From Russia With Built-In Losses

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

The Story Behind The Story

Judge Bruggink did not mention one of the sources of Ms. Zimmerman's reputation for special knowledge about Russia's financial markets back in the nineties and around the turn of the millennium, when the transactions in this case were going on. For that you can go to this 2004 press release from the Inspector General of the US Agency for International Development where the IG is bragging about getting Ms. Zimmerman's then company Farallon Fixed Income Associates  to cough up $1.5 million.  (Farallon morphed into a company known as Bracebridge which is still in business with $10 billion in assets under management.)

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.

There was even more litigation and scandal surrounding those issues with Harvard and Shleifer agreeing to pay the government over $30 million.  David McClintick told the story in an article titled How Harvard Lost Russia in 2006. In 2006, the New York Times speculated that McClintick's article was a factor in the ouster of Lawrence Summers as Harvard's President.

Russian Debt For Pennies On The Dollar

Russian Recovery Fund was supposed to be an opportunity to make money on undervalued assets coming out of Russia's transition from Communism to a sort of capitalism.

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.

As it turned out, marketing of RRF as an investment opportunity did not go that well.

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.

Along Comes Deutsche Bank

The decision is pretty lengthy with lots of commentary on expert testimony and flurries of email.  In the end RRF was used as a vehicle to transfer the tax basis that Tiger Management LLC had in Russian debt that it wished to unload to buyers, who unlike Tiger could benefit from US tax losses . Tiger became a partner in RRF by contributing assets with a built-in loss of approximately $223 million.  It quickly sold its interest in RRF to other partners, but as the law was then, that did not change the partnership's basis in the underlying assets.  Even though the Tiger losses were sold at an economic gain not long after the partnership's acquisition, the partnership flowed through a $49 million loss to its partners from their disposition in 2000. In 2004 RRF would claim a further loss of $170,909,000 when preferred stock that it received in 2000 was redeemed.

The whole thing was put together by Deutsche Bank which was one of the major players in the raid on the treasury orchestrated by the Big Four accounting firms that is documented in Tania Rostain and Milton Regan's Confidence Games.  A couple of key numbers make it clear that the whole thing had become about tax losses rather than distressed Russian debt.  Assets worth about $14 million were contributed to RRF.  Those assets were sold not too long afterwards from over $20 million, which is some indication of Ms. Zimmerman's genius.  Deutsche Bank ended up getting nearly $10 million in fees which indicates that the good economics were the sizzle and the tax losses were the steak.

Why This Would Not Work At All Now - Probably

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.

A Good Partnership Gone Bad?

The simplest way that deals like this get blown up is through showing that the partnership had no business purpose.  Ms. Zimmerman made it a little harder for the Government to do that as the judge noted:

...... 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.

That was good, but it was not enough.

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.

 Other Coverage Not So Much

I'm almost a month late in  getting to this case.  (Curse that September 15 deadline that has my partner expecting me to do some actual work.) I'm surprised that it has not attracted much attention, particularly given the Harvard Russia connection, which goes unnoted in the brief mentions of the decision.  There is a certain irony to the whole thing as it seems like financiers were too focused on looting the US treasury with phony shelters to see the probably larger upside of distressed Russian assets.