UNITED STATES COURT OF APPEALS FOR THE THIRD CIRCUIT
argued: February 18, 1977.
UNITED STATES OF AMERICA, APPELLANT
APPEAL FROM THE UNITED STATES DISTRICT COURT FOR THE EASTERN DISTRICT OF PENNSYLVANIA (D.C. Civil Action No. 69-2791).
Seitz, Chief Judge, Van Dusen and Weis, Circuit Judges.
Author: Van Dusen
VAN DUSEN, Circuit Judge.
The question in this case is whether payments made on two series*fn1 of obligations (denominated "debentures") of Scriptomatic, Inc. (plaintiff) were deductible as interest under 26 U.S.C. § 163, or were, in reality, disguised dividends and therefore not deductible by the corporation. On June 24, 1975, the district court entered judgment for plaintiff notwithstanding a December 1973 jury verdict answering special questions in favor of defendant,*fn2 see Scriptomatic Inc. v. United States, 397 F. Supp. 753 (E.D. Pa. 1975), from which the government appeals.*fn3 The judgment n.o.v. having been properly entered, we affirm the district court order.
In Fin Hay Realty Co. v. United States, 398 F.2d 694 (3d Cir. 1968), this Court enumerated sixteen criteria which as we stated there, have been isolated by the courts and commentators as factors which have been used in evaluating "the nature of an instrument which is in form a debt." 398 F.2d at 696. However, those criteria were never intended to obtain talismanic significance. The essence of Fin Hay is contained in the following quotation from it:
"Neither any single criterion nor any series of criteria can provide a conclusive answer in the kaleidoscopic circumstances which individual cases present.
"The various factors which have been identified in the cases are only aids in answering the ultimate question whether the investment, analyzed in terms of its economic reality, constitutes risk capital entirely subject to the fortunes of the corporate venture or represents a strict debtor-creditor relationship. Since there is often an element of risk in a loan, just as there is an element of risk in an equity interest, the conflicting elements do not end at a clear line in all cases.
"In a corporation which has numerous shareholders with varying interests, the arm's-length relationship between the corporation and a shareholder who supplies funds to it inevitably results in a transaction whose form mirrors its substance. Where the corporation is closely held, however, and the same persons occupy both sides of the bargaining table, form does not necessarily correspond to the intrinsic economic nature of the transaction, for the parties may mold it at their will with no countervailing pull. This is particularly so where a shareholder can have the funds he advances to a corporation treated as corporate obligations instead of contributions to capital without affecting his proportionate equity interest. Labels, which are perhaps the best expression of the subjective intention of parties to a transaction, thus lose their meaningfulness.
"To seek economic reality in objective terms of course disregards the personal interest which a shareholder may have in the welfare of the corporation in which he is a dominant force. But an objective standard is one imposed by the very fact of his dominant position and is much fairer than one which would presumptively construe all such transactions against the shareholder's interest. Under an objective test of economic reality it is useful to compare the form which a similar transaction would have taken had it been between the corporation and an outside lender, and if the shareholder's advance is far more speculative than what an outsider would make, it is obviously a loan in name only." [Footnote omitted. Emphasis added.]
398 F.2d at 697.
Under Fin Hay, then, the ultimate issue is measurement of the transaction by objective tests of economic reality, and the touchstone of economic reality is whether the transaction would have taken the same form had it been between the corporation and an outside lender - whether, in sum, "the shareholder's advance is far more speculative than what an outsider would make." The analysis suggested by this approach to the debt-equity question may be expressed in terms of two lines of inquiry: assuming that the obligation is debt in form,*fn4 (1) did the form result from an arm's-length relationship, and/or (2) would an outside investor have advanced funds on terms similar to those agreed to by the shareholder.*fn5
If question one is answered in the affirmative (the form did result from arm's-length dealings), the obligation is debt. If question two is answered in the affirmative (an outsider would have advanced funds on terms similar to those agreed to by the shareholder), the obligation is debt - despite the fact that the negotiations leading to its issuance were not at arm's length. As is apparent, if there is proof or agreement that an outsider would have purchased an instrument on the terms available to a shareholder, the question as to whether the form of the obligation resulted from arm's-length negotiation is irrelevant to resolution of the debt-equity issue. The crucial issue is the economic reality of the marketplace: what the market would accept as debt is debt.
