Bank Failed to Establish Basis in Intangible Assets Acquired During S&L Crisis

(Parker Tax Publishing June 2018)

The Federal Circuit denied a bank's refund claim resulting from losses and deductions it claimed it incurred from the amortization and abandonment of intangible assets obtained through mergers with failing savings and loan institutions in the 1980s. The Federal Circuit upheld a finding by the Court of Federal Claims that the bank had zero basis in the assets because there were significant errors in the bank's valuation, and it rejected the bank's argument that the Claims Court should have undertaken an independent allocation of basis among the assets. WMI Holdings Corp. v. U.S., 2018 PTC 160 (Fed. Cir. 2018).

Savings and loan institutions, or thrifts, provide two main services. They maintain customers' deposits in interest bearing savings accounts, and they make mortgage loans funded by these deposits. Thrifts are designed to earn interest on mortgages at a higher rate than they pay on savings accounts. When interest rates rose to unprecedented levels in the 1970s, thrifts became unprofitable. They were locked into fixed rate mortgages, while the interest they were required to pay on savings accounts increased and customers began withdrawing their deposits in favor of alternative investments. Many thrifts became insolvent and failed as a result.

The Federal Savings and Loan Insurance Corporation (FSLIC) responded to the crisis by encouraging healthy thrifts to take over failing ones in so-called supervisory mergers. These transactions relieved the FSLIC of its deposit insurance liability in exchange for providing a package of incentives to the acquiring thrifts. Two of those incentives were branching rights and regulatory account purposes (RAP) rights.

Branching rights permitted acquiring thrifts to open branches in states other than their home states, which was generally prohibited before 1981. RAP rights affected regulatory accounting treatment for business combinations. At the time, thrifts were required to maintain a minimum capital level of three percent of liabilities. This presented an obstacle for the acquiring thrifts because by definition, failing thrifts' liabilities exceeded their assets. Regulators removed this obstacle by permitting acquiring thrifts to treat the failing thrifts' excess liabilities as an asset called supervisory goodwill under Generally Accepted Accounting Principles (GAAP). This goodwill in turn counted toward the acquiring thrifts' minimum regulatory capital requirements, and could be amortized over a forty year period. Such treatment was guaranteed by FSLIC, regardless of future regulatory changes.

Home Savings of America, a subsidiary of the predecessor of WMI Holdings Corp., was a thrift originally based in California. Between 1981 and 1985, Home entered into four supervisory mergers in six states and assumed the acquired thrifts' liabilities in exchange for branching and RAP rights. Home later sold off those branches in an effort to focus on its California presence.

In 1988, Home acquired a New York thrift, Bowery Savings Bank. Prior to the acquisition, the Federal Deposit Insurance Company (FDIC) had been providing Bowery with assistance, including a RAP right, in accordance with a previous government assisted merger. As a result of Home's 1988 acquisition, however, Bowery negotiated a new assistance package which replaced the 1985 RAP right with a new one. Like the supervisory RAP right, the 1988 Bowery RAP right allowed Bowery to count the goodwill arising out of the acquisition toward regulatory capital. However, the 1988 Bowery RAP established a 20 year, rather than a 40 year, amortization period.

WMI sued in the Court of Federal Claims for a tax refund of over $250 million based on the amortization of the RAP rights and the abandonment of Home's branching rights in several states. To support its claims, WMI submitted a valuation report prepared by its expert, Roger Grabowski. The report valued each RAP right as a contractual right, conveyed to Home by FSLIC, which allowed Home to treat the goodwill as an asset for purposes of meeting regulatory capital requirements. Grabowski estimated the cost of raising and maintaining replacement capital to maintain a hypothetical buyer's pre-merger capital level. In other words, he assumed that regulatory approval was required to treat the goodwill created by the transactions as an asset amortizable over 40 years. The report valued the branching rights by forecasting the cash flow a hypothetical buyer would have expected by operating in a state other than its home state and made certain assumptions regarding the number of new branches, the growth of deposits, and the income a buyer would earn on new mortgage loans.

The Claims Court rejected the refund claims because it found that WMI failed to prove Home's basis in the branching rights, RAP rights, and the Bowery government assistance rights to a reasonable degree of certainty. The Claims Court saw the RAP rights not as creating a contractual right but as a guarantee of the right to continue amortizing the goodwill over 40 years even if the regulations later changed. The Claims Court likewise found Grabowski's approach to the branching rights unreasonable and at odds with the economic realities during the savings and loan crisis. With respect to the Bowery rights, the Claims Court found that the 1988 government assistance was materially different from that provided to Bowery in 1985, and rejected WMI's argument that the exchange qualified as a Code Sec. 1031 like-kind exchange.

WMI appealed to the Federal Circuit. It argued that the Claims Court clearly erred by not independently estimating Home's basis in the rights and in holding that the shortcomings in Grabowski's valuations justified a zero basis determination. According to WMI, Grabowski's approach to the RAP rights was supported by a 1981 Federal Home Loan Bank Board memorandum. WMI claimed that the memorandum required acquiring thrifts to apply for authorization to use the purchase method of accounting and to amortize supervisory goodwill. With respect to the branching rights, WMI argued that the Claims Court should have disregarded the assumptions it disagreed with and provided its own inputs using Grabowski's methodology. WMI also asserted that the Claims Court improperly treated the RAP rights valuation errors as a basis for rejecting the valuation of the branching rights.

The Federal Circuit upheld the Claims Court's decision to reject WMI's valuation and apply a zero basis. First, the Federal Circuit found that the Claims Court was not required to undertake an independent valuation analysis where WMI's own evidence was insufficient to allow it to do so. The Federal Circuit explained that a court has discretion to choose a method of valuation but not to make a finding of the value of an asset where there is no evidence to support it. And while it is unreasonable for a court to reject a taxpayer's valuation based on minor flaws, the Federal Circuit found that the Claims Court was correct in concluding that WMI's errors were major and systemic.

The Federal Circuit found that Grabowski's valuation was so flawed that the Claim Court's finding of a zero basis was justified. The Federal Circuit agreed with the Claims Court's finding that Grabowski overvalued the RAP rights as contractual rights. The Federal Circuit found that the reference to an application in the Bank Board memorandum merely reflected the fact that all business combinations were required to obtain regulatory approval, regardless of whether they intended to use the purchase method of accounting. Grabowski's misplaced assumption about the nature of the RAP rights undermined WMI's fair market value determination for those rights, and for that reason the Claim's Court's finding was not clearly erroneous.

The Federal Circuit also agreed with the Claims Court's finding that Grabowski used invalid assumptions in his valuation of the branching rights and relied on outdated market data. The court also noted the high interest rates and customer account closings during the acquisition period and found that these conditions contradicted Grabowski's prediction of significant deposit growth.

Finally, the Federal Circuit agreed with the Claims Court that the exchange of rights in the Bowery acquisition constituted a realization event because the government assistance provided to Bowery in 1988 was materially different from that provided in 1985. For that reason, the Federal Circuit also found that the exchange did not qualify as a like-kind exchange.

For a discussion of determining basis in a taxable exchange, see Parker Tax ¶110,515.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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