Judge David J. Cowan, Case BP063500 2022-10-13 Tentative Ruling

Please notify Dept. 1’s courtroom staff by email (SMCDept1@lacourt.org) or by telephone (213-633-0601) no later than 8:30 a.m. the day of the hearing if you wish to submit on the tentative ruling rather than argue the motion. If you submit on the tentative, you must immediately notify the other side that you will not appear at the hearing. If you submit on the tentative and elect not to appear at the hearing, the opposing party may nevertheless appear at the hearing and argue the motion. Please keep in mind that appearing at the hearing and simply repeating the arguments set forth in the papers is not a good use of the court’s time or the parties’ time.

Ruling: The Petition to Approve Zacadia Settlement is CONTINUED to December 8, 2022.

FTI is ordered to file a Supplement to the Petition by November 14, 2022 addressing (1) the status of Ziskin’s bankruptcy and whether any Zacadia assets or liabilities will be affected; (2) the status of, and further information about, the Trust’s fraud claims against Ziskin in the adversary proceeding; (3) the risks and costs of future litigation by Zacadia and the benefits of settling that litigation now; (4) the proportionality of the settlement to the risks of the above litigation by and against Ziskin and Zacadia; and (5) the status of the Motion for Approval of Settlement by the bankruptcy court, and relevance of that Motion to this Petition (if any).

On April 20, 2018, Beneficiary Alexander Hughes filed his Consolidated Objections to Pending Accountings of the Former Trustees of the Mark Hughes Family Trust. As relevant here, Beneficiary objected to Former Trustees' “mishandling of an estate tax strategy known as the Graegin transaction, and their involving of former Trust counsel Kenneth Ziskin as an advisor and interested party in the transaction.”

On September 9, 2022, Fiduciary Trust International of California (“FTI”), as Successor Trustee of the Mark Hughes Family Trust, filed a Petition for Order Approving Settlement with Zacadia Financial Limited Partnership and Related Parties. The Court did not receive any Objection to the Petition to Approve.

In November 2002, Hughes Investment Partnership, LLC (HIP), a Trust-owned LLC, “‘loaned’ approximately $50 million to Zacadia,” an entity affiliated with Kenneth Ziskin, and “Zacadia simultaneously ‘loaned’ the $50 million to the Trust.” (Zacadia Settlement Petition, para. 9.) Zacadia issued a promissory note to HIP and the Trust issued a promissory note to Zacadia, both set to mature in 2027. The notes differed in one material respect--the "note given by Zacadia to HIP bears interest at the rate of 8.6% per annum, and the not given by the Trust to Zacadia bears interest at the rate of 8.75% per annum," such that the "Trust will 'owe' Zacadia about $12 million more than Zacadia will 'owe' HIP" when the notes mature in 2027. (Settlement Petition, para. 12.) Moreover, though the notes arranged "for HIP to loan $50 million to Zacadia, and for Zacadia to loan that $50 million to the Trust," HIP simply "wired the $50 million directly to the Trust, bypassing Zacadia" with Zacadia's agreement. (Settlement Petition, para. 11.)

As a result of the loan, the Trust “incurred interest obligations of about $300 million,” nearly “all of it . . . to be paid in 2027,” and used “this interest expense as an estate tax deduction.” (Settlement Petition, para. 9.) However, as a “tradeoff[] for the estate tax deduction,” the loan forced HIP to “recognize” and “pay income taxes” on the “imputed interest income on HIP's ‘loan’ to Zacadia”—the amount of imputed interest income totals “more than $291,000,000.” (Settlement Petition, para. 9.) The Trust then used the $50 million transferred from HIP to the Trust to pay estate taxes. In sum, the Graegin loan “replaced a large up-front estate tax payment with tens of millions of dollars in income taxes payable” until the notes mature. (Settlement Petition, para. 9.)

However, in 2008 and again in 2014, Zacadia initiated litigation against the Trust to recover its $12 million anticipated profit, which was unsuccessful and resulted in significant fee awards against Zacadia. (Settlement Petition, para. 18-20; Zacadia Fin. Ltd. Partnership v. Fiduciary Trust Int’l of Cal. (Ct. App. Jan. 8, 2014) G047613, 2014 WL 69618 (affirming judgment against Zacadia); Zacadia Fin. Ltd. Partnership v. Fiduciary Trust Int’l of Cal. (Ct. App. Jan. 8, 2014) G047921, 2014 WL 61082 (affirming $2.5 million fee award against Zacadia); Zacadia Fin. Ltd. Partnership v. Fiduciary Trust Int’l. of Cal. (Ct. App. Feb. 6, 2018) B271520, 2018 WL 719021 (affirming $500,000 fee award against Zacadia))

