.
FNBC’s finance department was responsible for computing the
administrative costs adjustment. Its objective was to ascertain
the costs attributable to administering the existing swaps over
their existing life, assuming that there were no new deals. As
of the end of the quarter, FNBC (through its finance department)
calculated the administrative costs adjustment on a portfolio
(rather than swap-by-swap) basis; i.e., FNBC determined the
administrative costs for the entire portfolio and did not compute
or allocate those costs to individual swaps. FNBC did not
calculate a per-swap administrative expense amount.
For the relevant years, the amounts of the administrative
costs that FNBC estimated were needed to manage its swaps to
maturity were as follows:
Estimated
Year Administrative Costs
1989 $4,271,337
1990 5,253,337
1991 3,318,920
1992 3,843,770
1993 4,832,469
For Federal income tax purposes, FNBC reported the annual
increases or decreases to these estimated administrative costs as
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administrative costs adjustments to its midmarket values. FNBC
reported the following amounts for administrative costs
adjustments (with the negative amounts decreasing the midmarket
values and the positive amounts increasing the midmarket values):
Administrative
Year Costs Adjustment
1990 ($982,000)
1991 1,934,417
1992 (524,850)
1993 (988,699)
The administrative costs adjustment’s net effect on income was to
decrease (or increase) income per books by the net increase (or
decrease) in the aggregate balance of the administrative costs
adjustment.
B. Calculation of the Adjustment
FNBC’s administrative costs adjustment reflected FNBC’s
estimate of the aggregate of: (1) Its future budgeted costs
(both direct and indirect) for its swaps business, (2) its future
budgeted costs (both direct and indirect) for the allocable
portions of the costs of the back office to manage FNBC’s swaps
to maturity, and (3) the allocable future budgeted costs of the
nontrading departments of FNBC that FNBC believed would be
necessary to support its swaps business in managing the swaps to
maturity. For purposes of the administrative costs adjustment,
all of these future estimated costs were adjusted upward by an
inflation factor and then present valued. The inflation factor
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for future costs was 3.5 percent for 1992 and the first three
quarters of 1993 and 4 percent for the fourth quarter of 1993.
These inflation factors were consistent with the inflation
factors built into FNBC’s budgeting process. The present values
of these estimated expenses, as adjusted by the inflation factor,
were computed by using the same zero-coupon yield curve that was
used in computing midmarket value.
In order to reflect the fact that its swaps matured, FNBC
(through its finance department) prepared a roll-off schedule
showing the number of its swaps that matured each year and, going
forward, the number of those swaps that would be in place each
year until the entire portfolio had matured. The roll-off
schedule was used to estimate the number of years that FNBC would
be incurring expenses for swaps that had not yet terminated. In
the later years, the estimated costs were reduced in proportion
to the declining number of swaps that would still be in
existence. The maturity estimates did not take into account the
percentage of FNBC’s swaps that were bought out each month.
The present values of the expenses, after they had been
adjusted for inflation, were then allocated between the swap
portfolio and the interest rate guarantee portfolio. FNBC then
attributed to the existing swaps the percentage of the resulting
estimated expenses, as adjusted, that bore the ratio of the
existing swaps to total swaps. The amount of the difference
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between the administrative costs adjustments for the current
quarter and the previous quarter was the amount that FNBC claimed
on its books as a portfolio adjustment for the current quarter’s
deferral.
C. Preparation for the Adjustment
The starting point in calculating the administrative costs
adjustment was the swap department’s annual budget, as approved
by the swap department’s senior management. In order to arrive
at the amount of salaries, bonuses, and benefits (collectively,
personnel costs) to allocate to its administrative costs
adjustment calculation, FNBC multiplied its personnel costs by a
fraction. The fraction’s numerator equaled the number of
full-time equivalent employees (FTEs) estimated to be required to
maintain the portfolio to maturity.37 The fraction’s denominator
equaled the total budgeted trading department FTEs. FNBC also
allocated to the management of the existing swap portfolio the
same percentage of direct costs.
The number of FTEs estimated necessary to maintain the
current portfolio to maturity changed during the relevant years
as shown below:
37
The finance department ascertained the level of staffing
needed to manage the existing portfolio by interviewing primarily
the head of the trading desk.
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FTEs estimated FTEs budgeted Percentage of
Beginning Ending to maintain in trading FTEs used to
quarter quarter portfolio department maintain portfolio
1/1/90 3/31/91 - - Unavailable
4/1/91 9/30/91 1 8 12.5%
10/1/91 12/31/92 1.5 15 10
1/1/93 9/30/93 2 26.5 7.5
10/1/93 12/31/93 2 24 8.33
At the end of 1993, for example, the front office consisted of 24
individuals working as traders, trading assistants, marketers, or
managers. Seven of the 24 individuals were traders of interest
rate products (more specifically, 1 was the desk head, 2 were
traders of U.S. dollar swaps, 1 was a trader of Canadian dollar
swaps, 2 were traders of interest rate options, and 1 was engaged
solely in modeling). The remaining 17 individuals were financial
derivative marketers and trading assistants. For purposes of the
fourth quarter of 1993, FNBC’s finance department ascertained
that managing the current portfolio of interest rate swaps,
commodity swaps, swaptions, and interest rate guarantees would
require 2 of the 24 employees (i.e., 8.33 percent). The duties
of the FTEs would include making sure that the portfolio remained
risk balanced (which would be primarily the responsibility of
traders and trading assistants) and attempting to transfer some
or all of the portfolio to other swaps dealers (which would
primarily require the time of traders and trading assistants,
with participation of other trading department personnel as
needed). FNBC attributed 8.33 percent of the budgeted front
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office personnel costs to the management of its portfolio. FNBC
also allocated to the management of its portfolio 8.33 percent of
the related direct costs.
The swap department’s annual budget included as “indirect
costs” amounts that were charged to the swap department by other
areas of the bank. The finance department conducted interviews
to determine what percentage of each item was attributable to the
management of the existing swap portfolio. The percentages used
for 1993 were 62 percent of the credit department costs, 25
percent of legal services, 50 percent of audit and finance, 0
percent of R&D, 0 percent of marketing, and 0 percent of
corporate utilities. FNBC also charged to the swaps department
the indirect costs of additional departments.
The total of all of the expenses attributable to the
management of FNBC’s existing swap portfolio represented FNBC’s
estimate of the total costs of administering its existing swap
portfolio for the upcoming year.
D. Expenses Included in the Adjustment
1. Direct and Indirect Budgeted Costs
The direct and indirect costs of the swap front office used
to calculate the administrative costs adjustment included office
rent, traders’ salaries and bonuses, all front office expenses,
certain miscellaneous costs, costs connected with the Devon
system, and retirement and other benefits for front office swap
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personnel. FNBC did not include the total amounts of these costs
but only the portions needed to manage its existing portfolio.
FNBC’s administrative costs adjustments for the front office may
also have included hedging expenses.
2. Amounts From Other Areas of FNBC
FNBC’s administrative costs adjustment for swaps also
included costs from other departments, including: (1) Computer
systems; (2) accounting; (3) facilities management; (4) credit
process review department; (5) corporate staff from other
departments; (6) systems development; (7) general manager;
(8) service products group; (9) risk management administration;
(10) financial analysis; (11) corporate and institutional
banking; and (12) other service charges. These costs, to the
extent allocated to swaps and interest rate guarantees, included:
(1) Charges from FNBC’s law department, audit department, data
processing center, allocable rent (occupancy area), cost to hedge
the swaps in existence to maturity, and telephone costs;
(2) charges from FNBC’s credit policy group, which set policy on
all customer credit transactions, including loans, leasing
products and derivatives; (3) charges from management for the
credit policy group in addition to other charges from the credit
department of FNBC; (4) charges from FNBC’s treasury management
group which was responsible for corporate customer cash and other
accounts; (5) charges from FNBC’s facilities management section,
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which maintained the floors, etc., for FNBC’s building, and
charges for maintenance of electronic and computer equipment;
(6) charges for data processing systems, virtual memory and
mainframe computer systems; (7) charges from FNBC’s commercial
bank credit area; (8) charges from FNBC’s internal mail and
corporate staff; (9) charges from FNBC’s internal audit
department and finance department; and (10) charges for high
level expenditures for top level executives such as, but not
necessarily, a corporate jet.
XI. FNBC’s Credit Adjustment
A. Overview
At the inception of each swap, FNBC (through its finance
department) determined an initial credit adjustment for that
swap. While the midmarket values for each swap were recalculated
annually to determine yearend swap values, FNBC never
recalculated its credit adjustments for its swaps.
1. Initial and Subsequent Methods
For the relevant years, FNBC used two different methods to
calculate its credit adjustments. It used one method from 1990
through the third quarter of 1992. It used a second method for
new swaps that arose in the fourth quarter of 1992 through 1993.
As to the two methods, FNBC considered the first method to be the
more accurate but also believed that the first method was more
error prone.
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2. First Method
Under the first method, FNBC calculated and recorded a
credit adjustment for each swap. FNBC amortized each swap’s
credit adjustment over the life of the swap as ascertained by its
maturity date. In the event that a swap was terminated or bought
out, FNBC included in income all of the remaining credit
adjustment attributable to that swap.
3. Second Method
Under the second method, FNBC stopped amortizing the credit
adjustments on a per-swap basis over the life of the swap and
began applying an aggregate approach of amortization based upon
the life of all of the swaps considered initiated in each
quarter. For this calculation, FNBC considered each swap to be
initiated 1 month after the date when it was actually initiated.
Each quarter, FNBC amortized the credit risk into income on
the basis of the life of all the swaps considered initiated
during the quarter. FNBC did not make any adjustments in the
case of occurrences such as early terminations, changes in
mark-to-market amounts, or changes (positive or negative) in the
credit rating of a swap counterparty.
a. Methodology
Under the second method, FNBC ascertained its initial credit
adjustment through a three-step process. First, as to each swap,
FNBC calculated a credit exposure measurement (CEM) amount as of
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the last day of the quarter in which the swap was considered
initiated; e.g., if the swap was actually initiated on a day that
fell between March 1 and May 31, the initial credit adjustment
was calculated on June 30.38 Second, FNBC assigned the swap
counterparty to one of its credit risk rating classes (discussed
infra p. 133) and ascertained the corresponding CRESCO39 loss
reserve factor from the credit rating that FNBC had assigned to
that CRESCO loss reserve factor.40 Third, FNBC multiplied the
swap’s CEM amount by the counterparty’s CRESCO loss reserve
factor to arrive at the swap’s initial credit adjustment.41
For the period beginning in the fourth quarter of 1992, FNBC
accounted for its credit adjustment as follows. First, on the
quarterly basis, FNBC reduced income by the credit adjustment for
the group of swaps originating in the quarter (with the 1-month
38
The CEM determined how much of the credit limit was
consumed by each swap.
39
The acronym “CRESCO” refers to the Credit Strategy
Committee, a committee consisting of the most senior officers of
FNBC, including the chairman, the president, the chief financial
officer, the chief credit officer, and the chief economist.
40
FNBC also referred to the CRESCO loss reserve factor as
the loan loss reserve factor.
41
For example, if the counterparty had a credit rating of
2, the corresponding CRESCO loss reserve factor during most of
1993 was .05 percent. Therefore, if a swap with this
counterparty had a CEM of $1 million, the swap’s initial credit
adjustment would be $500 (0.05% x $1 million).
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lag)42 and correspondingly reduced the value of assets on the
balance sheet. Second, FNBC amortized the credit adjustment back
into income on a straight-line basis. FNBC’s stated policy was
that, on schedules before June 1993, it would amortize the credit
adjustments into income over the average term of deals executed
during the quarter for the applicable product.43 For June 1993
and after, FNBC’s stated policy was that it would amortize the
credit adjustments into income over the weighted average term of
deals executed during the quarter for the applicable product in
the quarter. FNBC actually computed the weighted average term
for the applicable product only in the fourth quarter of 1993.
For the remaining quarters of 1993, FNBC calculated the weighted
average term for all products combined.
b. Effect of Methodology
Under FNBC’s procedure, the credit adjustments for swaps
with shorter-than-average lives, relative to others originated in
the same quarter, were amortized into income over a longer term
than the life of the swap. The converse was true for swaps with
longer-than-average lives. For example, as to the first point,
FNBC had a swap with an individual amortization period of 4
42
The December 1993 credit adjustment to the swap portfolio
did not include 32 swaps that FNBC actually originated in
December 1993. The inclusion of those swaps would have added
$106,769 to the credit adjustment calculation.
43
Examples of FNBC’s applicable products were interest rate
derivatives, currency derivatives, and foreign exchange options.
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quarters that FNBC amortized into income over 10 quarters. As to
the second point, for example, FNBC had a swap with an individual
amortization period of 56 quarters that FNBC amortized into
income over 10 quarters.
B. Swaps in Issue for 1993
1. Identification of Swaps
For purposes of its 1993 credit adjustment calculations,
FNBC treated 488 swaps as commencing in 1993. These swaps are
identified as follows:
Number Outstanding Number Treated As
Category At Yearend 1993 Commencing in 1993
IRSWs 1,147 387
CYSWs unknown 67
COMSs 52 18
COMBs unknown 16
488
2. Duration of Swaps
The 488 FNBC swaps had specific durations as follows:
Duration in Duration in Duration in
Months Number Months Number Months Number
1 17 26 8 54 2
2 3 27 3 57 2
3 8 28 2 59 3
4 3 29 6 60 36 or 37
5 3 30 5 61 1
6 11 31 2 63 2
7 3 32 3 65 1
8 4 33 3 70 4
9 11 35 7 72 1
10 3 36 53 or 54 78 1
11 1 37 3 79 2
12 78 38 3 83 2
13 1 39 1 84 16
15 1 42 5 85 1
17 1 43 1 89 1
18 9 45 5 90 1
19 3 46 1 119 2
20 9 47 1 120 4
21 6 48 16 124 2
22 6 49 1 168 2
23 7 51 1 173 1
24 81 52 1 Total 488
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3. Credit Adjustments Claimed
For 1993, FNBC calculated per-swap credit adjustments with
respect to 418 of the 488 swaps. The amount of the credit
adjustment calculated by type of swap was as follows:
Category Number Credit Adjustment
IRSW 387 $718,978
CYSW 67 100,884
COMS 18 7,782
COMB 16 154,351
Total 488 981,995
In 1993, FNBC decreased its swap values reported for 1993 by
credit adjustments totaling $981,995. Of the 488 swaps, (1) 9
were a risk class 1 and had a credit adjustment totaling $6,764;
of these, 8 were interest rate swaps, with a combined credit
carveout of $6,235; (2) 179 were a risk class 2 and had a credit
adjustment totaling $257,654; of these, 135 were interest rate
swaps, with a combined credit adjustment of $102,311; (3) 26 were
currency swaps with a combined credit adjustment of $11,197; (4)
9 were combination swaps with a combined credit adjustment of
$141,527; (5) 8 were commodity swaps with a combined credit
adjustment of $1,498; and (6) 1 was a swaption with a credit
adjustment of $1,121.
As to the total credit adjustment of $981,995: (1) $93,203
arose from transactions that were not in existence on
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December 31, 1993;44 (2) $264,418 arose from transactions with
counterparties rated AA or better; (3) $94,421 arose from swaps
that had a tenor of 9 months or less;45 (4) $167,109 arose from
swaps on which FNBC did not expect to be the net receiver of
cash; and (5) at least $6,338 arose from swaps that were known to
have the risk of nonpayment of cashflows offset, in full or in
part, by other swaps with the same counterparty.
When FNBC reported credit adjustments on swaps where it had
more than one swap with the same counterparty, FNBC did not check
to see whether the swaps were mirror or partially offsetting
swaps. Credit risk credit adjustments should not be taken on
mirror swaps. Credit risk also is reduced on partially
offsetting swaps.46
44
Of the 488 swaps, 55 had a stated maturity of on or
before Dec. 31, 1993, and 47 of them terminated on or before
Dec. 20, 1993. For 1993, the initial credit adjustments claimed
for those 55 swaps totaled $93,203.
45
Sixty-three of the 488 swaps had tenors of 9 months or
less. No credit adjustment was claimed on 12 of these 63 swaps.
FNBC reported initial credit adjustments totaling $94,421 on the
remaining 51 transactions and amortized those adjustments over
the following periods:
Quarter of Amortization
Deemed Origination Period (months)
1st 39
2d 33
3d 45
4th 90
46
A partially offsetting swap is a swap that offsets, in
(continued...)
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C. Components of the Second Method
The three components that entered into the calculation of
FNBC’s initial credit adjustment under the second method were
the: (1) CEM amount, (2) credit risk class rating, and (3)
CRESCO loss reserve factor. Each of these components was
developed separately and independently for purposes other than
valuation and was not used in combination with the other two
components for any other business purpose. FNBC developed the
CEM amount to measure credit exposure for purposes of risk
management and banking regulatory requirements. FNBC developed
the risk class system for commercial loan purposes to evaluate
the creditworthiness of a borrower. FNBC developed the CRESCO
loss reserve factors to meet banking regulatory requirements on
loss reserves and capital adequacy requirements.
1. CEM Amount
a. Overview
Expected cashflows from an interest rate swap can vary as
interest rates change. When the expected cashflows from a swap
change, the credit exposure of one counterparty to the other
counterparty usually changes. FNBC’s CEM amount statistically
measured FNBC’s maximum potential loss (and not expected
exposure) on a swap, over its tenor and at a preselected cutoff
46
(...continued)
part, the market and credit risk of another swap.
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number (confidence level), if the counterparty to the swap were
to default without recovery by FNBC. The CEM amount at the
inception of a swap was significantly higher than the current
exposure at the inception of the swap; i.e., the CEM amount was a
measure of the maximum that FNBC might receive (lose) on the swap
in the future, within a certain confidence level, while the
current exposure was a measure of the current value of the swap.
During the relevant years, FNBC ascertained its CEM amounts
for financial derivatives by using a system called the VEP
system. FNBC’s VEP system recalculated the CEM amount at least
annually. For transactions where the mark-to-market amount
exceeded the CEM amount, the CEM amount was recalculated monthly.
FNBC calculated the CEM amount for all swaps. A swap that had a
negative value (FNBC was the net payor) always had a CEM amount
that was greater than zero.
b. Hsieh Model
FNBC’s initial VEP system was developed for it in the late
1980s by David A. Hsieh (Hsieh). Hsieh designed FNBC’s VEP
system for risk management purposes to measure credit exposure on
interest rate and currency products in a manner consistent with
the rules of the FRB. The VEP system was designed specifically
for products with a tenor greater than 18 months and had problems
calculating the CEM amount for swaps with shorter maturities.
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FNBC had retained Hsieh in 1987 to develop for it a model to
measure credit exposure for interest rate and currency swaps. In
1988, Hsieh produced a paper which described the model (Hsieh
Model) that he developed for FNBC. The Hsieh Model used
quarterly historical interest and exchange rates, and the
resulting volatilities, correlations, and covariance, to perform
a Monte Carlo simulation to estimate a distribution of 10,000
possible outcomes for each quarter throughout the term of a given
swap. Hsieh developed two programs for FNBC in 1988. The first
program used the simulation model on an individual transaction
basis. The second program used the same statistical model but
did multiple transactions with the same counterparty and took
into account the netting of offsetting transactions with the same
counterparties. FNBC did not during the relevant years use the
second program.
c. FNBC’s VEP System
i. Evolution of the System
FNBC’s VEP system during the relevant years had evolved from
the initial version designed by Hsieh. Each version of FNBC’s
VEP system was based upon the Hsieh Model. The first versions
were formulated on tables and were not accessible to traders via
direct computer link; i.e., on line. The first table version was
a table of values at different confidence levels. The second
table version was a series of tables by product, maturity, and
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confidence level. Each of the table versions produced the
maximum number within the chosen confidence level.
The next series of versions of the VEP system were on line.
The first version of the on-line system allowed traders to pull
up information on their screens. Traders input details of trade,
and the machine calculated the exposure numbers based upon the
tables then in use. The resulting CEM amount was then added to
the customer’s existing credit exposure. During 1993, traders
could for purposes of discussions have used tables to calculate
the CEM amount or they could have gone on line. For actual
transactions, FNBC preferred that the traders and marketers use
the on-line system.
ii. Effect of the System
FNBC’s VEP system allowed traders and marketers to do
business without going to the credit department if a VEP credit
limit had been established for that customer and if the new swap
would not exceed that credit limit. It allowed FNBC to move away
from each swap’s being individually approved by the credit
department.
The VEP system permitted the establishment of VEPLs, under
which multiple VEP transactions with the same counterparty were
permitted as long as the VEPL was not exceeded. A VEPL was
required to be renewed at least annually. Once a VEPL was
approved, traders and marketers could conduct transactions with
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the approved counterparty without additional approval from the
credit management area so long as the credit exposure for the
transaction did not exceed the VEPL at the time the transaction
was initiated. This system enhanced the ability of FNBC to
determine whether sufficient credit limits were available to do
new transactions.
VEP transactions could also be approved deal by deal with
counterparties that had availability under existing Internal
Guidance Limits (IGLs) approving business with the customer.
FNBC’s IGL was an internal preapproved agreement on the amount of
credit capacity FNBC would make available to a customer and how
it was to be allocated among types of transactions, e.g., loans
or letters of credit. The VEPL was an allocation of part of the
IGL to financial derivative transactions with a customer.
iii. System’s Operation
FNBC’s VEP system could calculate the credit exposure for
many types of financial derivatives, including interest rate
swaps, currency swaps, commodity swaps, FRAs, interest options,
currency options, and long-term foreign exchange. The VEP system
generally employed a Monte Carlo simulation model using 10,000
potential variations of quarterly interest rates over the
remaining term of each swap and produced a distribution of 10,000
amounts representing values/credit exposures at any future
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date.47 In order to translate this plethora of numbers
characterizing the exposure into a single number, FNBC selected
and applied an 80-percent confidence level during the relevant
years to ascertain a maximum credit exposure through time for
this confidence level.48 The CEM amount was useful for risk
management purposes in that it alerted management when a
portfolio’s potential exposure was increasing, it identified the
portions of the portfolio with the greatest exposure, and it
allowed management to identify the most potentially dangerous
swaps for special attention. The CEM amount was not an accurate
price of credit risk and was inappropriate for pricing or
valuation.
FNBC’s VEP system overstated FNBC’s credit exposure in that
the system did not consider collateral and other security or the
offsetting losses with the same counterparties based on legally
enforceable termination and netting rights. FNBC reported this
deficiency in its 1993 annual report. That report acknowledged
that credit exposure amounts might be overstated since those
amounts did not take into account collateral, other security, or
termination and netting rights.
