This post was originally published on Forbes Sep 8, 2015
Nancy Zimmerman was the star of last month's Court of Claims decision Russian Recovery Fund Ltd v United States. Judge Bruggink was very impressed
... with the breadth of her knowledge about the operation of international financial markets, the instruments for creating and transferring obligations, and the opportunities afforded for making money on pricing differentials
FFIA was owned in-part and operated by Nancy Zimmerman, wife of Andrei Shleifer, a Harvard professor who was the head of the Harvard Russia Project at that time.
In 1997, the Harvard Russia Project was suspended and ultimately terminated after the USAID Office of Inspector General uncovered evidence that Shleifer and his second in command, Jonathan Hay, were making investments in Russia and assisting their wives in establishing businesses in Russia. This included using their influence with Russian government officials to obtain favorable licensing, funding, and other benefits for themselves and their wives in violation of the terms of the agreement between USAID and Harvard.
In sum, Ms. Zimmerman, who controlled Bracebridge, believed that she could make money for herself and investors by obtaining devalued Russian debt at pennies on the dollar in anticipation of a recovery of the ruble and hence something approaching face value of debt instruments. Given the depressed nature of the debt (most had lost over 90% of their value), even small increases would be highly leveraged. Bracebridge therefore created RRF in late 1998 as a Cayman Islands limited liability company. Bracebridge also created Russian Recovery Advisors as a separate management company to guide RRF, through which Ms. Zimmerman also hoped to make money through management fees.
Bracebridge began marketing efforts at the end on 1998 to try to obtain investors that were willing to contribute either assets in kind or cash in exchange for an interest in the RRF partnership. The person primarily responsible at Bracebridge for doing this marketing was Jonathan Grenzke, who testified at trial. Although the government seeks to cast doubt on the bona fides of the marketing effort, we are persuaded that Mr. Grenzke did in fact undertake a serious campaign, at least initially, to bring in investors. The marketing campaign, was not much of a success, however. With the exception of the Tiger transaction which we will examine shortly, there were only a relatively small number of investments into RRF, and those were principally by Bracebridge-controlled entities and a few colleges.
One of the advantages that partnerships have over S corporations is that a 754 election allows the partnership to align its basis with the basis of a partner who acquires an interest in the partnership. Of course this is only an advantage if the departing partner is selling at a gain. If the exiting partner is selling at loss, the basis in assets will be stepped down, not up. So in the RRF deal there was an explicit provision that RRF could not make a 754 election. The American Jobs Creation Act of 2004 changed the law so that a step-down can no longer be dodged when partnership basis in assets exceeds fair market value by $250,000. Of course after a decade we can't rule out someone having figured a way around that provision. Tax law is something of an arms race between people coming up with clever ideas and regulators and legislators cleaning up behind them.
...... Ms. Zimmerman persuaded the court that she had a legitimate business interest in creating RRF. Her explanation of her evolution as a fund manager was a tour de force, which reflected real knowledge of a wide range of investment strategies and vehicles. She has obviously been very successful in the formation of funds and in their performance. Her explanation of the opportunities she saw after the collapse of the Russian bond market and associated securities was not contrived. We find that she was genuinely interested in putting together a fund to attract investors that already owned or were interested in owning devalued Russian assets because she saw the potential for making money for Bracebridge as a fund manager.
We are prepared to accept, in other words, the bona fides of RRF as an entity and that its marketing efforts in the first half of 1999 were probably a genuine effort to find investors in the “macro play” of capitalizing on a hoped-for increase in value of distressed Russian assets. Thus far, so good. The wheels fall off, however, when we come to the Tiger transaction. .......
Those two entities later sold the Tiger assets at a gain, but claimed between them losses on disposition of approximately $360 million. It does no injustice to plaintiff to observe that, in substance, Tiger suffered the loss but even greater losses were claimed by RRF and General Cigar, which both gained on the sales. As it turns out, sometimes things really are too good to be true.
Although section 721(a) allows non-recognition of gain or loss at the time of an in-kind contribution “in exchange for an interest in the partnership,” we agree with the government that Tiger had no real intention of becoming a partner in RRF, and that RRF had reason to know that. A review of the evidence demonstrates that Tiger and RRF were not partners and their transaction was a sham, that the transaction lacked economic substance, that the contribution can be ignored, and that the transaction should be characterized as a sale.