Moreover, in 2015, with approval of the probate court, FTI funded an escrow account with securities valued in excess of “the payment that Zacadia will be entitled to receive on December 31, 2027” under the Graegin loan. (11/13/15 Order (granting FTI’s Petition to Approve Escrow of Treasury Securities); see Zacadia Fin. Ltd. Partnership v. Fiduciary Trust Int’l. of Cal. (Ct. App. Feb. 6, 2018) B271520, 2018 WL 719021 at *2 (FTI funded escrow “with assets with a present value in excess of the amount of Zacadia's 2027 profit, less the amount Zacadia will owe the Trust in 2027 as a result of the fee awards in the prior litigation.”)) The deposited securities are allegedly now worth roughly $2.2 million. (Settlement Petition, para. 28.)

In 2008, Ziskin filed “a personal chapter 7 bankruptcy petition,” and the “former trustees filed an adversary proceeding alleging that Ziskin . . . had defrauded the Trust” while acting “as counsel to the trustees.” (Settlement Petition, para. 25.) The Petition alleges the Former Trustees sought relief against Ziskin for advising them to “enter into the Graegin transaction with Zacadia,” affiliated with Ziskin, and by being “involved in the funding of bequests to the beneficiary that Zacadia claimed constituted a default” under that loan transaction. (Settlement Petition, para. 25.) This litigation is still pending. In exchange for settlement of this litigation, Ziskin’s insurance provider will pay the Trust $250,000. (Settlement Petition, para. 28.)

In brief, the Trust would pay Zacadia $1.5 million in exchange for $250,000 from Ziskin’s insurer and return of the escrowed securities; in doing so, the parties resolve pending litigation against Ziskin for his involvement in the Zacadia transaction, and future litigation between Zacadia and the Trust over Zacadia’s 2027 profit and attorney’s fee liabilities.

The Court lacks sufficient information to approve the settlement. The Petition does not state whether Zacadia has entered bankruptcy, and the status of Ziskin’s bankruptcy is unclear. The Court requires clarification as to whether Ziskin’s personal bankruptcy will affect claims or debts of Zacadia (e.g., the fee judgments against Zacadia), and when the Trust’s adversary proceeding against Ziskin will be heard by the bankruptcy court. The Court lacks information about that proceeding, including the amount of damages sought and/or the parties’ views of the merits of the claims. As a result, it is difficult to assess whether the settlement is reasonable relative to the development of that action, the risks of continued litigation, and potential gains from prevailing. The Court requires further explanation why this settlement would be in the Trust’s best interests.

In particular, the settlement requires FTI to pay $1.5 million to Zacadia, even though Zacadia’s earlier litigation against the Trust was unsuccessful (and in fact resulted in large fee awards against Zacadia) and it has no pending litigation against the Trust. FTI has not adequately explained what it expects to happen if the claims are not settled; for example, whether further litigation will be necessary for the Trust to recover the escrowed securities (if that is the Trust’s goal) or enforce the fee judgments against Zacadia, or how costly FTI expects that litigation would be. Zacadia owes the Trust at least $4.7 million in attorney’s fees, whereas the escrowed securities are only worth about $2.2 million. (Settlement Petition, para. 24, 28.) It is simply unclear why FTI needs to pay Zacadia $1.5 million to settle possible future litigation over the escrowed securities.

The settlement also requires Ziskin’s insurer to pay the Trust $250,000, and no explanation is offered for the figure. It is not clear whether the $250,000 payment represents the policy limit of Ziskin’s insurance, or a lesser amount tailored to address the Trust’s claimed damages; and as discussed above, the Court was provided minimal information about the status of the adversary proceeding. As a result, the Court cannot discern whether this payment is reasonable to settle claims that Ziskin defrauded the Trust by advising the Zacadia transaction. (Settlement Petition, para. 9.) If the Trust is likely to prevail on a fraud claim against Ziskin for substantial damages, the settlement may not be adequate (though the Court recognizes that Ziskin’s ability to pay his liabilities may be impacted by his bankrupt state).

Finally, the Petition indicates that the settlement is “conditioned upon obtaining the approval of this Court and that of the United States Bankruptcy Court with respect to settlement of the Ziskin adversary proceeding.” (Settlement Petition, para. 27 (emphasis added).) But the Petition does not indicate whether the parties have sought approval from the bankruptcy court, or (more generally) whether that court has expressed any views regarding the reasonableness settlement. Though the bankruptcy court will consider whether the settlement is reasonable for the bankrupt party (Ziskin), while this Court considers whether it is reasonable for the Trust, that court is more familiar with the adversary proceeding to be settled, and that court’s views regarding the merits of the settlement may be instructive in deciding whether to approve this settlement.