47
The important characteristics of the distribution of
possible outcomes of some swaps could be calculated directly and
did not require a Monte Carlo simulation.
48
Initially, FNBC calculated the CEM amounts at a
95-percent confidence level but reduced that level to 80 percent
in 1989.
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2. Credit Risk Ratings
a. System of Risk Classification
Like most banks, FNBC had during the relevant years a
well-established system of evaluating and classifying credit
risks. FNBC used this system for all transactions including
loans, swaps, and any of its other products. FNBC’s credit
officers established a customer’s risk class rating on the basis
of FNBC’s evaluations of the creditworthiness of the customer and
the industry in which the customer did business. FNBC re-rated
its customers at least annually. FNBC’s credit officers were
independent of the business units responsible for originating
transactions.
FNBC’s credit risk classification system used numbers from 1
to 9. Risk class 1 was the best credit quality and carried with
it minimal risk. Risk class 9 was the worst credit rating and
was considered to be a loss. Risk classes 1 through 3 were
considered investment grade,49 counterparties in risk class 4
were generally considered to be acceptable bank quality assets
which required greater management attention, and counterparties
in risk class 5 were considered undesirable. FNBC did not enter
49
The finance department performed the credit adjustment
calculation on spreadsheets. The CEM amounts and credit ratings
shown on the spreadsheets were derived from information provided
by the credit department. If the risk class rating was not
provided by the credit department, the finance department would
use a risk class 3 rating. The finance department did not always
use the most current risk factors.
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into swaps with counterparties in a risk class lower than 5.
FNBC generally asked for collateral for counterparties in risk
class 4 or 5.
FNBC’s risk class ratings generally corresponded to the S&P
public debt ratings. Under FNBC’s risk classification system,
FNBC’s risk class ratings were listed as approximately equivalent
to the following S&P ratings:
Risk class S&P rating
1 AAA or AA
2 AA or A
3 A or BBB
4 BB or B+
5 B+ or B
The credit classes of the counterparties to the 488 swaps at
issue for 1993 were as follows:
Risk class Counterparties
1 47
2 192 or 193
3 200 or 201
4 45
5 3
FNBC’s internal risk class rating for itself was downgraded from
risk class 2 to risk class 3 at some point during the relevant
years because of bad performance.
b. Credit Procedures
FNBC used the same credit evaluation and risk classification
procedures for swaps as it used for loans and other transactions
involving the extension of credit. FNBC assigned risk class
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ratings to the facilities of a customer.50 The credit officers
assigned a risk class rating to each facility with each
customer.51 The rating would reflect not only the
creditworthiness of the customer, but also the risks associated
with a particular transaction. Risks included the tenor of the
swap, the industry in which the customer did business, and the
creditworthiness of the customer. The risk classification rating
for a facility could take into account the presence of various
credit enhancements supporting the transaction, such as a pledge
of collateral or a guaranty. Tax considerations were not taken
into account when assigning credit ratings.
FNBC had a systematic procedure for determining the risk
classification ratings. Before a new facility could be approved
(and at least annually thereafter), the credit officers would
review the customer’s financial statements, news reports, public
debt ratings, and other information, and would meet with the
relationship manager. For customers that were large enough to
use swaps, there would typically be at least three people from
the credit department involved in the evaluation: A credit
50
A facility was a written document entitling FNBC to enter
into credit business with a customer up to a stated maximum
amount of exposure.
51
A swap counterparty could have more than one rating in
that (1) the counterparty could have more than one facility and
(2) different facilities with a single customer could be rated
differently.
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analyst (who would compile the information and prepare a written
analysis), a junior credit officer, and a senior credit officer.
The credit officers also would consult with the relationship
managers and marketers before assigning a risk classification.
FNBC’s credit officers set a potential counterparty’s risk
class rating by first referencing the counterparty’s public debt
rating. FNBC could rate a counterparty differently than its
public debt rating but generally did not give the customer a risk
class rating higher than its public debt rating.
c. Review of Risk Classifications
FNBC regularly reviewed the credit ratings of its customers.
Credit officers and relationship managers would regularly review
the customer’s financial statements and news reports relating to
the customer and would hold discussions with the customer.
Reviews would also occur each time the customer sought additional
credit which was not covered by established credit limits.
Formal credit reviews of each customer would occur at least
annually.
The credit risk classifications were reviewed both
internally and externally. Internally, a unit of the bank known
as “Credit Process Review” (CPR) would review the ratings
assigned by the credit officers and the thoroughness of their
analysis. CPR did not always agree with the ratings and the
analysis of the credit officers and would sometimes upgrade or
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downgrade the risk class ratings. Externally, the OCC’s bank
examiners would review certain of the risk class ratings assigned
by FNBC, particularly those assigned to major credits. The OCC
did not review all risk class ratings assigned, and the OCC did
not always agree with the risk class rating assigned by FNBC.
3. CRESCO Loss Reserve Factors
a. Loss Reserves
Banks were required to establish loss reserves for expected
credit losses. These reserves were ascertained for each
transaction by applying the following three factors: (1) The
expected credit exposure, (2) the probability of default by the
counterparty, and (3) the percentage of loss in the event of
default by a counterparty.
b. CRESCO
CRESCO was FNBC’s overseer with respect to credit risk
appetite, its credit risk policies and procedures, and the
portfolios of credit risk that resulted from its activities. For
each risk classification, FNBC established a CRESCO loss reserve
factor to estimate its rate of credit losses for financial
accounting and everyday business purposes. This factor was
reviewed periodically by CRESCO.
The determination of the CRESCO loss reserve factor involved
many subjective estimates and business judgments. The loss
reserve factor was based on historical commercial loan loss
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experience, including real estate loans for certain periods at
issue. Management judgment also was applied to evaluate whether
past experience was likely to be an effective guide to future
loss experience for commercial loans in light of changes in
procedures or underwriting standards.
The CRESCO loss reserve factors were not determined with a
view toward using those factors for valuation purposes or in
calculating a credit adjustment. The CRESCO loss reserve factors
were used by FNBC in assessing the adequacy of its loan loss
reserves. Loan loss reserves were the amounts set aside for
credit losses that FNBC incurred in the ordinary course of
business. FNBC’s allowance for loan loss reserves contained no
specific accrual for swap credit risks.
c. Accuracy of CRESCO Loss Factors
In August 1992, CRESCO adopted the following loss reserve
factors for non-real-estate transactions (e.g., a swap):
Risk rating Reserve Factor
1 0.00%
2 0.05
3 0.25
4 0.45
5 1.60
Before that time, the loss reserve factors for non-real-estate
transactions were:
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Risk rating Reserve Factor
1 0.05%
2 0.10
3 0.20
4 0.75
5 1.50
In calculating swap credit adjustments, FNBC did not commence
using the new factors until the second quarter of 1993.
d. Same Factors Applied to Loans and Swaps
FNBC (and other banks) used the same loss reserve factors
for swaps as it used for loans. Swaps were considered to be less
risky than loans by FNBC’s traders and legal department. By
virtue of the ISDA form agreements, FNBC’s legal department
believed that swaps allowed for protection superior to loans
against bankruptcy stays. The ISDA form agreements also provided
for netting; i.e., as discussed infra p. 142, the right of a
nondefaulting party to offset transactions in the event of a
counterparty default. Most of FNBC’s ISDA form agreements also
provided for other credit enhancements, such as cross-default and
other credit triggers. FNBC also had collateral for many of its
swaps in addition to the credit enhancements and netting
provisions.
e. FNBC’s Credit and Tenor Enhancements
FNBC used credit and tenor enhancements to reduce credit
risk on its swaps. In the case of at least some counterparties
considered by FNBC to be risks, FNBC reduced the tenor limit for
swaps with that counterparty, required that the counterparty
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agree that its swaps with FNBC would be terminated early if the
counterparty’s public debt rating was downgraded to below
investment grade, required the counterparty to secure its
performance mainly by establishing a debt service reserve
account, or did all of these things. In at least one other case,
FNBC required that the counterparty agree to maintain:
(1) Adequate books under GAAP and, in certain cases, to permit
FNBC to inspect and audit its books, inventory, and accounts;
(2) certain levels of tangible net worth; (3) certain cashflow
coverage ratios; and (4) certain interest coverage ratios. The
counterparty also had to agree: (1) To maintain a certain
capitalization ratio; (2) not to engage in any business
operations substantially different from and unrelated to its
present business activities; (3) not to create, assume, or suffer
any liens, except certain permitted liens; (4) not to liquidate,
dissolve, or enter into any merger, or sell, transfer, assign, or
otherwise dispose of assets in a single transaction or series of
transactions, except, generally, in the ordinary course of
business; (5) not to make any acquisitions except under the terms
set out in a revolving credit agreement; (6) not to enter into
certain operating leases; (7) not to prepay, defease, refinance,
or repurchase certain indebtedness; and (8) not to enter into
certain inventory repurchase agreements.
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D. Static Instead of Dynamic Procedure
FNBC used a static rather than dynamic procedure to
ascertain its credit adjustment. With a static procedure, the
credit adjustment for each swap is calculated once, usually at
the inception of the swap, and then amortized on a straight-line
basis. With a dynamic procedure, the credit adjustments for each
swap are redetermined periodically over the life of the swap, on
the basis of a new calculation of the loan equivalent amounts and
taking into account changes in credit ratings, market conditions,
and other developments. FNBC’s static methodology for
calculating the credit adjustment did not account for changes in
interest rates, credit quality, credit exposures, or credit risk
ratings. Nor did it account for early terminations or subsequent
chargeoffs.
FNBC’s practice of straight-line amortization instead of
revaluing the credit risk is inconsistent with the G-30 report’s
suggestion to adjust a credit adjustment dynamically. The cases
in which one might expect a credit adjustment to be sizable
(e.g., after the inception of a swap, when the fair market value
could most likely deviate the most from midmarket value) are the
very cases that are not captured in a static valuation system. A
dynamic approach must be used to capture the actual market value
of credit risk at a date later than the inception of a swap.
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E. Netting
1. Types of Netting
a. Closeout Netting
When a dealer has several swaps with a single counterparty,
it is common for some of the swaps to have positive value and for
others to have negative value. If the counterparty were to
default, it would owe money to the dealer with respect to some
swaps, and the dealer would owe money to the counterparty with
respect to other swaps. In the event of a bankruptcy proceeding,
a dealer would want to offset the positive-valued swaps against
the negative-valued swaps. Otherwise, the dealer might have to
pay in full its obligations to the counterparty on the negative-
valued swaps, while possibly receiving little or no payment on
the positive-valued swaps. Such a right of setoff is called
closeout netting.
Closeout netting is an enforceable right, and market
participants placed significant stress on the use of netting
agreements. Closeout netting occurs where the counterparties
agree that, in the event of a default or triggering event, all
contracts between the counterparties will be terminated at the
option of the nondefaulting party, and the reciprocal claims
under the contracts will be netted. By facilitating closeout
netting and its legal enforceability, the ISDA form agreements
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lowered credit risk because the parties could take advantage of
offsetting transactions in the event of counterparty default.
For purpose of determining the closeout netting price, the
1992 ISDA form agreement allowed two methods of ascertaining the
closeout netting settlement amount. The first method was the
“Market Quotation” method. The second method was the “Loss”
method. Neither method provided specifically that the settlement
amount should take into account the credit risk of the
counterparty or administrative costs.
b. Single Transaction Netting
The ISDA form agreements provided that payments in the same
currency and with respect to the same swap were automatically
netted. This type of netting is known as single transaction
netting.
c. Multiple Transaction Netting
The ISDA form agreements provided that the parties could in
certain circumstances elect a net amount that would be payable
for two or more transactions. This type of netting is known as
multiple transaction netting. Multiple transaction netting
applied where the payments on more than one swap with the same
counterparty were due on the same day and in the same currency.
2. Netting in the Industry
During the relevant years, netting was commonly available to
estimate current exposure, and market participants placed
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significant stress on the use of netting agreements. The OCC
also encouraged the use of netting agreements. As part of the
credit approval function, the OCC expected credit officers to
assess the availability and impact of credit exposure reduction
techniques such as netting.
Pursuant to BC-277:
In order to reduce counterparty credit exposure, a
national bank should use master close-out netting
agreements with its counterparties to the broadest
extent legally enforceable, including in any possible
insolvency proceedings of such counterparties. * * *
* * * * * * *
The advantages of such netting arrangements include a
reduction in credit and liquidity exposures, the
potential to do more business with existing
counterparties within existing credit lines, and a
reduced need for collateral to support counterparty
obligations. * * *
3. Status of Netting Arrangements
Before 1990, prior law arguably allowed a U.S. bankruptcy
trustee or liquidator either to accept or to repudiate individual
contracts among a portfolio of financial derivatives, depending
on their profitability to the bankrupt party. The trustee or
liquidator could arguably enforce only those swaps that had
positive value.
In 1990, Congress amended then 11 U.S.C. section 362(b)(14)
(now section 362(b)(17) (2000)) and added to the Bankruptcy Code
11 U.S.C. section 560 to limit a bankruptcy trustee’s avoidance
powers. These sections exempted swap agreements from the
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automatic stay and permitted swap participants to net positions
in the setting of a bankruptcy. Congress passed the Federal
Deposit Insurance Corporation Improvement Act of 1991 (FDICIA),
Pub. L. 102-242, 105 Stat. 2286, 1 year later. Under 12 U.S.C.
sections 4401-4407 (2000), which were enacted as part of the
FDICIA, netting provisions are viewed by the CFTC as designed to
assure the enforceability of netting among specified financial
institutions and among members of clearing organizations for
CFTC-regulated exchanges. By enacting the FDICIA, and the
Financial Institutions Reform, Recovery, and Enforcement Act of
1989, Pub. L. 101-73, 103 Stat. 277, each applying to failed
depository institutions, Congress reduced systemic risk by
providing a high degree of legal certainty that netting
provisions would be upheld in insolvency proceedings in the
United States.
In the case of a foreign entity counterparty, netting was
not always enforceable. Of the 488 swaps at issue for 1993, 173
were with foreign counterparties. Of those 173, 119 were with
counterparties that hailed from countries which the G-30 report
concluded had enforceable netting arrangements.52 Of the
52
The G-30 report referenced legal memoranda prepared by
counsel familiar with the laws of nine countries discussing
issues of enforceability in Australia, Brazil, Canada, England,
France, Germany, Japan, Singapore, and the United States. In
each case, netting arrangements were considered by counsel to
almost certainly be enforceable in bankruptcy or insolvency
(continued...)
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remaining 54 swaps (173 - 119), 9 were with counterparties that
did not ultimately hail from a G-10 or European Union country.
Many, if not most, of FNBC’s swaps with foreign counterparties
were with other dealers, who while not subject to U.S. bankruptcy
laws, were extremely well capitalized and were most unlikely to
default on their obligations.
4. Practicability of Accounting for Netting
If a dealer had a legally enforceable netting agreement with
a counterparty, then it would be preferable for the dealer to
calculate the credit exposure for all of the swaps with the
counterparty on an aggregate (i.e., netted) basis. This was the
recommendation of the G-30 report. During the relevant years,
FNBC was capable of measuring credit exposure on an aggregate
(netted) basis by way of the program designed for it by Hsieh in
1988.
5. Impact of the Failure To Account for Netting
FNBC’s failure to account for netting produced large and
systematic biases. FNBC’s failure to take netting into account
produced substantial large exposures that were larger than the
actual risks under the individual agreements.
52
(...continued)
proceedings.
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6. FNBC’s Use of Netting Provisions
FNBC went to great lengths to include netting provisions in
all its swap agreements, and most of FNBC’s swaps were subject to
enforceable netting agreements.
XII. FNBC’s Adjustments Were Designed To Defer Income
A. Overview
FNBC’s credit and administrative costs adjustments were
designed to defer expenses to match income, not for valuation
purposes. FNBC’s adjustments were made to defer its compensation
and to allocate the compensation over the life of the swap.
B. FNBC’s Policy Statements
FNBC’s policy statement on credit adjustments for swaps was
contained in FNBC’s draft Financial Accounting Policies Manual
(FAPM) No. 397. FAPM 397 characterizes credit adjustments as
deferral accounting to prevent all income from being recognized
up front. According to that document: “By marking-to-market VEP
transactions at the mid-point between market bid and offer, all
income that results from the bid/offer price differential would
be recognized at the inception of the transactions, unless
deferral accounting is used to properly recognize certain
income.” Thus, as to the credit adjustment, “An appropriate
amount of income is calculated and deferred at the inception of
each VEP transaction * * * to provide for compensation for
inherent credit risk over its life.”
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On July 23, 1993, FNBC’s Control Department issued FAPM 396,
entitled “Nonperforming Variable Exposure Product
Transactions”.53 In relevant part, this document established the
policies for dealing with a swap (or other variable exposure
product) if the counterparty had not made a payment which FNBC
had an unqualified right to receive. According to FAPM 396,
FNBC’s policy was to account for swaps with a past due periodic
payment using a “‘modified’ lower of cost or market”. FAPM 396
stated further that changes in the value were recognized in the
applicable trading profits account currently as losses or gains
(only to the extent of prior losses). FAPM 396 further stated
that the modified lower of cost or market accounting treatment
might occur when (1) payment that FNBC had an unqualified right
to receive had not been made when due and (2) it had been
determined that the contract is nonperforming.
XIII. FNBC Had No Schedule M Adjustments
There were no Schedule M adjustments on FNBC’s tax returns
with respect to swaps booked through FNBC.
XIV. Nature and Amount of the Proposed Disallowances
The audit of FNBC’s 1990 and 1991 taxable years commenced in
December 1992. The assigned agent’s focus during the audit was
53
A contract was considered “nonperforming” if it was
determined that a counterparty would probably not fulfill its
cashflow (or other exchange) obligation under the terms of the
contract.
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set primarily on FNBC’s accounting for swaps and other notional
principal contracts. The agent proposed to disallow the credit
and administrative costs adjustments taken by FNBC. The notice
of proposed adjustment (Form 5701) and attached explanation of
items (Form 886-A) justified the disallowance on the ground that,
by reflecting such adjustments, “FNBC is, in effect, taking a
current deduction from taxable income for expenses which, for the
most part, will be incurred in future taxable years”.
Respondent’s notices of deficiency disallowed the amounts shown
therein with respect to the credit and administrative costs
adjustments because the “carve-out expenses does [sic] not
clearly reflect income in accordance with section 446 of the
Internal Revenue Code”.
XV. Petitioner’s Facts Set Forth in Its Petition
As relevant herein, petitioner’s petition set forth the
following facts to support its allegations of error as to 1990
and 1991:
(s-1) One of the ways that the Bank [FNBC] makes a
profit by selling or purchasing an interest rate swap
contract is through its ability to purchase a swap at
the lower bid price and sell the swap at the higher
offer price while its customers must purchase a swap at
the higher offer price and sell it at the lower bid
price.
(s-2) The compensation that results from the
bid/offer rate differential should neither be all
currently recognized in income at the inception of a
swap, nor all deferred over the life of a swap.
Instead swap compensation should be allocated between
current and deferred income recognition based on when
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it is earned, (i.e., a portion up front and a portion
over time). Based on an analysis of what the bid/offer
rate differential represents, the Bank values its swap
contracts using the mid-point between market bid and
offer rates. The difference between this valuation and
a bid or offer price paid or received by the Bank is
treated as deferred income designed to provide
compensation for inherent credit risk and periodic
administrative costs related to the swaps.
(s-3) The basis for making an allocation between
current and deferred income recognition is that a
reasonable estimate can be made of the amount allocable
to the inherent credit risk and periodic administrative
costs associated with the swap transaction.
(s-4) At the inception of each swap, the Bank
defers an appropriate amount of income to account for
inherent credit risks and periodic administrative costs
related to the swap. The amount deferred to account
for interest credit risks is determined by multiplying
the Credit Strategy Committee’s (CRESCO) loss reserve
factor times the credit exposure amount of the swap.
The result is restated as a per annum credit deferral
and is deferred via the swap revaluation process. The
Bank revalues interest rate swaps which are used in
trading strategies to market value at least once a
month. The per annum credit deferral is recognized in
income on a straight line basis over the life of the
swap agreement. The rationale for the income deferral
for the inherent credit risk is to defer an appropriate
amount of income to match compensation paid to assume
credit risk over the period of the risk.
(s-5) An additional amount of income is deferred
on the entire swap portfolio to match compensation paid
to assume periodic administrative costs.
Administrative costs include an allocation of direct
and indirect expenses of the swap management, trading
and operations areas.
Petitioner’s petition as to 1993 also set forth facts in
support of its allegations of error as to that year. In relevant
part, petitioner’s petition for 1993 repeated the facts set forth
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in the first five paragraphs above (but did so using the letter
“c” instead of “s”).
XVI. Pretrial Order of August 14, 2000
On August 14, 2000, the Court issued the following pretrial
order:
For cause, it is
ORDERED that each of the parties shall file no
later than September 5, 2000, a memorandum [issues
memorandum] setting forth--
(1) (a) The issues of fact (including
any issues subsidiary to ultimate issues) and (b) the
issues of law (including any issues subsidiary to
ultimate issues) to be resolved by the Court. Such
issues should be set forth in sufficient detail to
enable the Court to decide the case in its entirety by
addressing each of the issues listed.
(2) A clear, complete, and concise
exposition of each party’s position and the theory
underlying that position with respect to each of the
issues that are set forth pursuant to (1) above. In
this regard, each party shall include a statement in
narrative form of what each party expects to prove.
(3)(a) an indication as to whether
expert witness testimony is anticipated, (b) the nature
of the expert witness testimony, if any, and (c) the
questions the parties are expecting to ask the witness
on which to opine.
It is further
ORDERED that the statement of issues set forth
pursuant to (1) above shall control the admissibility
of evidence at trial and evidence offered at trial will
be deemed irrelevant unless it pertains to one or more
of the issues set forth pursuant to (1) above. It is
further
ORDERED that neither party will be allowed to
advance a position or theory underlying that position
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with respect to any of the issues set forth pursuant to
(1) above that is different from the positions or
theories set forth pursuant to (2) above.
On September 5, 2000, each party filed with the Court an issues
memorandum.
XVII. Expert Testimony
At trial, each party called expert witnesses in support of
its and his respective position. In addition, the Court for the
first time appointed its own experts under rule 706 of the
Federal Rules of Evidence to testify as to the relevant subject
matter.