It is only within this framework that the many factors listed in Fin Hay and in other court decisions in this area have any meaning or function. One or more of those factors may be relevant to the threshold question of whether the instrument is debt in form. One or more of those criteria may, in the same sense, be helpful in evaluating whether there was an arm's-length relationship. Certain of those elements may also bear on the fundamental inquiry, whether an obligation is commercially valuable as an obligation and, therefore, debt in "economic reality." However, the criteria which will be relevant to each of those three areas of inquiry will vary from case to case, as will the weight which should be accorded each criterion. For this reason, two court decisions in this area will rarely present comparable situations and it will be unusual for any particular case to have controlling effect in any other case on the basis of the particular factors applied or the weight accorded a specific criterion. The weight of precedent in the realm of debt-equity determinations flows from the framework of analysis on the basis of factors such as those enumerated in Fin Hay.
Since the facts relating to the organization of taxpayer and issuance of the instruments in question are set forth accurately in the district court opinion, 397 F. Supp. 753, 755-57 (E.D. Pa. 1975), we need not repeat them here. A description of matters not discussed by the district court, including the stipulations agreed to at the end of trial, the charge to the jury, the return of the jury verdict, and entry of judgment notwithstanding the verdict, follows.
As the district court noted, most of the facts in this case have been stipulated (see Stipulation of Facts filed on December 11, 1973 in Scriptomatic Inc. v. United States, Civil Action No. 69-2791 (E.D. Pa.), reproduced at 5a-17a). Not the least of those detailed stipulations were two entered into at the very end of trial, when the following exchange transpired:
"MR. MULLARKEY: The government will stipulate that the plaintiff could have sold the debentures in conjunction with the 4,856.25 shares of common stock which were issued in January of 1963 to an outside person who had no other interest in the plaintiff on the same terms, conditions and circumstances as those original debentures in conjunction with common stock were actually sold.
"We will further stipulate that the plaintiff could have sold the Series "B" Debentures in conjunction with the 785 shares of common stock which were issued in connection therewith in late 1965 to outside persons who had no other interest in the plaintiff on the same terms, conditions, and circumstances as those Series "B" Debentures plus common stock are actually sold.
"MR. MUNGALL: And the plaintiff is prepared to stipulate
and does hereby stipulate that it has not met the burden on this record of establishing that an unrelated person would have purchased a debt instrument similar to the instrument entitled 7 percent Subordinated Debenture due January 15, 1973 solely as an investment for the interest to be earned thereon even if a reasonably higher rate of interest than the amount stated had been promised, if it had not also carried with it a common stock interest in the corporation, and that stipulation extends both to the debentures issued in 1963 and those issued in 1965."
N.T. 7:6-8, reproduced at 420a-422a.
Immediately thereafter, counsel addressed the jury, and the district court charged the jury and posed two interrogatories:
"Were the interests of the persons who acquired the capital stock and debentures of the plaintiff sufficiently varied and diverse so that the form of the transaction consisting of the issuance of the shares of the debentures was the result of arms-length relationships among them?
"You have to consider that for 1963 and again for 1965.
"Then you will have to consider the second question:
"Were the advances evidenced by the instrument entitled 7% Subordinated Debentures due January 15, 1973 loans to the corporation rather than equity investment?
"Once again, you must answer that question for those issued in 1963 and for those issued in 1965."
Charge of the Court at N.T. 7:128. The jury answered "no" as to both parts (1963 and 1965) of each question.
Judgment was entered in favor of the defendant, United States, whereupon plaintiff moved for judgment notwithstanding the verdict, which was granted by the district court, using this language as the conclusion of its opinion:
"In summary, the debentures in question were drafted to create a legally enforceable debtor-creditor relationship. They were treated as evidence of debt by their purchasers and by the corporation which issued them. Finally, the realities of Scriptomatic's economic situation do not require that the advances in question be treated as equity. I conclude that no other reasonable decision could be reached from the evidence in this case. Accordingly, the plaintiff is entitled to judgment notwithstanding the verdict."
397 F. Supp. at 766. *fn6
In accordance with the analytical framework suggested by Fin Hay, the district court first considered the question of whether the two series of instruments involved here were debt in form. Based upon its determinations that the instruments: (1) are labelled "subordinated debentures," rather than "preferred stock;" (2) contain a fixed payment date; (3) provide for a "substantial rate of return for that period;"*fn7 (4) contain an unconditional promise to pay, and "the right to force complete payment in the event of a default in payment of either interest or principal;" (5) are not automatically subordinated to the claims of tradesmen and vendors; and that (6) sale of a "package" in which "common stock was issued with each debenture, did not automatically convert the indebtedness into equity," the district court found that "by every test . . . the form of these debentures was that of debt instruments." 397 F. Supp. at 758-760.