The Court requires further input from FTI in the form of a Supplement to the Petition for Approval. The Court CONTINUES the Petition for Approval to December 8, 2022. FTI shall file a Supplement by November 14, 2022 addressing the issues identified above, specifically including (1) the status of Ziskin’s bankruptcy and whether any Zacadia assets or liabilities will be affected; (2) the status of, and further information about, the Trust’s fraud claims against Ziskin in the adversary proceeding; (3) the risks and costs of future litigation by Zacadia and the benefits of settling that litigation now; (4) the proportionality of the settlement to the risks of the above litigation by and against Ziskin and Zacadia; and (5) the status of the Motion for Approval of Settlement by the bankruptcy court, and relevance of that Motion to this Petition (if any).

The Petition to Approve Zacadia Settlement is CONTINUED to December 8, 2022. Zacadia is ordered to file a Supplement to the Petition by November 14, 2022.

~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~

Matters: OSC Re: Phantom Income
Tax; OSC Re: Bifurcation of Phantom Income Issues; Status Conference Re:
Attorney Fees and Valuation phases of trial

Ruling: The
parties are ordered to prepare for a fourth phase of trial concerning phantom
income tax liability incurred by the Trust as a result of loans made in
connection with Tower Grove. The Court orders discovery reopened as to phantom
income tax issues, consistent with the parties’ agreement in the Joint Report
filed September 29, 2022.

The phantom income tax liability trial phase shall follow
the scheduled third phase of trial concerning attorney’s fees and costs
incurred by the Trust in Tower Grove-related litigation. The Court schedules
trial to begin on August 25, 2023. The Court schedules, and issues an OK to
set, hearings for July 18, 2023 on the parties’ cross-motions for summary
adjudication.

The Court discharges the OSC Re: Bifurcation of Phantom
Income Issues. However, the Court CONTINUES the OSC Re: Phantom Income Tax to
December 8, 2022. FTI shall file its further response to the OSC by November
14, 2022. Beneficiary shall file a response to FTI by November 21, 2022. Former
Trustees shall file a response to FTI and Beneficiary by November 28, 2022.

The Court sets a Trial Setting Conference Re: Attorney’s
Fees for November 3, 2022. The parties shall submit trial briefs for the fee
phase by October 27, 2022.

The Court schedules the valuation phase trial to begin on
January 4, 2023, per the dates proposed by the parties.

On December 23, 2021, Beneficiary
and Former Trustees filed a Joint Stipulation Re: Tower Grove Trial Dates
providing that the first phase of trial would pertain to the value of Tower
Grove, the second phase of trial would pertain to the amount of damages from
Former Trustees' breach of trust and Former Trustees' defenses, and the third
phase of trial would pertain to attorney's fees and costs incurred in
connection with the Tower Grove litigation.

On February 4, 2022, the Court
entered a Trial Sequence Order indicating it would first address the Trust’s
damages by determining whether Former Trustees are equitably estopped from
asserting Tower Grove would not have properly sold for $23.75 million in 2004, per
an Option Agreement with Dickens.

On February 24, 2022, addressing the
above issue, the Court concluded that Former Trustees were equitably estopped
from denying that a sale of Tower Grove $23.75 million in 2004 would have been
proper and reflective of Tower Grove’s value” for purposes of lost profits analysis.

On March 10, 2022, Former Trustees
and Beneficiary each filed Supplemental Briefs Re: Offers of Proof for Lost
Profits. Beneficiary argued for the first time that the Court should consider
damages to the Trust based on tax payments on “phantom income” accruing on the
loans to Dickens after his default.

On April 15, 2022, the Court reached
an initial conclusion that “the Trust suffered losses of $76,337,000,
consisting of $22,325,000 in net sales proceeds reinvested between 2004 and
2021 at an annual rate of return of 7.5%, accumulating $54,012,000 in
interest,” subject to potential offset based on the value of Tower Grove. The
Court then requested input from the parties regarding the upcoming trial on the
valuation of Tower Grove.

On
May 31, 2022, the Court set an OSC Re: Scope of Trial and OSC Re: Scope of
Valuation Phase Testimony for hearing on July 8, 2022; the OSCs were later
continued to July 14, 2022.