A. Identity and Qualifications
1. Experts Retained by Petitioner
Petitioner presented the testimony of two experts, Charles
Smithson (Smithson) and Robert P. Sullivan (Sullivan). Smithson
was qualified by the Court as an expert in financial economics,
financial derivative products, and risk management. He has a
Ph.D. in economics from Tulane University and is the managing
partner of a financial consulting firm specializing in risk
management. He is affiliated with the ISDA and served for a
number of years as a director on its board. His concentration is
in the management of financial risk, and he has written a number
of books and articles on that subject.
Sullivan was qualified by the Court as an expert in
financial derivatives, including the generally accepted
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accounting standards for financial derivatives, the valuation of
financial derivatives, and the risk management of financial
derivatives. He is a partner in one of the large multinational
accounting firms, and he specializes in the accounting treatment
of financial derivatives. He has a bachelor of science degree in
business administration from Merrimack College and is a certified
public accountant in Massachusetts and New York.
2. Experts Retained by Respondent
Respondent presented the testimony of three experts:
Patricia O’Brien (O’Brien), John Parsons (Parsons), and Owen
Carney (Carney). O’Brien was qualified by the Court as an expert
in accounting. She holds a bachelor’s degree cum laude in
mathematics and economics from Cornell University and an M.B.A.
and a Ph.D. in accounting and econometrics from the University of
Chicago. She is a professor of accounting at the University of
Waterloo and has also taught at the University of Rochester, the
Massachusetts Institute of Technology, the University of
Michigan, the University of Chicago, the University of Helsinki,
and the University of Amsterdam. She has chaired the accounting
group at London Business School, coauthored a book on accounting,
and served on the editorial boards of the Accounting Review and
the Journal of Accounting and Public Policy.
Parsons was qualified by the Court as an expert in financial
economics, valuation, financial derivatives, and risk management.
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He holds a bachelor’s degree in economics from Princeton
University and an M.B.A. and a Ph.D. in economics from
Northwestern University. He is employed as a vice president with
an economics consulting firm, where a significant part of his
consulting work on risk management has focused on the calculation
of discount rates that measure the risk of particular assets and
the valuation of assets. He has worked as an expert for the
FRB’s Board of Governors and the International Trade Commission.
He has published articles on hedging and liquidity in
publications such as Derivatives Quarterly and Risk Magazine.
Carney was qualified by the Court as an expert in the manner
in which the OCC regulates national bank activities, including
financial derivatives, and the particular manner in which the OCC
regulates financial derivatives. He worked for many years in the
OCC and was trained and worked as a lead national bank examiner
for the OCC (this involved a 4- to 5-year on-the-job training
process and testing before he could be an examiner-in-charge of
OCC bank audits as a commissioned national bank examiner). He
has served as the Chief of the OCC investment securities
division, worked on the task force that drafted a banking
circular, drafted sections of the OCC’s handbook on bank
securities dealers activities, and been responsible for OCC
policy development relating to national banks’ financial
derivatives activities.
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3. Experts Appointed by the Court
The Court-appointed experts are J. Darrell Duffie (Duffie)
and Barry S. Sziklay (Sziklay). Duffie was appointed by the
Court as an expert in the field of financial economics and
financial derivatives. He holds a Ph.D. in engineering systems
from Stanford University, a master’s of economics (economic
statistics) from the University of New England (Australia), and a
bachelor’s of science in engineering from the University of New
Brunswick (Canada). He is employed as the James Irvin Miller
Professor of Finance at Stanford University’s Graduate School of
Business, where he teaches courses in the doctoral, executive,
and MBA programs and has been a member of Stanford’s finance
faculty since 1984. He teaches and conducts research in various
subject areas, including the market valuation of securities, and
he spends a significant portion of his teaching and research
focusing on the market valuation and management of credit risk.
He has consulted and written a multitude of articles and books on
subjects related to financial derivative securities, fixed-income
pricing, risk management, and credit risk.
Sziklay was appointed by the Court as an expert in the field
of fair market value and GAAP. He holds a bachelor’s degree in
accounting and economics from Queens College and is a certified
public accountant in New York, New Jersey, and Florida. His
practice focuses on business valuation, and he has a specialty
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designation in business valuation issued by the American
Institute of Certified Public Accountants. He has spoken and
written on the topic of business valuation.
B. Procedure Used by the Court To Appoint Our Experts
As mentioned above, the Court for the first time appointed
experts under rule 706 of the Federal Rules of Evidence. In so
doing, the Court generally followed the following procedure.
First, in September 2000, before the commencement of trial, the
Court informed the parties’ counsel that we believed that:
(1) The cases involved a significant, complex, and novel
big-dollar issue that was widespread in the financial industry
and (2) in deciding this issue, it would be helpful to the Court
to obtain opinions from one or more experts appointed by the
Court under rule 706 of the Federal Rules of Evidence.54
One week later, the Court met with counsel to discuss the
mechanics of retaining one or more Court-appointed experts. At
that time, the Court suggested to counsel that: (1) They could
provide to the Court either separate lists or a joint list of
potential experts or (2) the Court could conduct its own
54
The Court noted that we have become all too accustomed to
hearing testimony elicited from experts that merely followed the
litigating position of the retaining party and lacked any true
benefit to the Court. E.g., Neonatology Associates, P.A. v.
Commissioner, 115 T.C. 43, 86-87 (2000), affd.
299 F.3d 221
(3d Cir. 2002); Auker v. Commissioner, T.C. Memo. 1998-185;
Estate of Mueller v. Commissioner, T.C. Memo. 1992-284; Jacobson
v. Commissioner, T.C. Memo. 1989-606; cf. Laureys v.
Commissioner,
92 T.C. 101, 129 (1989).
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investigation into potential experts. The parties agreed that
the Court should conduct its own investigation. Subsequently,
the Court, with the permission of the parties, compiled a short
list of potential experts that might be suitable for Court
appointment and, outside the presence of counsel but with both
counsels’ consent, interviewed each of these potential experts
posing questions regarding their expertise, availability, cost,
and potential conflicts of interest. Following these interviews,
the Court chose Duffie and Sziklay. The Court informed the
parties as to our choice and discussed with the parties a
consensus of questions to be posed to the experts for their
opinions.
Later, on October 30 and 31, 2000, the parties met with the
Court in chambers and agreed to stipulate the duties and
procedures that the Court would use in appointing the experts.
On November 20, 2000, the Court filed the parties’ stipulation as
to that matter. (We attach that stipulation hereto as appendix
A.) On the same day, the Court issued an order appointing the
experts and directed each party to submit to the Court for filing
a list of specific questions for the Court’s experts. On
December 4, 2000, the Court filed respondent’s proposed questions
for the Court-appointed experts. On December 5, 2000, the Court
filed petitioner’s proposed questions for the Court-appointed
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experts. The Court also filed on December 5, 2000, a supplement
by respondent to his proposed questions.
After the conclusion of the testimony by all other
witnesses, including the parties’ experts, Duffie and Sziklay
were each furnished with the complete trial record up to that
point, and they each submitted a written report. Thereafter,
petitioner submitted a joint rebuttal report on behalf of
Smithson and Sullivan, and later, after that report was excluded
from evidence, separate rebuttal reports on behalf of each
expert. Respondent submitted to the Court the separate rebuttal
reports of O’Brien and Parsons. The Court-appointed experts then
submitted their rebuttal reports. The trial was resumed, at
which time the parties cross-examined the Court-appointed experts
and presented the rebuttal testimony of their own experts.
Respondent challenged the admissibility of Sullivan’s
rebuttal report. Respondent asserted that the report was
inadmissible because it was tainted in its preparation by the
significant participation of petitioner’s counsel. By order
dated January 15, 2003, we excluded Sullivan’s rebuttal report
from evidence. We noted that Sullivan has never explained to our
satisfaction that the words, analysis, and opinions in that
report were his own work. We ruled that petitioner, as the
proponent of the expert testimony, failed to establish the
report’s admissibility by a “preponderance of proof.” See
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Daubert v. Merrell Dow Pharm. Inc., 509 U.S. 579, 592 n.10
(1993).
OPINION
I. Overview
These cases address the Federal income taxation of financial
derivatives. Congress has required for approximately the last 10
years that taxpayers participating in certain types of financial
derivatives report the value of those derivatives at their fair
market value. The taxpayers subject to this valuation
requirement are plentiful, and the tax dollars affected by this
requirement reach into the billions, if not the trillions.55
Congress chose cognizantly not to promulgate explicit rules
mandating valuation methods for this purpose. H. Conf. Rept.
103-213, at 616 (1993), 1993-3 C.B. 393, 494. Congress opted
instead to delegate to the Department of the Treasury (Treasury
Department) the authority to promulgate these rules while
advising the Treasury Department that “the conferees expect that
the Treasury Department will authorize the use of valuation
methods that will alleviate unnecessary compliance burdens for
55
As to the regularity of interest rate swap transactions,
it has been noted by the Court of Appeals for the Seventh
Circuit, the court to which an appeal of these cases would
typically lie, that “‘The swaps dealers--mostly banks--that
create, market, and broker these [interest rate swaps] deals have
made billions.’” Caisse Nationale de Credit Agricole v. CBI
Indus., Inc., 90 F.3d 1264, 1267 n.1 (7th Cir. 1996) (quoting
Greising, “Chicago’s Swaps Sweepstakes”, Business Week, June 14,
1993).
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taxpayers and clearly reflect income for Federal income tax
purposes.” Id. The Treasury Department has never prescribed the
referenced valuation rules.
We proceed to interpret section 475, the provisions of which
we set forth in appendix B.56 These provisions were added to the
Internal Revenue Code by the Omnibus Budget Reconciliation Act of
1993, Pub. L. 103-66, sec. 13223, 107 Stat. 481, effective with
taxable years ended after December 30, 1993.57 We are the first
court to opine upon section 475 in any regard.
56
Petitioner argues, in part, that we should interpret sec.
475 favorably to it because the Treasury Department has failed to
fulfill Congress’s mandate to prescribe regulations interpreting
the valuation requirements of that section. We reject this
argument. In the absence of regulations, we construe the
statutory text in light of all pertinent evidence, textual and
contextual, of its meaning. See Commissioner v. Soliman,
506 U.S. 168, 173 (1993); Crane v. Commissioner,
331 U.S. 1, 6
(1947); Old Colony R. Co. v. Commissioner,
284 U.S. 552, 560
(1932). See also White v. United States,
305 U.S. 281, 292
(1938), where the Supreme Court rejected a similar argument,
stating:
We are not impressed by the argument that, as the
question here decided is doubtful, all doubts should be
resolved in favor of the taxpayer. It is the function
and duty of courts to resolve doubts. We know of no
reason why that function should be abdicated in a tax
case more than in any other * * *
57
Sec. 475 was amended in the Taxpayer Relief Act of 1997,
Pub. L. 105-34, sec. 1001(b), 111 Stat. 906, to redesignate old
sec. 475(e) as sec. 475(g) and to add new sec. 475(e) and (f) to
allow dealers in commodities and traders in securities and
commodities to elect mark-to-market accounting. That amendment
is not applicable here. Id. sec. 1001(d)(4).
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Section 475(a) requires that a “dealer in securities” report
its securities at the end of the taxable year by using one of two
mark-to-market rules set forth in that section. See also sec.
1.475(c)-1(a)(2)(i) and (ii), Example (1), Income Tax Regs. (a
swaps dealer is a “dealer in securities” within the meaning of
section 475). The first rule requires that a dealer include in
its inventory the fair market value of each security held in its
inventory at the end of the taxable year. The second rule
requires that a dealer recognize gain or loss on each other
security held at the end of the taxable year as if the security
had been sold for its fair market value on the last business day
of that year.
By its terms, section 475 does not apply to FNBC’s 1990
through 1992 taxable years. FNBC, however, claimed that it was
reporting its swaps income for those years using a mark-to-market
method, and respondent has never disallowed FNBC’s use of such a
method. See generally sec. 1.471-5, Income Tax Regs. (permitted
dealers in securities to value their securities inventories at
market for taxable years before the effective date of section
475). We believe under the facts herein, including especially
that FNBC’s methodology for reporting its swaps income was
substantially the same in each of the years 1990 through 1993,
that our decision as to 1990 through 1992 flows correspondingly
from our analysis of the mark-to-market rules of section 475.
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Petitioner attempts in its opening brief to raise an issue
that its methodology is permissible for 1990 through 1992
because, it asserts, that methodology met the reasonableness
requirement of Notice 89-21, 1989-1 C.B. 651. Notice 89-21,
1989-1 C.B. at 652, clarifies that swaps income from lump-sum
payments should be spread over the life of the swap “using a
reasonable method of amortization.” We decline to consider this
issue. Petitioner has raised the issue on brief in violation of
our August 14, 2000, order, see Estate of Maggos v. Commissioner,
T.C. Memo. 2000-129 (Court held that a party would not be
entitled to raise an issue not set forth in a memorandum filed by
that party in response to a similar order of this Court), and we
find credible respondent’s assertion on brief that he justifiably
relied upon our August 14, 2000, order in preparing for and
conducting the trial of this case. We also agree with respondent
that he would be prejudiced were we now to decide whether
petitioner’s method of accounting for its 1990 through 1992 swaps
income met the reasonableness requirement of Notice 89-21, supra.
II. Does Section 475 Involve a Method of Accounting?
A. Overview
For each relevant year, respondent determined that FNBC’s
method of accounting for its swaps (more specifically, its
treatment of the adjustments) did not clearly reflect its swaps
income. Accordingly, respondent determined, he was entitled to
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change FNBC’s method of accounting for its swaps income to a
method of accounting that did clearly reflect that income.
Respondent argues that his method of accounting under which each
of FNBC’s swaps is valued at its midmarket value clearly
reflected FNBC’s swaps income for each relevant year.
Petitioner replies that FNBC properly reported its swaps
income for each relevant year. Petitioner observes that FNBC:
(1) Calculated and reported as swaps income the mid-market values
of its swaps and (2) offset that reported income by adjustments
for credit risk and administrative costs connected with the
swaps. Petitioner alleged in its petition that FNBC’s
adjustments were necessary to defer income to match related
expenses. Petitioner clarifies on brief that the adjustments
were necessary to reflect the fair market value of FNBC’s swaps
under its mark-to-market methodology.
Petitioner argues that these cases are a “valuation case”,
as opposed to a method of accounting case, and that FNBC’s
valuations must be sustained because its underlying methodology
was reasonable. Alternatively, petitioner argues, the fact that
FNBC’s methodology was reasonable means that it must prevail even
if these cases are a “method of accounting case”. According to
petitioner, a reasonableness standard controls our decision
because (1) FNBC’s valuations were recurring and business in
nature, (2) FNBC’s valuations were the result of an exercise of
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its business judgment, (3) the valuation of swaps is a novel and
complex issue, (4) the Treasury Department has yet to fulfill a
congressional mandate to issue regulations on the valuation of
financial derivatives under section 475, and (5) FNBC’s
methodology is supported by the legislative history of section
475. FNBC’s methodology was reasonable, petitioner asserts,
because: (1) That methodology was recognized by the industry,
regulators, and accounting profession as the best approach for
valuing financial derivatives, (2) FNBC’s valuations met the fair
value standard of accounting, a standard, petitioner contends,
that is identical in all pertinent respects to the concept of
fair market value, and (3) whereas an undervaluation of swaps
would have lowered reported earnings, FNBC had strong incentives
not to undervalue its swaps and to report strong earnings.
B. Identification of a Method of Accounting
We decide first whether the reporting of income under
section 475, inclusive of the valuation requirement subsumed
therein, is a method of accounting. Respondent argues that such
reporting of income is a method of accounting. Petitioner argues
that such reporting of income is not a method of accounting but
is a question of valuation. We agree with respondent.
Although the Internal Revenue Code does not define the term
“method of accounting”, the regulations do. Those regulations
provide that the term “method of accounting” includes both:
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(1) The overall plan of accounting for gross income or deductions
and (2) the treatment of a material item. Sec. 1.446-1(a)(1),
Income Tax Regs.; see also FPL Group, Inc. & Subs. v.
Commissioner, 115 T.C. 554, 561 (2000). The regulations provide
further that an item is material if it involves the proper timing
of income or expense; i.e., when an item is included in income or
is taken as a deduction. Sec. 1.446-1(e)(2)(ii)(a), Income Tax
Regs.; see also FPL Group, Inc. & Subs. v.
Commissioner, supra at
561; Wayne Bolt & Nut. Co. v. Commissioner,
93 T.C. 500, 510
(1989). As construed by the courts, section 1.446-1(a), Income
Tax Regs., serves to classify as a “method of accounting” the
consistent treatment of any recurring, material item, whether
that treatment be correct or incorrect. E.g., FPL Group, Inc. &
Subs. v.
Commissioner, supra at 561; H.F. Campbell Co. v.
Commissioner,
53 T.C. 439, 447 (1969), affd.
443 F.2d 965 (6th
Cir. 1971).
Here, FNBC’s reporting of income under section 475 is a
method of accounting in that it involves the proper timing of
income and expenses connected with FNBC’s swaps. Section
475(a)(2) mandates for each taxable year that the fair market
value of FNBC’s swaps be considered received as of the end of the
last business day of that year, and that any gain or loss be
currently recognized. Thus, under the statute, FNBC’s valuation
method affects the timing of its swaps income in that the method,
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if improper, would either accelerate or postpone the recognition
of that income. See Knight-Ridder Newspapers, Inc. v. United
States, 743 F.2d 781 (11th Cir. 1984).
Our conclusion is further supported by a line of cases under
section 481 dealing with inventory. Those cases are pertinent in
that FNBC’s swaps are analogous to inventory and section 481
defers to section 446(e) to define a change in method of
accounting. Three of the seminal cases are Hamilton Indus. Inc.
v. Commissioner, 97 T.C. 120 (1991), Wayne Bolt & Nut Co. v.
Commissioner, supra, and Primo Pants Co. v. Commissioner,
78 T.C.
705 (1982). In Hamilton Indus. Inc. v.
Commissioner, supra, the
taxpayer attempted to shield the recognition of gain on inventory
acquired in a bargain purchase by treating that inventory and
subsequently acquired raw materials and manufactured goods as a
single item of inventory under the LIFO method. The Court
concluded that this practice was unacceptable for tax purposes
and constituted a change in method of accounting.
Id. at 127.
In Wayne Bolt & Nut Co. v.
Commissioner, supra, the taxpayer had
used for a number of years a sampling method for determining the
value of its ending inventory. When the taxpayer actually took a
complete physical count of its inventory, it discovered that
approximately $2 million worth of inventory that had been
previously written off was actually still in inventory. The
taxpayer increased its opening and ending inventories in order to
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correct this problem. The Court held that this correction was a
change in the method of accounting that, under section 481,
required the taxpayer to recapture in income the cost of items
mistakenly written off in prior years. Id. at 513. In Primo
Pants Co. v.
Commissioner, supra, the taxpayer consistently
valued its inventories as a percentage of cost when its
inventories should have been valued at full cost. The Court held
that deferral of income until final closing inventory was
corrected was a timing question that constituted a change in
accounting method.
Id. at 725; accord Dearborn Gage Co. v.
Commissioner,
48 T.C. 190, 197-198 (1967) (concluding that the
exclusion of overhead costs in valuing inventory is an erroneous
method of accounting involving a material item); Hitachi Sales
Corp. of Am. v. Commissioner, T.C. Memo. 1994-159 (a change from
an improper method of valuing inventory to a proper valuation
method is a change in method of accounting), supplemented T.C.
Memo. 1995-84.
We find in the legislative history under section 475 further
support for our conclusion that the instant issue involves a
method of accounting. That history, although considered to be
secondary when interpreting the statutory text, is most useful
when it comes to discerning a statute’s intended purpose. Bob
Jones Univ. v. United States, 461 U.S. 574, 586 (1983);
Albertson’s, Inc. v. Commissioner,
42 F.3d 537, 541 (9th Cir.
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1994), affg. 95 T.C. 415 (1990); Booth v. Commissioner,
108 T.C.
524, 569 (1997). We understand from the legislative history that
Congress intended that the mark-to-market rules under section
475, including the valuation requirement subsumed therein, be
considered a method of accounting. In fact, the House Committee
on Ways and Means even articulated in its report a specific
provision as to the procedure to be used by taxpayers who were
required to change their methods of accounting to comply with the
legislation. H. Rept. 103-111, at 666 (1993), 1993-3 C.B. 167,
242. This provision refers to “A taxpayer that is required to
change its method of accounting to comply with the requirements
of the provision”, a “section 481(a) adjustment”, and the need to
account for the section 481 adjustment through the “principles of
* * * Rev. Proc. 92-20", 1992-1 C.B. 685, the revenue procedure
that governs the changes in method of accounting in general.
These references, we believe, are most consistent with our
conclusion that the applicable mark-to-market rule is a method of
accounting.
We also bear in mind Congress’s placement of section 475 in
part II of subchapter E (chapter 1) of the Internal Revenue Code,
a part that is entitled “Methods of Accounting”. This placement,
of course, is by no means dispositive. Sec. 7806(b). This
placement, however, can surely not be ignored. Sec. State Bank
v. Commissioner, 214 F.3d 1254, 1257-1258 (10th Cir. 2000), affg.
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111 T.C. 210 (1998). Such is especially so where the legislative
history of section 475 identifies the applicable mark-to-market
rule of that section as a method of accounting applicable to
securities dealers and also provides explicit rules under which
taxpayers may change their methods of accounting to comply with
the mark-to-market requirement. E.g., H. Rept. 103-111, supra at
666, 1993-3 C.B. at 236, 242.
III. Burden of Proof
Petitioner argues that respondent bears the burden of proof
as to any method of accounting issue because, petitioner asserts,
the notices of deficiency are arbitrary and excessive as to
respondent’s method for reporting FNBC’s swaps income. According
to petitioner, respondent’s method set forth in the notices of
deficiency is the midmarket method, and it is only respondent who
disputes that sound economic principles lead to the conclusion
that the fair market value of a swap is not its midmarket value.
Respondent argues in rebuttal that petitioner bears the burden of
proof. First, respondent asserts, the notices of deficiency are
neither arbitrary nor excessive as to the method of accounting
issue. Second, respondent asserts, petitioner has previously
acknowledged to the Court that it bears the burden of proof and,
in any event, has raised this issue untimely.
We agree with respondent that petitioner bears the burden of
proof as to the method of accounting issue. Indeed, petitioner’s
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counsel has already acknowledged this fact and, in any case, has
raised this issue untimely and in contravention of our pretrial
order dated August 14, 2000.
As to the acknowledgment, the following colloquy occurred
between the Court and the parties at the beginning of trial:
THE COURT: * * * let me just make sure that
the Court’s understanding that the burden of
proof in this case is on the Petitioner. Is
that a correct understanding?