The government offers two bases for overturning this conclusion of the district court: (1) that the debentures were "expressly subordinated" to any debt incurred by taxpayer, including obligations to tradesmen and vendors, and (2) that "where an advance would not have been made without the accompanying equity feature, an inference arises that the package represents preferred stock," which inference the government terms "virtually an inescapable conclusion," in this case. Brief of Appellant at 14-15.
The district court specifically addressed the argument of the government with regard to debenture subordination provision 1.07(c),*fn8 and "ruled as a matter of law that the language of paragraph 1.07(c) did not automatically place tradesmen and vendors in a position superior to that of debenture owners. The uncontradicted testimony revealed that it was the intention of Scriptomatic to have the debentures subordinated to the notes given Fischer for the inventory of Scriptomatic parts and future bank loans, but not other creditors."*fn9 397 F. Supp. at 759-760.
The specific portion of 1.07(c) which the government believes to be inconsistent with this result is that which reads: "indebtedness incurred . . . by the company in connection with the acquisition by it of its properties and assets." The government contends that this phrase "expressly" subordinates the debentures to trade creditors. However, we do not believe that the clause is so clear and unambiguous as to require such a conclusion.
While the terms "properties and assets" could conceivably be used to describe all goods and services procured by the taxpayer during the course of ordinary operations, such language is not generally associated with this meaning. The interpretation urged by the government would lead us to conclude that obligations to pay for everything from raw stock for manufacturing to rubber bands and to paper cups for the water cooler would be superior indebtedness to these debentures. In view of the absurd result this interpretation of the debenture language leads to, and in view of the ambiguity apparent from the fact that the language of the clause could sustain some form of the interpretation urged by either party, the district court properly took testimony as to what the language was intended to mean, and as to what the taxpayer treated it as meaning.*fn10
As the district court recognized, the uncontradicted statement of the scrivener of this clause was that its primary purpose was to subordinate the debenture to the "indebtedness to be incurred upon the closing of the SICORP-Fischer contract," which signalled the beginning of the taxpayer as a viable, operating corporate entity. N.T. 234, reproduced in Appendix at 234a. Moreover, while the district court did conclude that this provision, "by the affirmative action of the corporation under the provisions of paragraph 1.07(b)," could have been used to place trade creditors in the position which the government urges they were placed in automatically, the district court also found that no such action was taken. There is nothing in this record to suggest that the taxpayer ever considered acting, or ever acted, in a manner inconsistent with the view that the main function of 1.07(c) was to subordinate the debentures to the obligation to Fischer. And there is nothing to suggest, on this record, that the district court incorrectly evaluated the effect of this limited subordination provided for by 1.07(c) or its impact upon the determination of whether these instruments represent debt in form. See P.M. Finance Corp. v. Comm'r, 302 F.2d 786, 789 (3d Cir. 1962). For these reasons, we reject the contention of the government that 1.07(c) of the indenture "expressly" or otherwise subordinated the debentures to trade creditors. We likewise reject the suggestion that the manner in which that court interpreted the ambiguous language of this provision and its effect was in any way improper.*fn11
In addition to suggesting that the district court erred in interpreting the subordination provision in the manner it did, the Government asserts that an inference that the debenture-stock packages represent preferred stock arises from the stipulated fact that an outsider would not have purchased the debentures alone, but only as part of the package. See pages 368-369 above. We need not decide the question of whether such an inference arises in view of the other findings of the district court in this case. As the district court noted, the debt instruments contain a fixed payment date, provide for a commercially reasonable rate of return, contain an unconditional promise to repay and "the right to force complete payment in the event of a default in payment of either interest or principal," and are not automatically subordinated to the claims of tradesmen and vendors. In view of these factors,*fn12 including the fact that the debt could not have been sold without the equity in 1963 and 1965, we conclude that the district court properly entered judgment n.o.v. in favor of the plaintiff.*fn13
In addition to the arguments noted above, the government urges that the district court be reversed for its alleged failure to apply proper tests, or accord such tests sufficient weight.*fn14 As Fin Hay states, "neither any single criterion nor any series of criteria can provide a conclusive answer in the kaleidoscopic circumstances which individual cases present." 398 F.2d at 697. We find no error in the district court determinations of the applicable factors, the weight to be accorded each factor, the evaluation of those factors, or their impact upon the ultimate determination in this case.
The judgment of the district court will be affirmed.
The judgment of the district court will be affirmed.