MR. SCHIFFMAN: Yes, Your Honor.
THE COURT: Counsel?
MS. GILBERT: Yes, Your Honor.
It was only when petitioner filed its brief with the Court that
it argued for the first time that the burden of proof was on
respondent. Petitioner’s raising of this issue in its brief was
untimely, prejudicial to respondent, and in violation of the
referenced pretrial order. See Estate of Maggos v. Commissioner,
T.C. Memo. 2000-129.
Even if the issue as to the burden of proof was properly
before the Court, the notices of deficiency were neither
arbitrary nor excessive under the facts at hand, including,
especially, that petitioner failed during the audit to provide to
respondent adequate substantiation to support its return
position. In Mitchell v. Commissioner, 416 F.2d 101 (7th Cir.
1969), affg. T.C. Memo. 1968-137, for example, a taxpayer who
lacked adequate records argued that the burden of proof was on
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the Commissioner. The Court of Appeals for the Seventh Circuit
disagreed. The court stated that shifting the burden of proof to
the Commissioner “would be tantamount to holding that skillful
concealment of income by failure to keep records and destruction
of the original documents from which income could be
reconstructed would be an invincible barrier to proof.” Id. at
102. The Court of Appeals for the Ninth Circuit ruled similarly
in Clapp v. Commissioner,
875 F.2d 1396 (9th Cir. 1989). There,
the court rejected a taxpayer’s argument that a significant
disparity between the amounts in a notice of deficiency and the
amounts in a stipulated judgment was proof that the
Commissioner’s determination was arbitrary. The court noted that
the discrepancies were simply the product of the taxpayer’s
refusing to cooperate with the audit.
Id. at 1402; accord Am.
Fletcher Corp. v. United States,
832 F.2d 436, 442 (7th Cir.
1987) (Cudahy, J., concurring) (“Taxpayers are required to keep
adequate records to support their declaration of taxable income,
and have no grounds for protest if the Commissioner imposes a
workable accounting method when confronted with inadequate
records.”).
Petitioner asserts that respondent is required either to
introduce into evidence FNBC’s swap records or to advance
alternative computations in order to legitimize as other than
arbitrary or erroneous his determination as to the credit and
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administrative costs adjustments. We disagree. Petitioner
either controls or has controlled all of the documents necessary
to support its claim to the credit and administrative costs
adjustments. Whereas petitioner has chosen not to introduce
those documents into evidence, it is not now incumbent on
respondent to do so. As the Court of Appeals for the Seventh
Circuit stated in Pfluger v. Commissioner, 840 F.2d 1379, 1383
(7th Cir. 1988), affg. T.C. Memo. 1986-78, while rejecting a
similar argument:
They [the taxpayers] willfully refused to cooperate
with the audit. They cannot thereby force the
Commissioner to resort to “averages” to estimate the
deductions that they could have taken. If that were
the case, nobody would cooperate with an audit. The
use of estimates could often result in allowance of
more deductions than the taxpayer was actually entitled
to take; if it did not, the taxpayer would simply
petition for a redetermination and substantiate greater
deductions. * * *
IV. Tax Accounting for Methods of Accounting
Section 446(a) contains the general rule for tax accounting.
Section 446(a) generally requires that the accounting method used
by a taxpayer to compute its taxable income be based on the
method of accounting used by the taxpayer to compute its book
income. The regulations interpreting section 446(a) restate this
requirement and clarify that the requirement must be met unless
the Internal Revenue Code provides a more specific accounting
method for an item. Sec. 1.446-1(a), Income Tax Regs. The
regulations list “research and experimental expenditures, soil
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and water conservation expenditures, depreciation, [and] net
operating losses” as examples of items which require a more
specific accounting method. Id. The regulations do not indicate
that the mark-to-market rules of section 475 involve an item that
requires a specific method different than book method.
Even in cases where an item is not listed as requiring a
specific method of tax accounting, section 446(b) gives the
Commissioner broad authority to require a certain method of tax
accounting as to that item when the taxpayer’s method of tax
accounting fails to reflect the taxpayer’s income clearly. Thor
Power Tool Co. v. Commissioner, 439 U.S. 522, 532 (1979);
Commissioner v. Hansen,
360 U.S. 446, 467 (1959); see also sec.
1.446-1(a)(2), Income Tax Regs. The Commissioner’s authority
under section 446(b) encompasses overall methods of accounting,
as well as specific methods used to report any item of income or
expense. Thor Power Tool Co. v.
Commissioner, supra at 531;
Prabel v. Commissioner,
91 T.C. 1101, 1112-1113 (1988), affd.
882 F.2d 820 (3d Cir. 1989); Wal-Mart Stores Inc. v.
Commissioner, T.C. Memo. 1997-1, affd.
153 F.3d 650 (8th Cir.
1998); see also sec. 1.446-1(a), Income Tax Regs. The
Commissioner’s authority under section 446(b) authorizes the
Commissioner to change a method of accounting used by a taxpayer
such as FNBC to report its swaps income under section 475 if that
method does not clearly reflect that income.
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Petitioner argues that its burden as to section 446(b) is to
prove simply that FNBC’s method of reporting its swaps income was
reasonable. We disagree. We understand section 446(b) to
require that a method of accounting clearly reflect income and
not that it simply be reasonable. A taxpayer’s method of
accounting, although believed by the taxpayer to be reasonable,
may not necessarily be a method which clearly reflects the
taxpayer’s income for purposes of Federal income taxes. Such is
especially so considering that the Commissioner is given broad
discretion under section 446(b) to determine whether an
accounting method clearly reflects income, and that his exercise
of authority under that section is given “much latitude” and
cannot be disturbed unless “clearly unlawful” or “plainly
arbitrary”. Thor Power Tool Co. v. Commissioner, supra at
532-533; Lucas v. Am. Code Co.,
280 U.S. 445, 449 (1930); Am.
Fletcher Corp. v. United States, supra at 438. Moreover, it is
well engrained in our tax jurisprudence that a taxpayer
challenging the Commissioner’s exercise of authority under
section 446(b) bears a heavy burden of proving that the
Commissioner’s determination is “clearly unlawful” or “plainly
arbitrary”. Thor Power Tool Co. v.
Commissioner, supra at 532-
533; Lucas v. Structural Steel Co.,
281 U.S. 264, 271 (1930);
Lucas v. Am. Code Co., supra at 449. See also Am. Fletcher Corp.
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v. United States, supra at 438, where the Court of Appeals for
the Seventh Circuit stated:
Our task [in reviewing the Commissioner’s determination
that a method of accounting does not clearly reflect
income] is limited to determining whether the
Commissioner abused his discretion in finding it
necessary to change the taxpayer’s method of
accounting, recalling that a taxpayer has the heavy
burden of proving that the Commissioner’s determination
is plainly arbitrary. [Citations and quotation marks
omitted.]
Nor must the Commissioner establish any bad faith on the part of
a taxpayer in using a particular method of accounting before
requiring that the taxpayer change that method of accounting.
Prabel v. Commissioner, supra at 1112.
The fact that the Commissioner possesses broad authority
under section 446(b), however, does not mean that the
Commissioner may change a taxpayer’s method of accounting with
impunity. For example, the Commissioner may not change a method
of accounting which clearly reflects income to another method
that the Commissioner believes reflects income more clearly.
Osteopathic Med. Oncology & Hematology, P.C. v. Commissioner,
113 T.C. 376, 381 (1999); Ansley-Sheppard-Burgess Co. v.
Commissioner,
104 T.C. 367 (1995); Bay State Gas Co. v.
Commissioner,
75 T.C. 410, 417 (1980), affd.
689 F.2d 1 (1st Cir.
1982); see also Wal-Mart Stores, Inc. v.
Commissioner, 153 F.3d
at 657 (having ruled that inventory shrinkage estimates are not
prohibited by the Internal Revenue Code or the regulations
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thereunder, the court held that the Commissioner abused his
discretion in changing the taxpayer’s method of accounting
because that method complied with GAAP, was applied consistently
for both tax and financial accounting purposes, and produced
accurate results). Nor may the Commissioner change an accounting
method that clearly reflects income to a method that does not
clearly reflect income. See Harden v. Commissioner, 223 F.2d 418
(10th Cir. 1955), revg. and remanding
21 T.C. 781 (1954); Rotolo
v. Commissioner,
88 T.C. 1500, 1514 (1987); Brountas v.
Commissioner,
74 T.C. 1062, 1069 (1980), supplementing
73 T.C.
491 (1979), vacated and remanded on other grounds
692 F.2d 152
(1st Cir. 1982), affd. in part and revd. in part on other grounds
sub nom. CRC Corp. v. Commissioner,
693 F.2d 281 (3d Cir. 1982).
Respondent argues that the Court may find that the
Commissioner has abused his discretion under section 446(b) only
if the Court first finds that the taxpayer’s method of accounting
clearly reflects income. We disagree. We find nothing in either
the statute or the caselaw that preconditions a finding of an
abuse of discretion under section 446(b) on a finding that the
taxpayer’s method clearly reflects income.58 In fact, the
58
The caselaw does, however, establish the converse of
respondent’s proposition; i.e., the Commissioner lacks the
discretion to change a taxpayer’s method of accounting if the
taxpayer establishes that the method clearly reflects its income.
E.g., Peninsula Steel Prods. & Equip. Co. v. Commissioner,
78 T.C. 1029, 1044-1045 (1982); see also Capitol Fed. Sav. & Loan
(continued...)
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caselaw leads to the opposite conclusion. Ft. Pitt Brewing Co.
v. Commissioner, 210 F.2d 6, 10-11 (3d Cir. 1954), affg.
20 T.C.
1 (1953); Russell v. Commissioner,
45 F.2d 100, 101 (1st Cir.
1930) (“An arbitrary adoption of a substitute method of computing
a tax, which does not in fact ‘clearly reflect the income’ of the
taxpayers, cannot be sustained. The commissioner’s discretion
must be exercised reasonably, on sound grounds.” (Citation
omitted.)), revg.
12 B.T.A. 56 (1928); see also Harden v.
Commissioner, supra at 421; Prabel v. Commissioner,
91 T.C.
1112; Golden Gate Litho v. Commissioner, T.C. Memo. 1998-184.
Compare Helvering v. Taylor,
293 U.S. 507, 514 (1935), where the
Supreme Court stated:
We find nothing in the statutes, the rules of the
board or our decisions that gives any support to the
idea that the commissioner’s determination shown to be
without rational foundation and excessive, will be
enforced unless the taxpayer proves he owes nothing or,
if liable at all, shows the correct amount. * * *
Contrary to respondent’s belief, that line of cases firmly
establishes that courts do not simply sustain the Commissioner’s
change of a taxpayer’s accounting method merely because the
taxpayer’s method was found to be erroneous.
When a taxpayer challenges the Commissioner’s authority
under section 446(b), we inquire whether the accounting method in
58
(...continued)
v. Commissioner, 96 T.C. 204, 210 (1991) (and cases cited
thereat); Prabel v. Commissioner,
91 T.C. 1101, 1112 (1988) (and
cases cited thereat), affd.
882 F.2d 820 (3d Cir. 1989)
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question clearly reflects income. The answer to this question
does not hinge on whether the taxpayer’s method is superior to
the Commissioner’s method, or vice versa. RLC Indus. Co. & Subs.
v. Commissioner, 98 T.C. 457, 492 (1992), affd.
58 F.3d 413 (9th
Cir. 1995); Wal-Mart Stores, Inc. & Subs. v. Commissioner, T.C.
Memo. 1997-1; see also Brown v. Helvering,
291 U.S. 193, 204-205
(1934). Rather, the answer is found by carefully analyzing the
unique facts and circumstances of the case. Ansley-Sheppard-
Burgess Co. v.
Commissioner, supra; Peninsula Steel Prods. &
Equip. Co. v. Commissioner,
78 T.C. 1029, 1045 (1982). Although
it is not dispositive in our analysis, we believe that a critical
fact is whether the taxpayer is consistently using a recognized
method of accounting that comports with GAAP and that is
prevalent in the industry. See Wilkinson-Beane, Inc. v.
Commissioner,
420 F.2d 352, 354 (1st Cir. 1970), affg. T.C. Memo.
1969-79; RLC Indus. Co. & Subs. v.
Commissioner, supra at 490;
Wal-Mart Stores, Inc. & Subs. v. Commissioner, T.C. Memo. 1997-1.
We recognize that the treatments of an item for financial
accounting and Federal income tax purposes do not always mesh,
and that an accounting method that is acceptable under GAAP may
be unacceptable for Federal income tax purposes because it does
not clearly reflect income. Thor Power Tool Co. v. Commissioner,
439 U.S. at 538-544; Am. Auto. Association v. United States,
367 U.S. 687 (1961); see also Hamilton Indus., Inc. v.
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Commissioner, 97 T.C. 128; Sandor v. Commissioner,
62 T.C.
469, 477 (1974), affd.
536 F.2d 874 (9th Cir. 1976).
Nevertheless, the regulations under section 446(b) contemplate
that a method of accounting “ordinarily” will clearly reflect
income when it “reflects the consistent application of generally
accepted accounting principles in a particular trade or business
in accordance with accepted conditions or practices in that trade
or business”. Sec. 1.446-1(a)(2), Income Tax Regs.; see also Am.
Fletcher Corp. v. United
States, 832 F.2d at 439-440. Moreover,
as recognized by the Court of Appeals for the Seventh Circuit:
“Not only does the applicable regulation make generally accepted
accounting principles a pertinent criterion but the courts have
also applied that criterion to establish what method clearly
reflect[s] income under Section 446 of the Code.” Am. Fletcher
Corp. v. United States, supra at 439-440 (citations and quotation
marks omitted).
V. FNBC’s Mark-to-Market Book Method
A. Mark-to-Market Method Acceptable for Section 475
Consistent with the practice of the financial derivatives
industry, FNBC used a mark-to-market method to compute its swaps
income for financial accounting purposes.59 We believe that it
59
We refer to the specific mark-to-market method used by
FNBC as “a” mark-to-market method instead of “the” mark-to-market
method. As is true in the case of accrual accounting, for which
there is more than one accrual method, see sec. 446(c)(2), we
(continued...)
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was acceptable for FNBC also to have used its mark-to-market
method for purposes of section 475 as long as the method actually
arrived at the fair market value of FNBC’s swaps. Stated
differently, we believe that FNBC’s mark-to-market method will
clearly reflect its swaps income for Federal income tax purposes
if the method was in fact a mark-to-market method.
1. Acceptable in Theory
Mark-to-market accounting has for decades been considered by
academia and other commentators to be the most theoretically
desirable of all the various systems of taxing income in that
mark-to-market accounting consistently measures and levies tax on
a taxpayer’s economic (or Haig-Simons) income.60 See Haig, The
Concept of Income--Economic and Legal Aspects, The Federal Income
Tax (1921), in Readings in the Economics of Taxation 68-69
59
(...continued)
believe that there may be more than one specific method of
accounting that may properly be considered a mark-to-market
method under sec. 475(a)(2).
60
As the Court noted in Collins v. Commissioner, T.C. Memo.
1992-478, affd. 3 F.3d 625 (2d Cir. 1993):
The Haig-Simons definition of income states that income
during a taxable period is properly defined as the sum
of (1) the market value of rights exercised in
consumption during the period, and (2) the increase in
the value of the store of property rights, or wealth,
between the beginning and the end of the period. Haig,
The Concept of Income--Economic and Legal Aspects, in
Readings in the Economics of Taxation 54 (Musgrave &
Shoup eds. 1959); Simons, Personal Income Taxation 50
(1938). * * *
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(Musgrave & Shoup eds. 1959); Simons, Personal Income Taxation
103 (1938); see also Brown & Bulow, The Definition of Taxable
Business Income, in Comprehensive Income Taxation 241, 242-43
(J. Pechman ed. 1977); Shakow, “Taxation Without Realization: A
Proposal For Accrual Taxation”, 134 U. Pa. L. Rev. 1111 (1986).
In the academic and policy literature dealing with the taxation
of swaps and other financial products, commentators have
regularly mentioned a superiority of mark-to-market accounting in
measuring income and the significant defects of competing
systems. E.g., Scarborough, “Different Rules for Different
Players and Products: The Patchwork Taxation of Derivatives”,
72 Taxes 1031, 1049 (1994); Shuldiner, “Consistency and the
Taxation of Financial Products”, 70 Taxes 781 (1992); Warren,
“Financial Contract Innovation and Income Tax Policy”, 107 Harv.
L. Rev. 460 (1993). As used by tax policymakers, mark-to-market
accounting is the paradigm of clear reflection of income to which
traditional accrual methods aspire.
Mark-to-market accounting is particularly appropriate for
OTC derivatives dealers. Swaps dealers employ mark-to-market
accounting for commercial and financial purposes because, they
believe, mark-to-market accounting is a superior method of
clearly reflecting a swaps dealer’s annual income. Swaps dealers
rely extensively on hedging techniques to reduce or eliminate
their exposure primarily to interest rate changes and other
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first-order economic risks. Many of these hedging transactions,
such as exchange-traded futures contracts, have maturities that
are much shorter than the long-term swaps contracts on a swaps
dealer’s books, and other hedging transactions (e.g., a long
position in physical securities) are regularly liquidated or
unwound as new customer swaps change the risk profile of a swaps
dealer’s book.
Traditional accrual method accounting, which uses the
realization principle as the bedrock of its income inclusion
rules, can subject a swaps dealer to enormous and unpredictable
distortions in the measurement of its income from its book of
customer swaps and hedges. The dealer’s recognized losses on
short-dated hedges, for example, would offset its unrealized
gains on its customer swaps as a commercial and economic matter.
The unrealized gain, however, would be ignored for tax purposes.
The only practical way to eliminate these large and
unpredictable timing distortions arising from a book of
short-dated hedges and long-dated customer contracts is to adopt
a mark-to-market method of tax accounting. Through the
recognition of all economic fluctuations in value in the swaps
dealer’s book of customer positions and hedges, a mark-to-market
method assures that a dealer is taxed each year on its true
annual change in net worth arising from its dealer activities.
In fact, many swaps dealers had been advocates of comprehensive
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mark-to-market tax accounting long before the adoption of section
475, and securities and commodities dealers (and, since the birth
of the industry, swaps dealers) have for decades maintained their
books on a mark-to-market basis for commercial and financial
purposes. See, e.g., A.R.M. 135, 5 C.B. 67 (1921), and A.R.M.
100, 3 C.B. 66 (1920), both of which permitted commodity dealers
to adopt a comprehensive mark-to-market accounting system for
their open hedge contracts. See also Rev. Rul. 74-223, 1974-1
C.B. 23 (updates and restates the conclusions of A.R.M. 135,
supra).
2. Acceptable in Practice
The use of mark-to-market accounting for taxpayers in
positions analogous to that of FNBC has been recognized for
Federal tax purposes for many years.
a. Market Valuation of Inventories
Since at least 1919, taxpayers have been permitted to value
their inventories at the lower of cost or market. T.B.R. 48, 1
C.B. 47; see also O.D. 8, 1 C.B. 56 (confirming that securities
dealers, like other taxpayers, may value their inventories at
lower of cost or market). A method of accounting is acceptable
for inventory accounting if it: (1) Conforms as nearly as may be
to the best accounting practice in the trade or business and
(2) most clearly reflects income. Sec. 471(a); sec. 1.471-
2(a)(1) and (2), Income Tax Regs.; see also Thor Power Tool Co.
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v. Commissioner, 439 U.S. at 531-532; Hamilton Indus. Inc. v.
Commissioner,
97 T.C. 130.
From 1958 until the date that it was superseded by section
475, section 1.471-5, Income Tax Regs., specifically authorized
dealers in securities to value securities inventories at
(1) cost, (2) market, or (3) lower of cost or market, so long as
the method employed by the dealer for tax purposes was also “the
basis upon which his accounts are kept”. The requirement that a
dealer’s tax accounting method for inventories conform to the
method used to maintain the dealer’s internal accounts and to the
accounting principles of the industry meant, in practice, that
the Commissioner and dealers alike expected that the same
valuations would be employed consistently for tax and for nontax
accounting purposes. In consequence, although many cases involve
disputes over the relevant “market” for purposes of applying, for
example, lower-of-cost-or-market accounting, e.g., Thor Power
Tool Co. v. Commissioner, 439 U.S. 522 (1979), we are unaware of
any decided case in which a taxpayer’s good faith calculations of
the actual fair market values of inventories, employed
consistently for tax and nontax accounting purposes, have been
challenged by the Commissioner.
b. Comprehensive Mark-to-Market Accounting
The same tradition of consistency holds true for
comprehensive mark-to-market accounting outside the context of
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inventory methods. For example, in Rev. Rul. 74-223, supra, the
Commissioner addressed futures contracts that commodities dealers
entered into as hedges. The Commissioner relied on the nontax
purposes for which the taxpayers’ mark-to-market method of
accounting was employed and concluded that the method clearly
reflected income.
Before the enactment of section 475, swaps dealers all
confronted the short-dated-hedges/long-dated-swaps timing
distortions discussed above. In response, many dealers
voluntarily adopted comprehensive mark-to-market tax accounting,
and swaps dealers in some cases lobbied Congress to adopt rules
confirming mark-to-market as a valid tax accounting method for
swaps dealers. E.g., Letter to Internal Revenue Service from
Saul Rosen, Salomon Brothers Inc., dated December 6, 1991, in
91 Tax Notes Today 255-37 (Dec. 17, 1991); Letter to Internal
Revenue Service from Cynthia Beerbower, on Behalf of Nine
Interest Rate Cap Dealers, dated March 4, 1988, in 88 Tax Notes
Today 69-29 (Mar. 28, 1988). See generally Kleinbard & Evans,
“The Role of Mark-to-Market Accounting in a Realization-Based Tax
System”, 75 Taxes 788, 798-799 (1997). The technical reason for
any concern was that, while swaps are directly analogous to
traditional securities inventories, swaps arguably are not
directly inventoriable, because once entered into, they are not
literally held for resale to other customers.
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In 1991, the Treasury Department responded to this
dealer-driven request to clarify the scope of mark-to-market
accounting by proposing section 1.446-4, Proposed Income Tax
Regs., 56 Fed. Reg. 31361 (July 10, 1990). These proposed
regulations would have allowed swaps dealers to place their OTC
derivatives businesses onto mark-to-market systems. The proposed
rules would have conditioned the availability of mark-to-market
accounting for a swaps dealer on the dealer’s employing the same
valuations for tax purposes as it employed in its financial
statements. The proposed regulations provided in relevant part:
(a) Mark-to-market election. A dealer or trader
in derivative financial instruments may elect to
account for those instruments on its income tax return
at market value. A dealer or trader in derivative
financial instruments may elect to account for a
derivative financial instrument at market value only
if:
(1) The dealer or trader purchased or
entered into the derivative financial
instrument either--
(i) In its capacity as a
dealer or trader; or
(ii) As a hedge of another
financial instrument that the
dealer or trader holds or intends
to hold in its capacity as a dealer
or trader;
(2) The dealer or trader values all of
the derivative financial instruments that it
holds in its capacity as a dealer or trader
(or as hedges of such instruments) at market
for purposes of computing net income or loss
on its applicable financial statement (as
defined in § 1.56-1(c)), and the dealer or
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trader uses the same method of valuing those
instruments on its income tax return;
(3) The dealer or trader and all persons
related to the dealer or trader within the
meaning of sections 267(b) and 707(b)(1)
account for the securities and commodities
that they hold in their capacity as dealers
or traders (or as hedges or such securities
or commodities) on their income tax returns
either on the basis of cost or on the basis
of market value, but not at the lower of cost
or market value;
(4) A description of the methods
employed to value each class of derivative
financial instruments is attached to the
dealer’s or trader’s income tax return for
each year; and
(5) The method elected under this
section is used consistently in subsequent
years, unless another method is authorized by
the Commissioner pursuant to a written
request under § 1.446-1(e) of the
regulations. [Id.]
Whereas the enactment of section 475 rendered moot any final
action on the relevant part of these proposed regulations, the
Treasury Department, in the end, never did finalize these rules.
The legislative history of section 475 itself indicates that
Congress anticipated that a taxpayer could use mark-to-market
accounting to comply with section 475. The history of section
475 establishes that Congress was well aware of how mark-to-
market accounting operated in practice in the swaps industry and
that Congress constructed section 475 in light of that current
practice. In fact, the first legislative proposal for what
became section 475, contained in the President’s Budget Proposal,
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see Department of the Treasury, General Explanation of the
President’s Budget Proposals Affecting Receipts 89-90 (Jan. 30,
1992), overlapped the G-30’s preparation of the G-30 report and
was released only a few months after the Treasury Department
published section 1.446-4, Proposed Income Tax Regs., supra, and
released its 1991 report, Modernizing the Financial System:
Recommendations for Safer, More Competitive Banks (Feb. 1991).
In describing the reasons for section 475, both Congress and
the President emphasized that the change in tax accounting rules
would simply move tax accounting to the already accepted
financial accounting treatment. H. Rept. 103-111, supra at 661,
1993-3 C.B. at 237 (“Inventories of securities generally are
easily valued at year end, and, in fact, are currently valued at
market by securities dealers in determining their income for
financial statement purposes.”); see also Department of the
Treasury, General Explanation of the President’s Budget Proposals
Affecting Receipts 36 (Feb. 25, 1993); Department of the
Treasury, General Explanation of the President’s Budget Proposals
Affecting Receipts 89-90 (Jan. 30, 1992). Congress also
expressed its expectation “that the Treasury Department will
authorize the use of valuation methods that will alleviate
unnecessary compliance burdens for taxpayers and clearly reflect
income for Federal income tax purposes”, H. Conf. Rept. 103-213,
supra at 616, 1993-3 C.B. at 494, thus implying that the
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Commissioner should defer to the taxpayer’s normal financial
accounting valuation, which in the case of a swaps dealer was
generally the method that was recommended by the G-30 report.
This implication that using financial accounting methods would
“alleviate unnecessary compliance burdens” is buttressed by
another part of the legislative history of section 475. This
other part, which relates to the identification of certain
securities as hedges (and not the fair market valuation of
securities), indicates that the use of financial accounting
methods would be an adequate and efficient method for applying
mark-to-market rules. The other part states:
It is anticipated that the identification rules
with respect to hedges will be applied in such a manner
as to minimize the imposition of additional accounting
burdens on dealers in securities. For example, it is
understood that certain dealers in securities use
accounting systems which treat certain transactions
entered into between separate business units as if such
transactions were entered into with unrelated third
parties. It is anticipated that for the purposes of
the mark-to-market rules, such an accounting system
generally will provide an adequate identification of
hedges with third parties. [H. Rept. 103-111, supra at
664, 1993-3 C.B. at 240.]
B. Standard of the Mark-to-Market Method Is Not
Reasonableness
Petitioner argues that FNBC was allowed to use its specific
mark-to-market method for purposes of section 475 because,
petitioner asserts, FNBC’s method was “reasonable”. We disagree
with petitioner that the reasonableness of a particular method of
accounting is the linchpin of an acceptable method under section
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475. Contrary to petitioner’s assertion, the mere fact that
FNBC’s swap valuations were recurring and business in nature does
not mean that FNBC was free to use for purposes of section 475
whatever “reasonable” method it decided was proper. We disagree
with petitioner when it asserts that an established business
judgment rule requires that this Court, for Federal income tax
purposes, defer to FNBC’s choice of either (or both) an
accounting method or a valuation method for nontax purposes. The
cases upon which petitioner relies, namely, as to a method of
accounting, Photo-Sonics, Inc. v. Commissioner, 357 F.2d 656 (9th
Cir. 1966), affg.
42 T.C. 926 (1964); Osteopathic Med. Oncology &
Hematology, P.C. v. Commissioner,
113 T.C. 376 (1999); Auburn
Packing Co. v. Commissioner,
60 T.C. 794 (1973); and Wal-Mart
Stores Inc. v. Commissioner,
153 F.3d 650 (8th Cir. 1998), and,
as to a valuation method, Vinson & Elkins v. Commissioner,
7 F.3d
1235 (5th Cir. 1993), affg.
99 T.C. 9 (1992); Portland
Manufacturing Co. v. Commissioner,
56 T.C. 58 (1971); and Utah
Med. Ins. Association v. Commissioner, T.C. Memo. 1998-458, do
not adequately support that argument. In this regard, we do not
question the reasonableness of FNBC’s business judgment, nor do
we substitute our business judgment for its. We simply analyze
whether the method of accounting resulting from FNBC’s exercise
of business judgment clearly reflects FNBC’s swaps income so as
to be acceptable under sections 446(b) and 475.
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Nor does the complexity of an issue, or the fact that an
issue may be novel, play any part in our determination of the
proper standard of review. Many determinations of fair market
value involve novel and/or complex calculations. Moreover, as
generally agreed upon by the experts, the valuation issue at hand
as applied to plain vanilla swaps, the principal financial
derivative in issue, is not that complex to a person familiar
with the industry.
We also disagree with petitioner that the lack of
regulations on the valuation of financial derivatives entitles it
to prevail under a reasonableness standard. Petitioner notes
correctly that Congress authorized the Treasury Department to
prescribe regulations under which financial derivatives would be
valued and that the Treasury Department has yet to do so.
Petitioner also notes correctly that both this Court and the
Court of Appeals for the Seventh Circuit have previously
criticized the Treasury Department for failing to prescribe
congressionally mandated regulations. E.g., Pittway Corp. v.
United States, 102 F.3d 932, 935-36 (7th Cir. 1996); First
Chicago Corp. v. Commissioner,
842 F.2d 180, 181-182 (7th Cir.
1988), affg.
88 T.C. 663 (1987); Estate of Maddox v.
Commissioner,
93 T.C. 228, 233-234 (1989); First Chicago Corp. v.
Commissioner,
88 T.C. 676-677; Occidental Petroleum Corp. v.
Commissioner,
82 T.C. 819, 829 (1984). In each of those cases,
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however, the statute itself clearly directed the Treasury
Department to prescribe specific regulations as to the matter in
question in order to effect congressional intent. Here, by
contrast, we find in the statute no clear direction from Congress
to the Treasury Department to prescribe rules valuing financial
derivatives, let alone a direction to prescribe those rules as a
precondition to effecting congressional intent as to section 475.
The fact that regulations have not been issued on the valuation
matter at hand does not provide FNBC with a basis to thwart
Congress’s mandate to value swaps at fair market value. Intl.
Multifoods Corp. v. Commissioner, 108 T.C. 579, 587 (1997) (and
cases cited thereat).
Nor do we agree with petitioner that the legislative history
of section 475 indicates that taxpayers are allowed to implement
under section 475 any “reasonable” method until the Treasury
Department exercises its regulatory authority.61 We trace the
history of section 475 to the Treasury Department’s concern that
certain existing tax rules applicable to securities dealers
appeared overly favorable when compared with GAAP. The specific
concern, as stated in the President’s Budget Proposal, see
Department of the Treasury, General Explanation of the
President’s Budget Proposals Affecting Receipts 89-90 (Jan. 30,
61
Petitioner relies erroneously on First Chicago Corp. v.
Commissioner, 88 T.C. 663 (1987), affd.
842 F.2d 180 (7th Cir.
1988), for a contrary proposition.
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1992), was that, for GAAP purposes, dealers had to mark to market
their inventories of marketable securities, while for tax
purposes they could (and did) use lower of cost or market or
other rules that were considerably more favorable in that they
tended to reduce taxable income. Under the caption “Conform Book
and Tax Accounting for Securities Inventories/Reasons for
Change,” that explanation noted, at 89:
Inventories of marketable securities are easily valued
at year end, and in fact are currently valued by
securities dealers in computing their income for
financial statement purposes and in adjusting their
inventory to an LCM [lower of cost or market] basis for
Federal income tax purposes. The cost method and the
LCM method tend to understate taxable income compared
to the market method that securities dealers use to
report their income to shareholders and creditors. The
market method represents the best accounting practice
in the trade or business of dealing in securities and
is the method that most clearly reflects the income of
a securities dealer.
Later, as the proposal that became section 475 wound its way
through the legislative process,62 its scope was expanded to
include not only marketable securities but also instruments such
as swaps and other financial derivatives for which no active
secondary market existed. During this process, Congress knew
that GAAP did not explicitly require mark-to-market accounting
62
The first legislative precursor of sec. 475 was sec. 372
of the Economic Growth Act of 1992 (H.R. 4150). H. Rept.
102-4150 (1991). H.R. 4150 was not enacted. However, sec. 3001
of the Revenue Bill of 1992, H.R. 11, 102d Cong. (1992),
contained similar language. H.R. 11 passed both houses of
Congress but was vetoed by the President.
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for nonmarketable securities. Congress also was told that, in
the case of instruments which did not have an active secondary
market, the implementation of a mark-to-market approach would be
a complex process. E.g., ABA Members Comment on Mark-to-Market
Accounting for Securities Dealer, dated September 10, 1992, in
92 Tax Notes Today 209-28 (Oct. 16, 1992). The compromise
Congress struck in enacting section 475 was (1) to require
mark-to-market accounting for dealer “securities,” regardless of
their marketability, and (2) to ask the Treasury Department to
prescribe regulations which would authorize valuation methods
which were more taxpayer favorable from a compliance point of
view. See H. Conf. Rept. 103-213, supra at 616, 1993-3 C.B. at
494. Given that the Treasury Department has yet to prescribe
these regulations, we believe it only natural to conclude that a
taxpayer such as FNBC must use under section 475 a method of
accounting that accurately marks its financial derivatives to
their market price as of the requisite valuation date.
Petitioner also argues that FNBC’s methodology in valuing
its swaps has been recognized by nearly everyone as the best
approach for valuing financial derivatives. Petitioner contends
that FNBC’s methodology was longstanding and systematic and that
each element was developed for important commercial and nontax
financial reasons. Petitioner contends that FNBC’s swaps were
valued at the same amounts in its general ledger, its financial
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statements, its tax returns, and its internal monthly management
reports. Petitioner contends that each element of the
methodology was consistent with GAAP and the recommendations of
the leading authorities, and that FNBC’s approach was in the
mainstream of industry practice for large dealers during the
relevant years. Petitioner observes that: (1) The G-30 report
recommends that midmarket values should be adjusted for credit
risk, administrative cost, and other items and (2) the OCC
(through BC-277) required that all national banks adjust their
values for credit, administrative costs, and other items.
We disagree with petitioner that FNBC’s methodology in
valuing its swaps has been recognized by nearly everyone as the
best approach for valuing financial derivatives. In support of
this argument, petitioner relies mainly (if not solely) on its
experts’ opinions that FNBC computed its adjustments in the same
manner as did the rest of the industry. We are unpersuaded by
these opinions. In the main, they conflict with the credible
evidence in the record including, for example, the testimony of
Duffie to the effect that (1) the industry did not compute its
adjustments in any one manner and (2) FNBC’s use of an 80-percent
confidence level as one data point was the only time that he had
heard of such an approach. Duffie also testified that FNBC’s
practices either were inconsistent with industry practice or were
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unknown to him to be the industry practice.63 Duffie’s inability
to state unequivocally that FNBC’s practices were consistent with
industry practice is particularly telling in view of his position
and status in the very field at issue in this case.
As to the G-30 report, it did not show any general consensus
on an industry standard. In fact, the G-30 report leads to a
contrary conclusion that there was very little in the way of
specific industry practice. See also BC-277, supra:
The best approach is to value derivatives portfolios
based on mid-market levels less adjustments.
Adjustments should reflect expected future costs such
as unearned credit spreads, close-out costs, investing
and funding costs, and administrative costs. Most
limited end-users (and some traders) may find it too
costly to establish systems that accurately measure the
necessary adjustments for mid-market pricing. In such
cases, banks may price derivatives based on bid and
offer levels, provided they use the bid side for long
positions and the offer side for short positions. This
procedure will ensure that financial derivatives
positions are not overvalued.
In this regard, the G-30 survey indicates that, during the
relevant years, there was no consistency among dealers on the use
63
For example, with respect to expected exposure, Duffie
was unable to state that FNBC’s use of a maximum exposure
methodology was consistent with industry practice. In fact, he
pointed to FNBC as the “one data point” for use of an 80-percent
confidence level. With respect to the question of whether FNBC
used a “system” that was consistent with industry practice,
Duffie stated that there was no consistent industry practice.
Duffie also opined that there was little standardization in the
techniques used by banks to value financial derivatives and
little consistency among bank financial derivatives dealers in
determining the amount of adjustments to be made to midmarket
values of financial derivatives during the early 1990s.
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of midmarket values with or without adjustment. The July 30,
1993, survey reveals that (1) 49 percent of the respondents
thereto used midmarket values for valuation and (2) of the
respondents thereto that used midmarket values with adjustments,
44 percent of them adjusted for credit and 54 percent adjusted
for administrative costs. The March 1994 survey reveals that (1)
31 percent of the respondents thereto still used midmarket values
without adjustments a year after the publication of the G-30
report and (2) of the respondents thereto using midmarket values
with adjustment, 32 percent adjusted for credit and 24 percent
adjusted for administrative costs.
Nor does the G-30 report contain a specific standard as to
the precise manner in which credit adjustments to midmarket
values must be computed. To the extent that the G-30 report sets
out general guidelines (e.g., recommendations as to netting,
dynamic computation of credit risk, expected versus maximum
exposure), FNBC’s methodology conflicts with each of these
guidelines. In fact, FNBC’s failure to take netting into account
deviated in significant respects from the industry’s consensus on
that subject. The CFTC viewed rationing via procedures such as
netting as widespread throughout the industry, and Duffie noted
that market participants placed significant emphasis on the use
of netting agreements. Duffie also concluded that the distorting
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effect of FNBC’s failure to take netting into account was large
and systematic.
VI. Application of Fair Market Value
A. Overview
As just discussed, we will respect FNBC’s mark-to-market
method for Federal income tax purposes if it meets the fair
market value requirements of section 475. FNBC’s application of
its mark-to-market method will meet those requirements only if
the method arrives at the fair market value of FNBC’s swaps and
does so as of the applicable valuation dates.
The term “fair market value” is used throughout the Internal
Revenue Code, but has never been defined by Congress.64 The
64
As the Court noted in Estate of Auker v. Commissioner,
T.C. Memo. 1998-185:
Disputes over valuation fill our dockets, and for
good reason. We approximate that 243 sections of the
Code require fair market value estimates in order to
assess tax liability, and that 15 million tax returns
are filed each year on which taxpayers report an event
involving a valuation-related issue. It is no mystery,
therefore, why valuation cases are ubiquitous. Today,
valuation is a highly sophisticated process. We cannot
realistically expect that litigants will, will be able
to, or will want to, settle, rather than litigate,
their valuation controversies if the law relating to
valuation is vague or unclear. We must provide
guidance on the manner in which we resolve valuation
issues so as to provide a roadmap by which the
Commissioner, taxpayers, and valuation practitioners
can comprehend the rules applicable thereto and use
these rules to resolve their differences. Clearly
articulated rules will also assist appellate courts in
their review of our decisions in the event of an
(continued...)
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Treasury Department has defined the term for Federal income tax
purposes as “the price at which the property would change hands
between a willing buyer and a willing seller, neither being under
any compulsion to buy or sell and both having reasonable
knowledge of relevant facts.” Sec. 1.170A-1(c)(2), Income Tax
Regs.; see also sec. 1.704-4(a)(3), Income Tax Regs. (similar
definition). See generally Rev. Rul. 59-60, sec. 2.02, 1959-1
C.B. 237. The Treasury Department has prescribed a similar
definition for Federal estate tax and gift tax purposes. See
sec. 20.2031-1(b), Estate Tax Regs.; sec. 25.2512-1, Gift Tax
Regs.
Petitioner argues that FNBC’s valuations of its swaps met
the fair market value requirement of section 475 in that they
were the fair value of the swaps for purposes of financial
accounting. According to petitioner, FNBC’s application to its
swaps of the standards governing fair value produced the same
values which would have resulted by applying to those swaps the
rules for determining fair market value. In other words,
petitioner argues, under the facts and circumstances of this
case, the concept of fair market value is the same as the concept
of fair value. We disagree. We conclude that the fair value of
FNBC’s swaps as reported for financial accounting purposes is not
64
(...continued)
appeal.
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the same as the swaps’ fair market value for purposes of section
475. Cf. Knight v. Commissioner, 115 T.C. 506, 516 n.6 (2000)
(in passing on the fair market value of certain property, the
Court declined to consider testimony of an expert who opined
solely as to the “fair value” of that property).
B. History of the Term “Fair Market Value”
We begin our analysis of the term “fair market value” by
looking at its history. We trace the first use of that term to
the case of United States v. Fourteen Packages of Pins, 25 F.
Cas. 1182 (E.D. Pa. 1832). There, the issue was whether fourteen
packages of pins were shipped from England to the United States
with a “false valuation” on the invoice which, if they were, was
illegal under the Congressional Act of May 28, 1830, ch. 147,
sec. 4, 4 Stat. 410. The court ruled that fair market value,
market value, current value, true value, and actual value all
require the same inquiry; i.e., what is the true value of the
item in question? United States v. Fourteen Packages of Pins,
supra at 1190.
The term “fair market value” appears to have first been used
for Federal income tax purposes as part of the Revenue Act of
1918, ch. 18, 40 Stat. 1057. Section 202(b), 40 Stat. 1060, of
that act provides that for purposes of determining gain or loss
on the exchange of property, the value of any property received
equals the cash value of its fair market value. The act offered
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no further explanation of the meaning of the term “fair market
value”, and the committee reports underlying the act were equally
silent, using the term without explaining it. H. Rept. 767, 65th
Cong., 2d Sess. (1918), 1939-1 C.B. (Part 2) 86, 88.
Over the years, judicial tribunals have defined the term by
enunciating certain standards which must be considered in passing
on a determination of fair market value. First, in 1919, the
Advisory Tax Board (ATB) recommended an interpretation of the
term “fair market value”. T.B.R. 57, 1 C.B. 40 (1919). There,
the ATB stated that the term refers to a fair value that both a
buyer and a seller, who are acting freely and not under
compulsion and who are reasonably knowledgeable about all
material facts, would agree to in a market of potential buyers at
a fair and reasonable price. Id. Six years later, in 1925, the
Board of Tax Appeals (Board) stated that the buyer is considered
to be a willing buyer and that the seller is considered to be a
willing seller. Hewes v. Commissioner,
2 B.T.A. 1279, 1282
(1925); accord United States v. Cartwright,
411 U.S. 546, 550-551
(1973) (“The willing buyer-willing seller test of fair market
value is nearly as old as the federal income, estate, and gifts
taxes themselves”). The Board also stated in that case that fair
market value must be determined without regard to any event that
occurs after the date of valuation. Hewes v.
Commissioner, supra
at 1282; accord First Natl. Bank v. United States,
763 F.2d 891,
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894 (7th Cir. 1985) (“a rule has developed that subsequent events
are not considered in fixing fair market value, except to the
extent that they were reasonably foreseeable at the date of
valuation”).
Two years after Hewes, the Board adopted the ATB’s
recommendation that fair market value be determined by viewing
neither the willing buyer nor the willing seller as being under a
compulsion to buy or to sell the item subject to valuation.
Hudson River Woolen Mills v. Commissioner, 9 B.T.A. 862, 868
(1927). After that case, the Board observed that neither the
willing buyer nor the willing seller was an actual person but was
viewed as a hypothetical person mindful of all relevant facts.
Natl. Water Main Cleaning Co. v. Commissioner,
16 B.T.A. 223
(1929); accord Estate of Bright v. United States,
658 F.2d 999,
1005-1006 (5th Cir. 1981) (clarifies that the views of both a
hypothetical buyer and a hypothetical seller must be taken into
account, and that the characteristics of each hypothetical person
may differ from the personal characteristics of the actual seller
or a particular buyer); Kolom v. Commissioner,
644 F.2d 1282,
1288 (9th Cir. 1981) (same), affg.
71 T.C. 235 (1978); Pabst
Brewing Co. v. Commissioner, T.C. Memo. 1996-506 (focusing too
much on the view of one hypothetical person, to the neglect of
the view of the other, is contrary to a determination of fair
market value); cf. Estate of Andrews v. Commissioner, 79 T.C.
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938, 956 (1982) (hypothetical sale should not be constructed in a
vacuum isolated from the actual facts that affect value). The
Board stated that the fair market value of an item is determined
from a hypothetical transaction between a “hypothetical willing
seller and buyer, who are by judicial decree always dickering for
price in the light of all the facts, [and] can not be credited
with knowing what the future will yield.” Natl. Water Main
Cleaning Co. v. Commissioner, supra at 239; accord Estate of
Watts v. Commissioner,
823 F.2d 483, 486 (11th Cir. 1987) (the
hypothetical buyer and the hypothetical seller each seek to
maximize his or her profit from any transaction involving the
property), affg. T.C. Memo. 1985-595; Estate of Curry v. United
States,
706 F.2d 1424, 1428 (7th Cir. 1983) (hypothetical willing
buyer and the hypothetical willing seller are presumed to be
dedicated to achieving the maximum economic advantage).
In 1936, the U.S. Supreme Court clarified as to the
definition of fair market value that fair market value is
determined by viewing the item under consideration on the basis
of its best use.65 St. Joseph Stock Yards Co. v. United States,
298 U.S. 38, 60 (1936). There, the Court held that two adjacent
pieces of land should be valued the same per square foot
65
The notion of “highest and best use” was later recognized
by Congress as a requirement of fair market value. H. Conf.
Rept. 94-1380, at 5 (1976), 1976-3 C.B. (Vol. 3) 735, 741.
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regardless of the fact that one was being used in its highest and
best use while the other was not being used at all.
In summary, the primarily judicially developed standards as
to fair market value are: (1) The buyer and the seller are a
willing buyer and a willing seller; (2) neither the willing buyer
nor the willing seller is under a compulsion to buy or to sell
the item in question; (3) the willing buyer and the willing
seller are both hypothetical persons; (4) the hypothetical
willing buyer and the hypothetical willing seller are both
reasonably aware of all relevant facts involving the item in
question; (5) the item in question is valued at its highest and
best use; and (6) the item in question is valued without regard
to events occurring after the valuation date to the extent that
those subsequent events were not reasonably foreseeable on the
date of valuation.
C. Determination of Fair Market Value
A determination of fair market value is a factual inquiry in
which the trier of fact must weigh all relevant evidence of value
and draw appropriate inferences. Commissioner v. Scottish Am.
Inv. Co., 323 U.S. 119, 123-125 (1944); Helvering v. Natl.
Grocery Co.,
304 U.S. 282, 294 (1938); Symington v. Commissioner,
87 T.C. 892, 896 (1986). Generally, three approaches are used to
determine the fair market value of property consistent with the
judicially espoused standards. These approaches are: (1) The
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market approach, (2) income approach, and (3) the asset-based
approach. The question of which of these approaches to apply in
a given case is a question of law. Powers v. Commissioner, 312
U.S. 259, 260 (1941).
1. Market Approach
The market approach requires a comparison of the subject
property with similar property sold in an arm’s-length
transaction in the same timeframe. The market approach values
the subject property by taking into account the sale prices of
the comparable property and the differences between the
comparable property and the subject property. Estate of Spruill
v. Commissioner, 88 T.C. 1197, 1229 n.24 (1987); Wolfsen Land &
Cattle Co. v. Commissioner,
72 T.C. 1, 19-20 (1979). The market
approach measures value properly only when the comparable
property has qualities substantially similar to those of the
subject property. Wolfsen Land & Cattle Co. v.
Commissioner,
supra at 19-20.
2. Income Approach
The income approach relates to capitalization of income and
discounted cashflow. This approach values property by computing
the present value of the estimated future cashflow as to that
property. The estimated cashflow is ascertained by taking the
sum of the present value of the available cashflow and the
present value of the residual value.
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3. Asset-Based Approach
The asset-based approach generally values property by
determining the cost to reproduce it.
D. Fair Market Value Compared With Fair Value
1. Meaning of the Term “Fair Value”
We understand the term “fair value” to have two separate and
distinct meanings, the first under GAAP and the second under
State law.
a. GAAP Purposes
As to the first meaning, the term “fair value” is often the
standard followed by accountants in their preparation of
financial statements. Financial statements are used not only by
the clients for whom they are prepared but also by lending banks,
buyers of businesses, the SEC, and countless others. For
purposes of financial accounting, SFAS No. 107 defined the fair
value of a financial instrument as:
the amount at which the instrument could be exchanged
in a current transaction between willing parties, other
than in a forced or liquidation sale. If a quoted
market price is available for an instrument, the fair
value to be disclosed for that instrument is the
product of the number of trading units of the
instrument times that market price.
b. State Law Purposes
As to its second meaning, most State statutes usually define
the term for purposes of valuing dissenting stockholders’
appraisal rights and, sometimes, for purposes of valuing property
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in cases of marital dissolution. In Illinois, for example, the
Illinois legislature has defined the fair value of a noncash
asset as:
(A) the amount at which that asset could be bought
or sold in a current transaction between arms-length,
willing parties;
(B) quoted market price for the asset in active
markets should be used if available; and
(C) if quoted markets prices are not available, a
value determined using the best information available
considering values of like assets and other valuation
methods * * *. [215 Ill. Comp. Stat. Ann. 5/179E-15
(West Supp. 2002).]
In passing on the definition of fair value, the Illinois courts
have held that the fair value of an item may be the same as its
fair market value, but that the fair value of an item is not
always its fair market value. Institutional Equip. & Interiors,
Inc. v. Hughes, 562 N.E.2d 662, 667-668 (Ill. App. Ct. 1990); see
also Laserage Tech. Corp. v. Laserage Labs., Inc.,
972 F.2d 799,
805 (7th Cir. 1992).
2. Difference Between Fair Market Value and Fair Value
Given the applicability to these cases of SFAS No. 107, we
believe that the accountant’s definition of “fair value” is more
pertinent to these cases than the State law definition.
Accordingly, we apply that definition to our analysis. The
concepts of “fair market value” and “fair value” are different
primarily in three regards. First, whereas fair market value
requires that the willing buyer and willing seller be reasonably
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aware of all facts relevant to the property to be valued, fair
value requires no such knowledge. Fair value simply anticipates
that the “willing parties” be “willing”.
Second, whereas fair market value requires that neither the
willing buyer nor the willing seller be under a compulsion to buy
or to sell the property in question, fair value merely requires
that the property not be the subject of a forced sale or
liquidation. At first blush, these requirements appear to be the
same. As noted correctly by Sziklay, however, as to the phrase
“forced or liquidation sale”, “it simply is not clear if that
condition attaches to both the buyer and the seller in this
definition. Fair market value for tax purposes must give equal
consideration to the hypothetical buyer and seller--neither can
be under compulsion.” In addition, a liquidation is not the same
thing as being under a compulsion to buy or to sell. One can
liquidate voluntarily.
Third, the words contained in the Treasury Department’s
definition of the term “fair market value” have been glossed
judicially to impute certain attributes into the valuation test.
For example, as discussed above, the willing buyer and willing
seller are both considered to be hypothetical rather than actual
persons. In addition, we learn from the jurisprudence underlying
the term “fair market value” that the property to be valued must
be valued by viewing the property in its highest and best use.
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We find neither of these requirements in the definition of “fair
value” as set forth in SFAS No. 107. Nor are we able to conclude
on the basis of the record that either of these requirements has
been imputed into that definition under SFAS No. 107, or, in
fact, into the accountant’s definition of that term in general.66
Our understanding of the difference between these two terms
is further reinforced by additional testimony from Sziklay. He
concluded that
Fair market value for income tax reporting purposes is
related to, but not the same as, fair value for
financial reporting purposes which is directed to the
needs of financial statement users. The former is
encompassed in the latter. I have not read anything in
the trial record, expert reports, the Internal Revenue
Code, Treasury regulations, Revenue Rulings, Revenue
Procedures, federal tax cases, etc. to suggest that
fair market value for income tax purposes must conform
to fair value for financial reporting purposes for the
purpose of marking-to-market * * * [FNBC’s] portfolios
of derivative securities.
He testified further that “the term, fair value, for accounting
purposes is a broader term than fair market value for tax
66
For purposes of financial accounting, the term “fair
value” denotes primarily:
1. Value determined by bona fide bargain between
well-informed buyers and sellers; the price for which
an asset could be bought or sold in an arm’s-length
transaction between unrelated parties; value in a sale
between a willing buyer and a willing seller, other
than in a forced or liquidation sale.
2. An estimate of such value, in the absence of sales
or quotations (e.g., the approximation of exchange
price in nonmonetary transactions). [Kohler’s
Dictionary for Accountants 211 (6th ed. 1983).]
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purposes. It could include a value which does not necessarily
meet the strict requirements of the Internal Revenue Code, U.S.
Treasury regulations, etc.”
Upon the cross-examination of petitioner’s counsel, Sziklay
did testify that the elements of “fair market value” and “fair
value”, when the definitions of the terms are construed
literally, were inconsequential when applied to FNBC’s swaps.
Sziklay testified initially, however, that the elements of those
two terms were different as applied to those swaps. We agree
with Sziklay’s initial testimony. We apply the term “fair market
value” as interpreted by the judiciary to include requirements
which are found outside of that term’s literal definition (e.g.,
requirements of hypothetical parties and highest and best use).
We also note that Sziklay’s later testimony was tangential to his
testimony concerning the valuation of FNBC’s swaps as if they
were hypothetical swaps each of which was between the actual
counterparty and (instead of FNBC) a hypothetical person. As
discussed infra p. 211, we value the swaps held by FNBC on the
basis of their actual attributes rather than viewing each of the
swaps as a hypothetical swap entered into between the actual
counterparty and (instead of FNBC) a hypothetical person.
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3. Conclusion
For the foregoing reasons, we conclude that the fair value
of FNBC’s swaps does not equal their fair market value.67
VII. Property To Be Valued
We consider next the specific property that must be valued.
Each piece of property is an interest rate swap to which FNBC is
a party.68 Each swap’s benefit is realized by the party thereto
that is entitled to receive the higher interest rate on the
valuation date. Each swap’s detriment is suffered by the party
thereto that is required to pay that higher rate.
Given the bilateral nature of a swap, we believe that the
fair market value of an interest rate swap is best ascertained by
67
As to the specifics of FNBC’s swaps income methodology,
and the question of whether that method arrived at the fair
market value of FNBC’s swaps for Federal income tax purposes,
Sziklay testified credibly that he was unable to answer that
question. He opined that the adjusted midmarket method is a
customized version of the discounted cashflow method, and that a
proper implementation of the adjusted midmarket method may result
in a fair market value consistent with the meaning of that term
for Federal income tax purposes. He testified, however, that
FNBC’s sole use of its adjusted midmarket method to value its
swaps was inconsistent with the general practice of the business
appraisal profession to use more than one approach to value an
asset. He specifically took exception to the fact that
petitioner produced no evidence of ever using the market
comparables approach to valuation, even as to a sample of its
financial derivative transactions.
68
We hereinafter limit our analysis to the treatment of
interest rate swaps. We believe on the basis of our
understanding of the other financial derivatives at issue that
the tax treatment of those derivatives follows naturally from our
decision as to FNBC’s interest rate swaps. If we are mistaken on
that point, then either party may bring this to our attention.
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determining the difference in the value of each of the swap’s
legs viewing the legs as if each of them was a bond bearing the
same attributes (e.g., identification of issuer, maturity,
interest rate) as the corresponding leg. In short, we view the
fixed leg as a bond the issuer of which is the fixed-rate payor
and the interest rate of which equals the fixed rate payable on
the swap. We view the floating leg as a bond the issuer of which
is the floating-rate payor and the interest rate of which is the
floating rate of interest. We consider the fair market value of
each swap to equal the difference between: (1) The price at
which a hypothetical willing buyer and a hypothetical willing
seller would agree to buy/sell the fixed leg and (2) the price at
which a hypothetical willing buyer and a hypothetical willing
seller would agree to buy/sell the floating leg.
We learn from Sziklay, generally speaking, that an interest
rate swap is analogous to two bonds.69 We learn from Duffie,
speaking more specifically, that a swap is simply an exchange of
a fixed-rate bond for a floating-rate bond of the same maturity,
both bonds bearing a face value equal to the notional principal
amount of the swap. We further learn from Duffie that a swap’s
69
Sziklay testified that the credit ratings of the issuers
must be taken into account when valuing the bonds. We agree. As
to each leg, its value to the payee equals the present value of
the payments due thereunder. Obviously, in determining this
value, one must take into account the creditworthiness of the
payor/issuer.
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value may be derived by comparing the difference in the values of
the fixed-rate and floating-rate bonds. Whereas Duffie qualifies
his position as to value by stating that adjustments may have to
be made to the difference in the values of the two bonds, e.g.,
to reflect credit risk, we reflect his qualifications by viewing
the two bonds as described above.
We view each of FNBC’s swaps as a swap between the two
actual counterparties, one of which is FNBC, and we determine the
fair market value of each swap as if its legs were bonds which
were bought and sold by hypothetical persons. We believe that
this manner of valuation is most consistent with the requirement
of section 475(a) and (c)(2)(D) that the property considered sold
as of the last business day is the “contract” rather than the
rights or liabilities of only one of the parties to that
contract. We also believe that this manner of valuation is most
consistent with the well-established willing buyer/willing seller
test, which considers the “willing seller” of FNBC’s swaps to be
a hypothetical seller rather than FNBC itself. See Estate of
Curry v. United States, 706 F.2d at 1428; Estate of Bright v.
United
States, 658 F.2d at 1005. This manner of valuation also
equates the valuation of swaps with the valuation of stocks and
bonds, the more common types of financial instruments which come
before this Court for valuation, in that we value the actual
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(rather than a hypothetical) financial instrument.70 In
determining our manner of valuation, we consider it important
that we are unable to find (nor does either party or the amici
suggest) that, except in rare cases, a party to a swap actually
sells its place in the swap to a third party. The record
indicates, and we find as a fact, that, except in those rare
cases, one party to a swap never sells only its position in the
swap but, instead, if it wants to get out of the swap, terminates
the swap in full primarily through a buyout.
VIII. Applicable Valuation Date
FNBC did not determine the value of its swaps as of the last
business day of its taxable years. Petitioner argues that the
early closing dates were reasonable and did not result in any
undervaluation of its swaps. Petitioner asserts that early
closing dates were common among banks and resulted, at most, in a
timing difference of 1 year. Petitioner relies upon Wal-Mart
Stores Inc. v. Commissioner, T.C. Memo. 1997-1, as support for
the early valuation dates used by FNBC.
We are unpersuaded by petitioner’s argument. Section 475
required that FNBC value its swaps as of the last business day of
its 1993 taxable year. Although section 475 by its terms also
70
In other words, were we to value FNBC’s swaps by assuming
that a hypothetical buyer replaces FNBC in the swap, we are no
longer valuing the actual swap but are now valuing a hypothetical
swap between the hypothetical buyer and the actual counterparty.
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did not apply to FNBC’s earlier years, we believe that FNBC was
bound by a similar rule for those earlier years. As we see it,
the rule in the earlier years was that a proper application of a
mark-to-market method required that FNBC value its swaps as of
the end of its taxable year.71
FNBC failed to meet this yearend valuation requirement in
that it did not value all of its swaps as of the last business
day before its yearend. Petitioner relies erroneously upon
Wal-Mart for a contrary conclusion. Whereas the taxpayer in Wal-
Mart estimated inventory shrinkage as of its yearend (the
applicable valuation date there), FNBC is not estimating the
value of its swaps as of its applicable valuation date (i.e., the
last business day before yearend) but is using an early valuation
date.
IX. Proper Hypothetical Market
We consider next the proper hypothetical market in which to
value FNBC’s swaps. The Code provides no specific rule as to the
proper market in which to determine fair market value. The
regulations do, at least in the case of valuations which are
required for Federal estate and gift tax purposes. For Federal
estate tax purposes, the regulations provide:
The fair market value of a particular item of property
includible in the decedent’s gross estate is not to be
71
As we observed supra, FNBC’s last business day of each
subject year was the same as its last day of the year.
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determined by a forced sale price. Nor is the fair
market value of an item of property to be determined by
the sale price of the item in a market other than that
in which such item is most commonly sold to the public,
taking into account the location of the item wherever
appropriate. Thus, in the case of an item of property
includible in the decedent’s gross estate, which is
generally obtained by the public in the retail market,
the fair market value of such an item of property is
the price at which the item or a comparable item would
be sold at retail. For example, the fair market value
of an automobile (an article generally obtained by the
public in the retail market) includible in the
decedent’s gross estate is the price for which an
automobile of the same or approximately the same
description, make, model, age, condition, etc., could
be purchased by a member of the general public and not
the price for which the particular automobile of the
decedent would be purchased by a dealer in used
automobiles. * * * The value is generally to be
determined by ascertaining as a basis the fair market
value as of the applicable valuation date of each unit
of property. For example, in the case of shares of
stock or bonds, such unit of property is generally a
share of stock or a bond. * * * [Sec. 20.2031-1(b),
Estate Tax Regs.]
For Federal gift tax purposes, the relevant regulations contain
virtually identical language. See sec. 25.2512-1, Gift Tax Regs.
Thus, in the case of Federal estate and gift taxes, the
regulations provide that the relevant market for the hypothetical
sale is the “public” market or, in other words, the retail market
in which the item is sold to the ultimate consumer; i.e., the
customer who does not hold the item for subsequent resale.72
72
In the case of the Federal income tax, more specifically,
charitable contributions, the regulations set forth rules for
determining the value of items which a taxpayer sells in the
course of its business. The regulations provide:
(continued...)
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Goldman v. Commissioner, 388 F.2d 476, 478 (6th Cir. 1967), affg.
46 T.C. 136 (1966); Lio v. Commissioner,
85 T.C. 56, 70 (1985),
affd. sub nom. Orth v. Commissioner,
813 F.2d 837 (7th Cir.
1987); see also Leibowitz v. Commissioner, T.C. Memo. 1997-243.
In fact, the regulations, by way of the used car example,
specifically adopt the price that a retail purchaser would pay
for an item in lieu of the price that a dealer would pay for it.
See Estate of Lemann v. United States, 73 AFTR 2d 2345, 2349, 94-
1 USTC par. 60159, at 84,195 (E.D. La. 1994) (rejecting prices
that a dealer would pay for estate jewelry in favor of the prices
which the customers would pay at auction). For this purpose, the
term “retail” does not denote that the most expensive source is
the only source for determining fair market value. Lio v.
72
(...continued)
If the contribution is made in property of a type which
the taxpayer sells in the course of his business, the
fair market value is the price which the taxpayer would
have received if he had sold the contributed property
in the usual market in which he customarily sells, at
the time and place of the contribution and, in the case
of a contribution of goods in quantity, in the quantity
contributed. The usual market of a manufacturer or
other producer consists of the wholesalers or other
distributors to or through whom he customarily sells,
but if he sells only at retail the usual market
consists of his retail customers. [Sec. 1.170A-
1(c)(2), Income Tax Regs.]
These regulations are not pertinent to our inquiry. FNBC did not
“sell” swaps in the course of its business. Swaps were seldom
sold in a secondary market, and no entity similar to FNBC
actually purchased a swap during the relevant years with the
intent to resell it.
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Commissioner, supra at 70. Fair market value is determined in
the market most commonly used by the ultimate consumer, and the
value in that market may or may not represent the highest value
for the product that is the subject of the valuation. Here, with
respect to the interest rate swaps in issue, we believe that the
applicable market is a market comprising largely end users
(including dealers acting as end users).
Having identified the appropriate market for valuation
purposes, we determine the fair market value of FNBC’s swaps at
the amount that an ultimate consumer/hypothetical buyer would in
that market pay for the swaps on the dates of valuation, bearing
in mind that the swaps are considered sold by a hypothetical
seller. Petitioner asks the Court to view the hypothetical buyer
as a dealer entering into swaps intending to earn a profit. We
decline to do so. We believe it inappropriate to limit the
hypothetical willing buyer to the requested subset of buyers
rather than viewing the hypothetical buyer as a member of the
broad group of potential buyers referred to in the accepted
definition of willing buyer. In addition to the fact that even
petitioner acknowledges that dealers enter into swaps without
expecting to earn a profit, e.g., to hedge risks in its portfolio
or to generate business, valuation at the equivalent of the
dealer’s own bid or ask price improperly limits consideration to
buyers who believe they are paying less than fair market value.
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The case of Dellinger v. Commissioner, 32 T.C. 1178, 1185
(1959), is instructive to our conclusion. There, a corporation
sold vacant lots to its shareholders at a bargain price. The
taxpayer argued that the fair market value of the lots was the
price that would be paid by an “investor”, and that an investor
would not have paid more than one-half of the price at which the
lots were expected to eventually sell. The Court rejected these
arguments. The Court stated:
Petitioner has not directed our attention to any case
where fair market value was predicated on or limited to
the amount that a hypothetical investor would pay for
the property, rather than the broader group referred to
in the accepted definition as a “willing buyer.” Fair
market value does not mean, of course, that the whole
world must be a potential buyer of the property
offered, but only that there are sufficient available
persons able to buy to assure a fair and reasonable
price in the light of the circumstances affecting
value. In considering the term “fair market value” as
used in section 301, supra, we cannot restrict the
market to dealers, investors, or any other limited
groups. * * * [Id.]
X. FNBC Implemented Its Mark-to-Market Method Inconsistently
With Section 475
A. Overview
FNBC primarily used its mark-to-market method to compute the
amounts that it reported as the fair market value of its swaps
for purposes of section 475. O’Brien testified that a valuation
method is not actually a mark-to-market method if the valuation
method does not arrive at fair market value. She concluded that
FNBC’s mark-to-market method did not arrive at fair market value.
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She concluded that FNBC’s mark-to-market method was not actually
a mark-to-market method.
We agree with O’Brien’s conclusion that FNBC’s
mark-to-market method was not in fact a mark-to-market method.
We conclude that FNBC’s mark-to-market method was inconsistent
with the fair market value requirement of section 475.
B. Midmarket Values
Section 475(a)(2) generally mandates that FNBC value each
swap that it “held at the close of any taxable year * * * as if
such security [swap] were sold for its fair market value on the
last business day of such taxable year”. FNBC’s midmarket method
failed this requirement. FNBC’s midmarket method did not
ascertain midmarket values for all of the swaps which FNBC held
at the end of each of its taxable years, as if those swaps had
been sold at their fair market value as of the last business day
of the appropriate years. The midmarket values which FNBC
computed as of its early closing dates were not last business day
values. Such an early valuation date is inconsistent with
section 475, especially when one considers that the values of at
least some of FNBC’s swaps changed significantly from the early
closing date to the date of the last business day. As Sziklay
noted, and we agree, the valuation date required by section 475
is December 31 for calendar year taxpayers such as FNBC, and an
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earlier valuation date simply does not meet that legislative
requirement.73
Nor was FNBC’s practice of valuing nonperforming swaps at
modified lower of cost or market consistent with the last
business day mark-to-market requirement of section 475. A policy
of valuing nonperforming swaps at lower of cost or market is not
mark-to-market accounting. A lower of cost or market method
recognizes losses in market value below the amortized cost value,
but it does not recognize gains in market value above the
amortized cost value. Gains in market value are recognized under
a lower of cost or market method only to the extent that they
recoup previously recognized losses. The legislative history of
section 475 also states specifically that a lower of cost or
market method is not acceptable for purposes of section 475.
That history notes that such a method generally understates the
income of securities dealers.
C. Adjustments in General
Petitioner argues that FNBC’s adjustments are allowed under
section 475 because, petitioner asserts, FNBC used and relied
upon its adjusted swap values for various nontax purposes; e.g.,
pricing swaps, risk managing swaps, reporting to regulatory
agencies and shareholders, and ascertaining employee bonuses.
73
We note that Dec. 31 was on a weekday during each of the
years 1990 through 1992.
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Petitioner has failed to establish that FNBC relied on its
adjustments or adjusted midmarket values for any of these
purposes.74 In fact, the evidence establishes to the contrary
that FNBC used midmarket to price and risk-manage its swaps, to
ascertain employee bonuses, and to report to management. The
evidence also establishes that the adjustments at issue were
lower than the materiality standard for audited financial
statement purposes, so as not to draw any criticism from FNBC’s
auditors, and that where a fair value standard did apply to
FNBC’s financial reporting in the form of the footnote
disclosures under SFAS No. 107, FNBC used midmarket values.
The fact that FNBC risk-managed its swaps by using midmarket
values is supported by Parsons’s observation that FNBC’s risk
management personnel did not rely upon information on either of
the carve-outs. In terms of managing credit risk, as opposed to
market risk, FNBC used updated calculations of exposure in the
form of updated CEM figures for risk management purposes and did
not rely on the valuations made using the “stale” CEM figures
incorporated into the credit adjustment. Parsons also testified
credibly that the swap industry used midmarket value for doing
actual business, for pricing swaps, for trading swaps, and for
risk-managing swaps.
74
Even if it did, we agree with Sziklay that FNBC’s use of
its adjusted midmarket method for any or all these purposes is
not dispositive for Federal income tax purposes.
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Petitioner also contended that the carve-outs were used for
pricing. The facts, however, show that pricing of swaps was
market-driven; i.e., FNBC’s traders quoted swap spreads based on
where the market was at the time, and where they thought it would
go. Nor were the bonuses for swap personnel ascertained strictly
on profitability. The size of the bonus pool for swap personnel
depended on many factors, including how the bank performed as a
whole, and did not depend on any adjustment taken by FNBC. To
the extent that swap profitability was a consideration in
determining the bonuses, compensation for traders and marketers
was based upon unadjusted mark-to-market revenues raised by each
trader or marketer, as well as certain other subjective factors.
Nor did FNBC rely upon adjusted midmarket values for buyout
purposes; it required that the buyout prices be (and effected its
buyouts) at the midmarket value.
D. Credit Adjustment
1. Need for a Credit Adjustment
Petitioner argues that FNBC’s calculation of credit
adjustments was necessary to reflect the fair market values of
its swaps.75 Respondent acknowledges that the midmarket value of
an interest rate swap may have to be adjusted for credit risk in
order to arrive at its fair market value when: (1) The
75
Petitioner concedes that FNBC could determine its current
exposure at any point.
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counterparty has the lower credit rating and (2) the parties to
the swap have not agreed to any credit enhancement that would
negate that lower rating. Respondent asserts that any credit
adjustment that is reported under section 475 must be ascertained
on the basis of a market benchmark, which is not present here.
We hold that a credit adjustment to the midmarket value of
an interest rate swap is necessary in certain cases to determine
the swap’s fair market value. Specifically, we hold that such an
adjustment is required to the extent that the adjustment properly
reflects the change to the swap’s midmarket value on account of
the actual parties’ respective creditworthiness, taking into
account all the facts and circumstances that would enhance or
diminish each party’s creditworthiness.76 We consider the
presence or absence of credit enhancements such as collateral or
netting provisions to be an important factor to take into account
as to the enhancement or diminution of a counterparty’s
creditworthiness.
We hear from all of the experts on financial derivatives
that credit risk may cause a swap’s fair market value to deviate
from its midmarket value and, therefore, that the fair market
value of a swap should reflect credit risk. We agree. A swap is
76
Given our conclusion that we must value each swap on the
basis of the traits of the actual parties thereto, we disagree
with respondent that a market benchmark as to credit adjustments
is indispensable to the determination of any such adjustment.
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a series of promised cashflows, the payment of which depends upon
the probability that they will be paid. Other things being
equal, the probability that a payment will be made is greater in
the case of a counterparty with a high credit rating than in the
case of a counterparty with a low credit rating. Thus, all other
things being equal, the fair market value of the promise of the
higher rated counterparty is usually greater than the fair market
value of the lower rated counterparty. The midmarket value fails
to reflect this basic principle in that the value is calculated
without regard to a counterparty’s actual credit rating and
without regard to the presence or absence of credit enhancements
or netting.
Petitioner and its experts argue that the midmarket value of
an interest rate swap will always overestimate its fair market
value because, they assert, credit risk can only lower the swap’s
fair market value. We disagree. Credit risk in swaps is
bilateral and may increase or decrease midmarket value. For
example, all other things being equal, a swap’s midmarket value
is less than the actual value of FNBC’s position in the swap if
the counterparty has a better credit rating than FNBC. An upward
adjustment, therefore, is appropriate in such a case. A downward
adjustment, however, is appropriate in the converse situation.
The downward adjustment is necessary to reflect the fact that a
swap’s midmarket value is greater than the actual value of FNBC’s
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position in the swap given that the counterparty has a worse
credit rating than FNBC. Whereas petitioner is correct that
credit risk is normally negligible at the inception of a swap,
and that interest rate movements after inception may produce an
incremental credit risk warranting a downward adjustment at a
revaluation date, petitioner ignores the reality of the converse
of this principle; i.e., that an upward credit adjustment might
be justified when changes in interest rates have caused the
market value of the swap to become negative.
2. One-Month Lag in Recording Swaps
Whereas FNBC calculated its credit adjustments quarterly,
those quarterly periods did not coincide with the calendar
quarters in which its swaps actually arose. FNBC treated each of
its swaps as arising 1 month after the date that the swap
actually arose. FNBC’s 1-month lag for determining the swaps
which it included in its credit adjustment for a quarter was
inconsistent with the section 475 mark-to-market requirement that
value be determined as of the last business day in the taxable
year. FNBC’s 1-month lag resulted inappropriately in FNBC’s
postponing the recognition of some of its credit adjustments for
1 whole year; e.g., the credit adjustments for 32 swaps which
FNBC initiated in December 1993 were actually claimed in 1994.
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3. Credit Ratings of Both Counterparties
Petitioner argues that the fair market value of FNBC’s
interest rate swaps does not take into account FNBC’s own credit
rating. Respondent argues that the fair market value of interest
rate swaps takes into account both parties’ creditworthiness. We
agree with respondent. We believe that a determination of the
fair market value of interest rate swaps, in that they are
bilateral contracts which by definition require the performance
of both parties thereto, must take into account the
creditworthiness of both of those parties. FNBC’s credit risk
methodology ignores the bilateral nature of swaps and the impact
that FNBC’s own credit risk has on a swap’s fair market value
flowing from the danger that FNBC may not fulfill its obligations
under the swap.
We agree with Duffie and Parsons that the credit rating of a
dealer such as FNBC affects the value of a swap. We also agree
with Duffie and Parsons that the credit adjustment may be either
positive or negative when a counterparty has a better credit
rating than the dealer, regardless of that higher rating. As
Parsons stated, a dealer such as FNBC may have to make an upward
adjustment if a swap becomes significantly off-market to the
dealer’s disadvantage, regardless of who has the higher credit
rating. In that case, the counterparty is exposed to credit risk
from the dealer, and the dealer is generally not exposed to any
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credit risk from the counterparty. On the other hand, Parsons
stated, the dealer may have to make a downward credit adjustment
if the swap becomes significantly off-market to the dealer’s
advantage, regardless of the relative credit ratings of the
dealer and its counterparty.
Duffie disagreed with the related analysis of petitioner’s
experts that rested on the premise that only the credit quality
of the dealer’s counterparty should be considered when making a
credit-risk adjustment, and that the relative quality of the
dealer itself is irrelevant. Duffie stated:
consider the case of interest-rate swaps, with two
possible dealers, Gilt and Silver, and an outside
counterparty, Z, that wishes to pay the floating rate.
We will ignore all adjustments except for credit.
Suppose the outside counterparty X is rated AA, that
Gilt is rated AA, and that Silver is rated BBB.
Suppose Z calls Gilt and asks for the fixed rate R to
be paid by Gilt that would be set so that there is no
initial exchange of cash, meaning that the fair market
value of this swap between Z and Gilt is zero.
Now, suppose Z calls the lower-quality dealer
Silver in order to obtain an interest rate swap under
which Z pays floating and Silver pays the same fixed
rate R. They negotiate a price P for this swap (under
the same standard of willing buyer and seller used in
the definition of “fair market value”) to be paid by
Silver to Z. The price is greater than zero because Z
was willing to receive a price of zero under the same
contractual terms when trading with the higher-quality
dealer Gilt. He would be unwilling to trade at a price
of zero with Silver, but rather would demand some
higher price as compensation for bearing the comparably
higher credit risk of Silver. This means an upward
adjustment in the market value of the swap to Silver,
relative to the price of zero obtained by Gilt. This
refutes the claim that Silver’s own credit quality
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should play no role in the fair market values at which
it trades.
The petitioner’s expert analysis suggests that
Silver should make a downward credit adjustment in
market value (from zero) associated with the potential
default of counterparty Z, disregarding its own lower
credit quality. Again, this is incorrect. The
petitioner’s experts rely on the argument that if the
low-quality dealer Silver were to attempt to “sell”
(that is, assign its position in) its swap with Z to
the higher-quality dealer Gilt, then Gilt “would not be
influenced to pay more or less” because of Silver’s
credit rating, because, if it purchased this swap from
Silver, it would not be extending credit to Silver.
* * * There is a logical fallacy here. Silver had
already been receiving, in terms of expected credit
exposure, an effective extension of credit from Z,
which was worth P to Silver, net of the value of the
effective credit it had offered Z. If Silver were to
ask Gilt to assume its position in the swap, it would
demand P in return for the net loss in market value on
the extension of credit by Z. Then, before completing
the deal with Silver, Gilt would turn to counterparty Z
and ask for an up front payment of P in return for
relieving Z of its net exposure to Silver, in the event
that the re-assignment of the swap from Silver to Gilt
were to occur. Since Z would indeed benefit from this
net reduction in credit risk that is worth P, Z would
agree to pay P to Gilt, contingent on the re-
assignment. All three parties would then consummate
the trade. Gilt would now be paying a fixed rate R to
Z on a fixed-for-floating swap, and have gotten into
this contract for a net price of 0. This is of course
the same price (zero) at which Gilt and Z would have
signed the swap contract in the first place. Of
course, there is some doubt in practice whether all
three counterparties would take the trouble to make
such contingent assignment arrangements, and indeed it
is unusual to see swap assignments, where there is a
material difference in the credit qualities of the
assignor and assignee. This does not lessen the “moral
of the story,” which is that Silver’s own credit
quality does indeed play a role in determining the
market value of its swap with Z.
Now, going back to the swap between Z and the low-
quality dealer Silver, suppose that interest rates fall
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dramatically, and the swap has moved so far into the
money (of positive value) to Silver, that Silver now
has an expected exposure to Z that is so large as to
cause an expected loss from default by Z that is much
larger than the expected loss to Z from default by
Silver, resulting in a new credit adjustment in
Silver’s market value that is downward.
That is, the same swap between the same two
counterparties can have an upward adjustment for credit
risk in some cases, and a downward credit adjustment in
other cases, regardless of the relative quality of the
counterparties. At the inception of a swap with no
initial exchange of cash flow, however, a dealer of
lower credit quality than its counterparty should not
apply a downward credit adjustment relative to a mid-
market valuation. If anything, the adjustment from
mid-market should be upward.
I have not learned of cases in which major dealers
have actually made upward credit adjustments from the
mid-market valuation of interest-rate swaps associated
with the fact that their own credit quality is lower
than that of their counterparty. Dealers are normally
of high quality in any case. When dealers (and other
firms) issue bonds, however, they sell them to
investors at a price that reflects their own credit
quality. The lower their quality, the lower the price
at which they are willing to issue their bonds,
relative to those issued by higher-quality firms. The
same principle applies to derivatives.
4. Midmarket Values Reflected AA Counterparties
Parsons stated that for a counterparty rated AA, the credit
risk is already reflected in the discount rate used to calculate
midmarket value. Parsons also stated that applying a credit
adjustment on a swap negotiated with an AA counterparty is double
counting absent the presence of an incremental credit risk above
and beyond that already reflected in the quoted AA swap rates.
Such an incremental credit risk could occur if the swap becomes
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significantly off-market to the advantage of the dealer. Duffie
stated similarly to Parsons that there should be no credit
adjustment at the inception of a swap with a counterparty rated
AA, but that a downward credit adjustment would subsequently be
warranted if changes in interest rates caused the value of the
swap to become positive.
We agree with the testimony of Duffie and Parsons. Given
that FNBC discounted at an AA rate, the midmarket values being
reduced by credit adjustments already were discounted by a factor
reflecting the risk of nonpayment by an AA-rated counterparty.
The impact of the AA discount rate coupled with the claimed
credit adjustments is that FNBC is taking two adjustments for the
risk of default by AA-rated counterparties. FNBC did not
increase the value of swaps with A and above A-rated
counterparties to take into account the impact of FNBC’s credit
rating of A-.77
5. Credit Enhancements
Whereas many of FNBC’s swaps were supported by credit
enhancements such as credit triggers, guarantees, collateral, and
credit agreements, FNBC did not take those enhancements into
account in computing its credit adjustments. We believe that
collateral and other types of credit enhancements must be
77
Duffie testified that it would be unusual to see a
difference in prices between counterparties rated AAA and AA.
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considered in determining credit risk. By ignoring these
enhancements, a taxpayer such as FNBC fails to consider that a
counterparty’s credit rating may actually be equivalent to an AA
rating.
6. Netting
The parties dispute whether netting applies in determining
the fair market value of a swap. Respondent argues that it does.
Petitioner argues that it does not. We agree with respondent.
Market participants during the relevant years placed significant
stress on the use of netting agreements, and most of FNBC’s swaps
during those years were covered by ISDA agreements with netting
provisions. Netting lowered FNBC’s credit risk in that FNBC,
were it to be a nondefaulting party, could take advantage of
offsetting transactions in the event of counterparty default.
As a consequence of single- and multiple-transaction
netting, when one swap is above market to the dealer and another
swap between the same parties is below market to the dealer,
credit exposure is reduced given that the corresponding
obligations will be netted against one another. As a consequence
of closeout netting, if one swap is above market to the dealer
and another swap between the same parties is below market to the
dealer, then in the event of default, the dealer’s potential loss
will be limited because these obligations also will be netted
against one another. Moreover, even when one of the parties to a
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payment and closeout netting contract becomes bankrupt or
insolvent, payment and closeout netting reduces credit exposure
of the nondefaulting party to the bankrupt counterparty.
FNBC had a program that took netting into account but
apparently chose not to use it. FNBC’s failure to take netting
into account in determining its credit adjustments overestimated
the credit adjustments and did not reflect the true value of its
swaps. In fact, FNBC acknowledged as much in its annual
statements when it reported that the credit exposure amount was
overstated because FNBC ignored the effects of netting and other
credit enhancements.
7. Static or Dynamic Procedure
FNBC ascertained its credit adjustments using a static
procedure. Petitioner argues that FNBC’s static procedure was
reasonable and consistent with industry practices and did not
overstate the credit adjustments compared to a dynamic model.
Petitioner asserts that the G-30 report endorsed the use of
straight-line amortization of a credit adjustment over the life
of the related transaction as the most common approach in the
industry.
We believe that a static procedure such as that used by FNBC
is contrary to the requirement of section 475 that a swap be
marked to market at each yearend. FNBC’s static procedure failed
to reflect (1) the changing market value of credit risk,
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(2) movements in interest rates, (3) changes in its and its
counterparties’ credit ratings, and (4) the early terminations of
some swaps or their subsequent chargeoffs. In fact, as to the
last point, FNBC in some cases even claimed adjustments to reduce
yearend swaps income when the swap that gave rise to the alleged
credit risk was paid in full before yearend. Not only was there
no value included on the return in that case, but there was no
longer a risk of nonpayment. Under mark-to-market accounting,
FNBC must reestimate the value associated with credit risk for
its outstanding swaps at yearend, in light of the then-current
conditions affecting the value of credit risk. FNBC also must
record any decreases (increases) in this value as income (loss).
Parsons testified that only a dynamic procedure captures the
actual value of credit risk at a date later than the inception of
the swap. We agree. Whereas FNBC calculated the credit
adjustment only at inception, when the midmarket value was
probably very close to fair market value, the credit risk of a
party is most often affected after inception.78 As stated by
Duffie, what may amount to small numbers at the inception of a
swap turns into the real “meat and potatoes” of the credit
adjustments, which will manifest itself after inception. FNBC’s
78
The credit risk inherent in a swap may peak not at
inception or termination, but during the life of the swap, and
the credit risk inherent in a swap may be lower at inception and
termination than at any other point in the life of the swap.
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method of calculating the credit adjustment inappropriately
accelerates to inception the maximum amount of credit risk
presented during the life of the swap. As for the recommendation
of the G-30 report, which of course was not made for purposes of
valuing swaps for Federal income tax purposes, but for risk
management purposes, the G-30 report specifically endorsed a
dynamic procedure. Not only was a static procedure not
recommended by the G-30 report, but such a procedure was not
followed as a matter of industry practice.
8. Confidence Levels
Petitioner argues that FNBC’s use of an 80-percent
confidence interval was reasonable and consistent with industry
practice. Respondent argues that FNBC’s use of the 80-percent
confidence level was improper. We agree with respondent.
When credit exposure is overstated, the credit adjustment
does not reflect the market value of credit risk and cannot
accurately reduce midmarket values and arrive at fair market
value. FNBC was the only known entity in the industry that used
an 80-percent confidence level when computing credit exposure,
and its use of a maximum 80-percent measure of exposure
overstated credit exposure. In fact, all of the experts on
financial derivatives opined that the CEM amount should use a
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mean exposure rather than the 80-percent level.79 Duffie and
Parsons, in particular, stated that FNBC should have used for
valuation purposes the mean exposure level generated by its Monte
Carlo simulation model, rather than the maximum exposure at an
80-percent confidence interval. Whereas the G-30 report endorsed
a higher confidence level for risk management purposes, the G-30
report endorsed a mean exposure measure for valuing credit risk.
9. Mirror and Partially Offsetting Swaps
FNBC claimed credit adjustments on mirror swaps. This
overstated the credit adjustment and understated fair market
value.
FNBC claimed credit adjustments on partially offsetting
swaps. This overstated the credit adjustment and understated
fair market value.
10. Per-Swap Adjustments
FNBC computed its credit (and administrative) adjustments
for groups of swaps. O’Brien opined that “Under FNBC’s
procedure, swaps having shorter-than-average lives, relative to
others originated in the same quarter, will have credit deferral
income amortized over a longer term than the life of the swap,
and conversely for swaps having longer-than-average lives.”
79
FNBC’s 80-percent confidence level for a swap’s exposure
at some future time is much larger than the mean exposure for
that same time.
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Sziklay took exception to the opinions of Sullivan and Smithson
that both theory and practice demonstrate that administrative
costs should be calculated on a portfolio basis. We agree with
O’Brien and Sziklay that the adjustments must be computed on a
swap-by-swap basis. See H. Rept. 103-111, supra at 665, 1993-3
C.B. at 241 (fair market value determined by valuing each
security separately); see also sec. 20.2031-1(b), Estate Tax
Regs. (“The value is generally to be determined by ascertaining
as a basis the fair market value as of the applicable valuation
date of each unit of property. For example, in the case of
shares of stock or bonds, such unit of property is generally a
share of stock or a bond.”).
E. Administrative Costs
1. Overview
Petitioner argues that the fair market value of FNBC’s swaps
included an administrative costs adjustment. Respondent concedes
that administrative costs may affect value and that market values
may need to be adjusted for future administrative costs to arrive
at fair market value. Respondent asserts that administrative
costs adjustments are allowed only to the extent that they are
derived from market data.
We agree with petitioner that the fair market values of
FNBC’s swaps include an administrative costs adjustment. We
agree with O’Brien that a procedure in which an entity such as
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FNBC adjusts midmarket value by the presumed market value of
future administrative costs, reestimates the value each period,
and reduces or increases income by the change in value is
consistent with mark-to-market accounting. We do not believe
that the procedures used by FNBC reflected fair market value.
2. Incremental Costs
FNBC calculated its administrative costs adjustments by
using fully allocated costs. The Court-appointed experts
testified that the administrative costs’ impact on the value of a
swap is no more than the marginal (incremental) costs to
administer the swap. We agree. FNBC’s method is incorrect in
that only incremental costs affect fair market value.
In contrast to fixed costs such as general overhead costs,
the incremental costs of a swap are the additional costs
associated with acquiring the swap. FNBC’s approach, which used
general overhead from its other departments as part of its
administrative costs adjustment, is wrong. For a dealer of
swaps, general overhead is not an incremental cost. General
overhead generally consists of the costs that would occur whether
or not additional swaps would be acquired. When a dealer is
considering whether to acquire a swap, only incremental costs
would affect the prices at which the dealers would be willing to
trade by reducing the present value of the cashflows associated
with acquiring the swap.
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3. Use of Own Costs
FNBC’s adjustments for administrative costs are based on
FNBC’s own costs and cost allocation rules rather than on market
data. We believe that such an approach was correct for purposes
of section 475. As mentioned above, we value FNBC’s swaps as the
difference in value between the legs. We believe that the
administrative costs must be taken into account in determining
the value of FNBC’s leg in that the inherent value of that leg
includes FNBC’s forecast of its administrative costs related
thereto. In this regard, we agree with the experts that the best
approach to valuation in these cases is the income approach.80
F. Other
Petitioner argues that FNBC did not include all of the
adjustments to midmarket value that may have been appropriate.
According to petitioner, the industry allows many adjustments,
and FNBC took adjustments only for administrative costs and
credit risks. Petitioner observes that the G-30 report and OCC
also recommended adjustments for (1) investing and funding costs,
(2) greater credit adjustments (e.g., FNBC did not take an
adjustment for compensation for credit exposure), and (3)
anticipated profit.
80
The record does not indicate that property similar to any
of FNBC’s swaps was sold near the valuation dates so as to use
the market approach. Nor does the record support applying the
asset-based approach to those swaps.
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We disagree with petitioner’s assertion that FNBC took only
two of the available adjustments. Although FNBC labeled its
adjustments solely as credit adjustments and administrative costs
adjustments, Duffie noted that FNBC took three, and maybe four,
of the adjustments listed in the G-30 report. FNBC included an
adjustment for hedging within its administrative costs adjustment
and may have included an adjustment for funding and cost of
capital within the administrative cost adjustment.
XI. Respondent’s Method of Accounting
Respondent determined that FNBC was required to report its
swaps income by valuing its swaps at their midmarket value and
not reporting any adjustments thereto; e.g., for credit risk or
administrative costs. Petitioner argues that respondent’s method
is erroneous in that it fails to reflect FNBC’s swaps income
clearly. Petitioner notes that virtually everyone who has
considered the valuation of swaps has rejected respondent’s
position that the fair market value of a swap is its midmarket
value.
We agree with petitioner that the midmarket method, standing
alone, fails to reflect FNBC’s swaps income clearly. Midmarket
is the value of the payments but not the value of the swap
contract in that FNBC must incur administrative costs and bear
the risk that a payment might never be received.
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Respondent invites the Court to adopt his proffered
mid-market valuation by analogy to the valuation of stocks and
bonds. In this regard, respondent notes, section 20.2031-2(f),
Estate Tax Regs., and section 25.2512-2(f), Gift Tax Regs.,
provide two rules for valuing stocks and bonds traded on
exchanges. The first rule, the mean transaction method, refers
to mean selling prices. That rule provides:
In general, if there is a market for stocks
or bonds, on a stock exchange, in an over-
the-counter market, or otherwise, the mean
between the highest and lowest quoted selling
prices on the valuation date is the fair
market value per share or bond. * * * [Sec.
20.2031-2(b)(1), Gift Tax Regs.]
See also sec. 25.2512-2(b)(1), Estate Tax Regs. The second rule,
the mean quotation method, refers to the mean of the bid and
asked prices. This rule provides:
If the provisions of paragraph (b) of this
section are inapplicable because actual sales
are not available during a reasonable period
beginning before and ending after the
valuation date, the fair market value may be
determined by taking the mean between the
bona fide bid and asked prices on the
valuation date. [Sec. 20.2031-2(c), Gift Tax
Regs.]
See also sec. 25.2512-2(b)(2), Estate Tax Regs. Respondent
asserts that the values ascertained by the mean-transaction or
mean-quotation method are never adjusted for credit risk or
administrative costs.
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Respondent asserts that for plain vanilla swaps with AA
dealers for counterparties, midmarket value is precisely equal to
fair market value. Respondent asserts that for plain vanilla
swaps between counterparties with different credit ratings, some
may have a fair market value less than midmarket whereas others
will have a fair market value greater than midmarket values.
Respondent contends that dealers that value their swaps on a
portfolio basis therefore have an accurate valuation by using
midmarket values without adjustment.
We decline respondent’s invitation to value FNBC’s swaps by
reference to the quoted regulations. As petitioner correctly
notes, all of the experts agree that the fair market value of a
swap must take into account credit risk and administrative costs
adjustments. Nor do we agree with respondent that it is
appropriate to value FNBC’s swaps collectively rather than
individually. As noted explicitly by the members of the House
Committee on Ways and Means: “For purposes of the provision,
fair market value generally is determined by valuing each
security on an individual security basis.” H. Rept. 103-111,
supra at 665, 1993-3 C.B. at 241; see also sec. 20.2031-1(b),
Estate Tax Regs.
XII. Conclusion
We conclude that FNBC’s mark-to-market method of tax
accounting for its swaps income failed for nine reasons to
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reflect its swaps income clearly. First, the method did not
value FNBC’s swaps as of yearend. Second, the method was not
applied to FNBC’s nonperforming swaps. Third, the method did not
reflect the creditworthiness of both parties. Fourth, the method
did not reflect the applicability of netting and other credit
enhancements. Fifth, the method used a 1-month lag in
ascertaining the applicable credit adjustments. Sixth, the
method used a static rather than dynamic procedure to ascertain
the applicable credit adjustments. Seventh, the method
inappropriately ascertained credit adjustments as to swaps which
were no longer in existence. Eighth, the method did not
ascertain administrative costs adjustments by using incremental
costs. Ninth, the method did not ascertain credit and
administrative costs adjustments as to each swap.81
We also conclude that respondent’s method of accounting for
FNBC’s swaps income did not clearly reflect that income.
Respondent’s method failed to reflect the need to adjust each
swap’s midmarket value by credit and administrative costs
adjustments in order to arrive at fair market value.
81
Of course, in lieu of the adjusted midmarket method, FNBC
could have valued its swaps using bid or ask rate, as applicable.
Bid prices would be used to value a long position (swaps where
the dealer received the fixed rate), and ask prices would be used
to value a short position (swaps where the dealer paid the fixed
rate).
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We return this case to the parties to prepare a computation
or computations under Rule 155. In that financial products are
an integral part of our Nation’s major institutions, far better
it is to have an acceptable valuation method as to these
products, even though checkered by occasional variance, than to
remain in the gray twilight of uncertainty. The parties should
determine the fair market value of each of FNBC’s swaps and other
like derivative products by valuing the derivative at its
midmarket value as properly adjusted on a dynamic basis for
credit risk and administrative costs. A proper credit risk
adjustment must reflect the creditworthiness of both parties,
with due respect to netting and other credit enhancements. A
proper administrative costs adjustment must be limited to
incremental costs.
XIII. Postscript--Weight Given to Expert Testimony
A. Role of the Experts
We set forth herein our opinions as to the various experts
and the weight that we have given to their respective testimony.
The Court has broad discretion to evaluate the cogency of an
expert’s analysis (including that of a Court-appointed expert).
Neonatology Associates, P.A. v. Commissioner, 115 T.C. 43, 85
(2000), affd.
299 F.3d 221 (3d Cir. 2002); see also Pennwalt
Corp. v. Durand-Wayland, Inc.,
833 F.2d 931, 943 (Fed. Cir. 1987)
(Bennett, J., dissenting in part) (majority “certainly should not
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have taken the additional step of recasting the court-appointed
expert’s testimony to support its position since the job of
evaluating the testimony of expert witnesses and witnesses in
general is peculiarly that of the trier of fact”). Sometimes, an
expert will help us decide a case. E.g., Booth v. Commissioner,
108 T.C. 573; Trans City Life Ins. Co. v. Commissioner,
106
T.C. 274, 302 (1996). Other times, he or she will not. E.g.,
Estate of Scanlan v. Commissioner, T.C. Memo. 1996-331, affd.
without published opinion
116 F.3d 1476 (5th Cir. 1997);
Mandelbaum v. Commissioner, T.C. Memo. 1995-255, affd. without
published opinion
91 F.3d 124 (3d Cir. 1996). Aided by our
common sense, we weigh the helpfulness and persuasiveness of an
expert’s testimony in light of his or her qualifications and with
due regard to all other credible evidence in the record.
Neonatology Associates, P.A. v.
Commissioner, supra at 85. We
may embrace or reject an expert’s opinion in toto, or we may pick
and choose the portions of the opinion to adopt. Helvering v.
Natl. Grocery
Co., 304 U.S. at 294-295; IT&S of Iowa, Inc. v.
Commissioner,
97 T.C. 496, 508 (1991). We are not bound by an
expert’s opinion and will reject an expert’s opinion to the
extent that it is contrary to the judgment we form on the basis
of our understanding of the record as a whole. IT&S of Iowa,
Inc. v.
Commissioner, supra at 508; see also Orth v.
Commissioner, 813 F.2d at 842.
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B. Court’s Impression of the Experts
We find Duffie, Parsons, and Smithson to be helpful to our
general understanding of the financial products at hand and the
workings of the related financial market. We find the first two
men to be more credible than the third as to their respective
analyses and conclusions. First, we view Smithson as biased in
that he is affiliated with and has served on the board of the
ISDA. The ISDA joined in filing with the Court a brief of amici
curiae in support of petitioner. Second, this Court’s
determination of fair market value requires that we apply the
firmly established standard of willing buyer/willing seller.
Smithson’s analysis as to fair market value was inconsistent with
that standard in that it was skewed improperly towards the price
that a willing buyer would want to pay for a swap as opposed to
the balanced price that a willing buyer would have to pay for the
swap in order for a willing seller to sell the swap to the
willing buyer. E.g., Pabst v. Commissioner, T.C. Memo. 1996-506
(the Court found that an expert did not properly analyze fair
market value when the expert stressed that the subject asset “is
only worth what a buyer will pay for it.”); accord Estate of
Cloutier v. Commissioner, T.C. Memo. 1996-49; Mandelbaum v.
Commissioner, supra. Smithson’s testimony as to a hypothetical
buyer also focused inappropriately on the amount that a “dealer”
would be willing to pay for the swap and further inappropriately
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limited the hypothetical buyer to a dealer seeking to earn a
spread. See e.g., Dellinger v. Commissioner, 32 T.C. 1185.
Third, Smithson’s testimony was sometimes evasive or
nonresponsive when it came to responding to questions that were
damaging to petitioner’s case. For example, whereas Smithson
continued to endorse FNBC’s methodology as to its credit
adjustment, he knew quite well that FNBC’s use of an 80-percent
confidence level was wrong. Smithson even acknowledged on
cross-examination that he had written a book that advised using
the mean confidence level and that, in 1993, he would have
advised FNBC to use a confidence level other than the 80-percent
confidence level. Fourth, Smithson’s testimony indicates his
belief the a single bid/ask spread applies to a given swap. Such
a belief contrasts sharply with our finding that the bid/ask
spread usually differed depending on whether a dealer entered
into a swap with another dealer, on the one hand, or with an end
user, on the other hand. Such a belief also ignores the fact
that a dealer sometimes intended to lose money on a specific swap
so as to risk-manage its books (and thus maximize its overall
profit) or to develop its clientele.
As to respondent’s two remaining experts, O’Brien and
Carney, we found each of these individuals to be helpful as to
her or his area of expertise. We found likewise as to Sziklay,
the other Court-appointed expert. We did not find the testimony
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of petitioner’s other expert, Sullivan, to be credible. Sullivan
was qualified as an expert in various areas, but his single
opinion was that FNBC’s adjustments to its midmarket values were
consistent with the industry practices for taking adjustments.
Sullivan is an accountant who has been advising his clients
worldwide on that issue for some time. Sullivan’s knowledge of
industry practice also was gleaned primarily from his few clients
in the financial derivative area whom he has been advising as to
that issue. Sullivan also endorsed petitioner’s administrative
expenses adjustment as consistent with industry practice but then
acknowledged that he actually was unaware of how other dealers
computed that adjustment.
____________________________________________
We have considered at length each argument of the parties.
All arguments not discussed herein are without merit or
irrelevant. To reflect the foregoing,
Decisions will be entered
under Rule 155.
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APPENDIX A
STIPULATION WITH RESPECT TO COURT APPOINTED EXPERTS
WHEREAS, the parties are engaged in complex civil
tax litigation involving novel issues of first
impression and significant importance; and
WHEREAS, the parties each have their own experts
to opine on certain issues; and
WHEREAS, the Honorable David Laro, the Judge in
this matter, has indicated that he believes it would be
helpful to have two experts appointed by the Court
pursuant to Federal Rule of Evidence 706 to opine on
certain issues which permeate these cases, and
WHEREAS, Judge Laro has asked that the parties
jointly consider and stipulate as to the duties and
procedures involved in the appointment of the Court’s
experts,
NOW THEREFORE, the parties do hereby stipulate to
the following:
1.0 That the Court may appoint Dr. J. Darrell Duffie
and Mr. Barry S. Sziklay as the Court’s experts to
assist the trier of fact in the above-entitled matter.
1.1 That Dr. J. Darrell Duffie may be appointed as an
expert in the field of financial economics and
financial derivatives and will be asked to opine on the
following questions in the context of these cases, and,
specifically, with regard to this petitioner:
a. The relative merits and deficiencies in
the various expert reports and opinions of
petitioner’s and respondent’s experts.
b. The generally accepted method or
methodologies of valuing the derivatives at
issue in this case.
c. With respect to the midmarket method of
valuation, what adjustments, if any, should
be made in order to arrive at the “fair
market value” of the derivative?
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1.2 That Mr. Barry S. Sziklay may be appointed as an
expert in the field of fair market valuation and
generally accepted accounting principles and will be
asked to opine upon the following questions in the
context of these cases and, specifically, with regard
to this petitioner:
a. Whether mid market valuation arrives at
“fair market value” (as that term is defined
for federal tax purposes)?
b. What adjustments, if any, should be made
to mid market values in order to arrive at
the “fair market value” of the derivatives
being valued?
c. With respect to the financial instruments
in these cases whether the accounting concept
of “fair value” is synonymous with the tax
concept of “fair market value”?
1.3 That for both of the Court’s experts, opinions
generally should be restricted to information,
techniques, and knowledge available or reasonably
foreseeable during the years in issue.
1.4 That after consultation with the parties, the
Court may propound other specific questions to be
addressed by the Court’s experts.
2.0 That each of the Court’s experts shall prepare and
sign a written report in accordance with Rule 143(f) of
the Court’s Rules of Practice and Procedure. Each
report shall contain a complete statement of all
opinions and the basis and reasons therefor, as well as
the data or other information considered by the witness
in forming the opinions, subject to the following
further limitations:
(a) Except by order of the Court, in the
preparation of their reports, the Court’s
experts shall be limited to considering the
trial record as of the date when both parties
have completed the presentations of their
respective cases, in this matter, as well as
materials of a type reasonably relied upon by
experts in the particular field.
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(b) Dr. Duffie and Mr. Sziklay may
communicate freely with each other.
Additionally, they may communicate ex parte
with the Court about administrative,
procedural or scheduling matters. Each
expert may identify an assistant with whom
the parties may communicate about
administrative matters, such as contracting
and payment for expert services. The Court’s
experts may not engage directly or indirectly
in any ex parte communications with any other
persons, including, but not limited to, the
parties to this matter, their counsel, the
parties’ experts, or any association (or
members thereof) who joined in filing the
amici brief in this matter with respect to
the issues in this case.
3.0 That the Court’s experts shall provide the Court
and shall serve upon counsel for each party their
expert reports in accordance with a schedule
established by the Court.
4.0 That upon request by the Court or any party,
within 15 days after service of the expert reports, the
Court’s experts shall make available for inspection and
copying, to the extent necessary, any materials relied
upon in preparing the reports that are not part of the
record or readily available.
5.0 That except by leave of Court, the Court’s experts
shall not be subject to discovery. However, consistent
with the Court’s Rules of Practice and Procedure,
either party is at liberty to utilize limited discovery
by way of written interrogatories to be served on the
expert for the sole purpose of ascertaining any
possible bias of the appointed experts.
6.0 That each party may submit rebuttal expert
reports, which shall be filed with the Court, served on
opposing counsel and provided to the Court’s experts.
7.0 That the reports of the Court’s experts will serve
as their direct testimony at trial. In the order of
Petitioner and then Respondent, the parties will have
the opportunity to cross-examine the Court’s experts.
The parties, in the same order of proceeding, will
thereafter have the opportunity to present any
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additional expert evidence in rebuttal to the testimony
of the Court’s experts. However, all expert testimony
will be limited to experts who have already testified
in this trial and there will be no additional fact
evidence adduced. The experts shall be limited to the
record and materials of a type reasonably relied upon
by experts in the particular field.
8.0 That further proceedings in this case shall not
resume any earlier than 15 days after service of the
last rebuttal reports.
9.0 That any report or other document required to be
served pursuant to this stipulation shall be served by
a next-day delivery service.
10.0 That the Court shall provide the schedule for the
reports to be filed and unless otherwise ordered, the
following schedule shall apply:
Court Appointed
Expert’s reports February 15, 2001
Rebuttal expert reports
submitted by the 15 days after the Court’s
parties expert’s reports
Rebuttal expert reports
submitted by the 15 days after the Rebuttal
Court’s experts expert’s reports
10.1 The Court may permit the Court’s experts or the
parties’ experts to offer expert rebuttal testimony
without a written report.
11.0 That the Court’s experts shall make themselves
available at a session of the Court at a place and at a
time designated by the Court for cross examination by
the parties on their report.
12.0 That after consultation with the parties, the
terms and conditions of the expert’s employment will be
directed by the Court, and executed by the parties.
The fees and expenses of the experts will be paid
equally by the parties hereto and the parties shall
timely pay the experts in accordance with the terms and
conditions of the expert’s agreement.
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13.0 Nothing in this stipulation should be construed
as respondent’s acquiesce to this procedure as a matter
of tax litigation policy or that respondent would agree
to a similar procedure in any other case. Respondent
will state his concerns with this procedure on the
record at the time this stipulation is presented to the
Court, and these concerns will be incorporated by
reference.
The foregoing are the stipulations of the parties.
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APPENDIX B
SEC. 475. MARK TO MARKET ACCOUNTING METHOD FOR DEALERS
IN SECURITIES.
(a) General Rule.--Notwithstanding any other
provision of this subpart, the following rules shall
apply to securities held by a dealer in securities:
(1) Any security which is inventory in
the hands of the dealer shall be included in
inventory at its fair market value.
(2) In the case of any security which is
not inventory in the hands of the dealer and
which is held at the close of any taxable
year--
(A) the dealer shall recognize
gain or loss as if such security
were sold for its fair market value
on the last business day of such
taxable year, and
(B) any gain or loss shall be
taken into account for such taxable
year.
Proper adjustment shall be made in the amount of any
gain or loss subsequently realized for gain or loss
taken into account under the preceding sentence. The
Secretary may provide by regulations for the
application of this paragraph at times other than the
times provided in this paragraph.
(b) Exceptions.--
(1) In general.--Subsection (a) shall
not apply to--
(A) any security held for
investment,
(B)(i) any security described
in subsection (c)(2)(C) which is
acquired (including originated) by
the taxpayer in the ordinary course
of a trade or business of the
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taxpayer and which is not held for
sale, and (ii) any obligation to
acquire a security described in
clause (i) if such obligation is
entered into in the ordinary course
of such trade or business and is
not held for sale, and
(C) any security which is a
hedge with respect to--
(i) a security to
which subsection (a) does
not apply, or
(ii) a position,
right to income, or a
liability which is not a
security in the hands of
the taxpayer.
To the extent provided in regulations,
subparagraph (C) shall not apply to any
security held by a person in its capacity as
a dealer in securities.
(2) Identification required.--A security
shall not be treated as described in
subparagraph (A), (B), or (C) of paragraph
(1), as the case may be, unless such security
is clearly identified in the dealer’s records
as being described in such subparagraph
before the close of the day on which it was
acquired, originated, or entered into (or
such other time as the Secretary may by
regulations prescribe).
(3) Securities subsequently not
exempt.--If a security ceases to be described
in paragraph (1) at any time after it was
identified as such under paragraph (2),
subsection (a) shall apply to any changes in
value of the security occurring after the
cessation.
(4) Special rule for property held for
investment.--To the extent provided in
regulations, subparagraph (A) of paragraph
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(1) shall not apply to any security described
in subparagraph (D) or (E) of subsection
(c)(2) which is held by a dealer in such
securities.
(c) Definitions.--For purposes of this section-–
(1) Dealer in securities defined.--The
term “dealer in securities” means a taxpayer
who--
(A) regularly purchases
securities from or sells securities
to customers in the ordinary course
of a trade or business; or
(B) regularly offers to enter
into, assume, offset, assign or
otherwise terminate positions in
securities with customers in the
ordinary course of a trade or
business.
(2) Security defined.--The term
“security” means any--
(A) share of stock in a
corporation;
(B) partnership or beneficial
ownership interest in a widely held
or publicly traded partnership or
trust;
(C) note, bond, debenture, or
other evidence of indebtedness;
(D) interest rate, currency,
or equity notional principal
contract;
(E) evidence of an interest
in, or a derivative financial
instrument in, any security
described in subparagraph (A), (B),
(C), or (D), or any currency,
including any option, forward
contract, short position, and any
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similar financial instrument in
such a security or currency; and
(F) position which--
(i) is not a
security described in
subparagraph (A), (B),
(C), (D), or (E),
(ii) is a hedge with
respect to such a
security, and
(iii) is clearly
identified in the
dealer’s records as being
described in this
subparagraph before the
close of the day on which
it was acquired or
entered into (or such
other time as the
Secretary may by
regulations prescribe).
Subparagraph (E) shall not include any
contract to which section 1256(a) applies.
(3) Hedge.--The term “hedge” means any
position which reduces the dealer’s risk of
interest rate or price changes or currency
fluctuations, including any position which is
reasonably expected to become a hedge within
60 days after the acquisition of the
position.
(d) Special Rules.--For purposes of this section--
(1) Coordination with certain rules.--The rules of
sections 263(g), 263A, and 1256(a) shall not apply to
securities to which subsection (a) applies, and section
1091 shall not apply (and section 1092 shall apply) to
any loss recognized under subsection (a).
(2) Improper identification.--If a taxpayer--
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(A) identifies any security under
subsection (b)(2) as being described in
subsection (b)(1) and such security is not so
described, or
(B) fails under subsection
(c)(2)(F)(iii) to identify any position which
is described in subsection (c)(2)(F) (without
regard to clause (iii) thereof) at the time
such identification is required,
the provisions of subsection (a) shall apply to such
security or position, except that any loss under this
section prior to the disposition of the security or
position shall be recognized only to the extent of gain
previously recognized under this section (and not
previously taken into account under this paragraph)
with respect to such security or position.
(3) Character of gain or loss.--
(A) In general.--Except as provided in
subparagraph (B) or section 1236(b)--
(i) In general.--Any gain or
loss with respect to a security
under subsection (a)(2) shall be
treated as ordinary income or loss.
(ii) Special rule for
dispositions.--If--
(I) gain or loss is
recognized with respect
to a security before the
close of the taxable
year, and
(II) subsection
(a)(2) would have applied
if the security were held
as of the close of the
taxable year,
such gain or loss shall be treated as
ordinary income or loss.
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(B) Exception.--Subparagraph (A) shall
not apply to any gain or loss which is
allocable to a period during which--
(i) the security is described
in subsection (b)(1)(C) (without
regard to subsection (b)(2)),
(ii) the security is held by a
person other than in connection
with its activities as a dealer in
securities, or
(iii) the security is
improperly identified (within the
meaning of subparagraph (A) or (B)
of paragraph (2)).
(e) Regulatory Authority.--The Secretary shall
prescribe such regulations as may be necessary or
appropriate to carry out the purposes of this section,
including rules--
(1) to prevent the use of year-end
transfers, related parties, or other
arrangements to avoid the provisions of this
section, and
(2) to provide for the application of
this section to any security which is a hedge
which cannot be identified with a specific
security, position, right to income, or
liability.