On
July 14, 2022, the Court issued an OSC Re: Phantom Income Tax for October 13,
2022, ordering FTI to “file its initial Brief concerning its treatment of
phantom income tax liability by August 31, 2022” and Former Trustees to respond
“by September 30, 2022.” The Court also “tentatively set[] a hearing for August
25, 2022 on Former Trustees’ Motion in Limine to exclude undisclosed testimony
concerning phantom income tax liability.” The Court expressed several concerns
with the phantom income theory, including that “Beneficiary did not
address FTI’s knowledge of its phantom income tax payments made between 2013
and 2019.”

On August 3, 2022, Former Trustees
filed Motion in Limine No. 10 seeking to exclude evidence or argument
concerning phantom income tax damages.

On August 25, 2022, the Court denied
Motion in Limine No. 10, finding Former Trustees had inadequately demonstrated
grounds for exclusion of phantom income tax issues based on disclosure of the
issue after close of discovery during this trial. Instead, the Court issued an
OSC Re: Bifurcation of Phantom Tax Issues, ordering the parties to “address[] (1) what discovery is
necessary to properly litigate phantom tax issues and how long this discovery
is likely to take; (2) what expert testimony (if any) Beneficiary and Former
Trustees intend to offer regarding tax liability; (3) whether the parties will
stipulate to reopen discovery via stipulation and/or an unopposed motion, or
whether any motion to reopen discovery will be disputed; (4) whether the
parties are willing to stipulate to an expedited briefing schedule for a motion
for summary adjudication[;] . . . and (5) whether a bifurcated trial is
necessary to adequately address phantom income tax liability issues without
undue prejudice to Beneficiary or Former Trustees, particularly given the
offset issue raised by FTI and absence of analysis of the Trust’s income
streams by Patel/Deloitte.” The Court also ordered the parties to file a “joint
trial report re valuation and briefs re attorney fees” by October 7, 2022,
setting a Status Conference Re: Attorney Fees and Trial Setting Conference Re:
Valuation Phase on October 13, 2022.

On August 31, 2022, FTI filed a
Supplemental Response to the Phantom Income Tax OSC.

On September 29, 2022, Beneficiary and Former Trustees filed a Joint Report
in response to the OSC Re: Bifurcation.

On September 30, 2022, Former
Trustees filed their Response to FTI’s Response and Supplemental Response to
the Phantom Income Tax OSC.

On October 10, 2022, Beneficiary and Former Trustees filed
a Joint Report Re: Attorney's Fees Phase of Trial and Joint Report Re: Valuation
Phase of Trial.

On October 11, 2022, FTI filed a
Reply to Former Trustees’ Response filed September 30, 2022. Former Trustees
later filed a Motion to Strike this Reply.

The
Joint Report indicates Beneficiary and Former Trustees are willing to address
phantom income tax issues in this trial. The parties have "stipulate[d] to
reopen discovery" to "propound written discovery" and take
depositions of several witnesses, including experts.[1] (Joint Response, p. 2-3.)
The parties estimate this discovery will take between five and seven months
(165 to 210 days) to complete. (Joint Report, p. 3.) Moreover, the parties
agreed to "stipulate to an expedited briefing schedule for cross-motions
for summary adjudication on the phantom income tax issue," to be filed
"no later than 45 days after completion of discovery." (Joint Report,
p. 4.)

Notably,
the parties agree that there is little practical distinction between
bifurcating the phantom tax issues for separate trial or adding a new trial
phase concerning those issues. (Joint Report, p. 4 ("Thus, adding another
'phase' as to the phantom income tax issue will effectively serve to bifurcate
the issue...")) Instead, the parties disagree whether that phase should be
tried before or after the phase concerning attorney's fees and costs incurred
in Tower Grove-related litigation. Beneficiary argues the phantom tax phase
should precede the fee phase to “allow the Court to most adequately address the
offset issue raised by FTIC,” and argues that “holding the attorney’s fees
phase first will stunt the flow of the trial, given that the phantom income tax
issue is directly related to the issues that will be set forth in the valuation
phase.” Former Trustees argue this phase "should come last" due to
Beneficiary's belated introduction of the issue, and argues this "would
avoid delaying the resolution of the other . . . phases" of trial.

The
phantom tax phase properly follows the attorney’s fees phase of this trial. The
parties have been preparing for the fee phase since 2021, and the parties are
(to the Court’s knowledge) prepared for that phase of trial. By contrast, the
parties will require several months to conduct discovery regarding phantom tax
issues, which may require discovery motion practice. The parties will then
require further time to prepare anticipated “cross-motions for summary
adjudication,” and then to prepare for trial. It is plainly efficient for the
parties for the parties to prepare for the phantom tax trial while the rest of
the trial proceeds as scheduled—the parties are represented by large firms
capable of efficiently dividing the labor of simultaneously conducting a
scheduled trial on valuation and fees while preparing for a new trial on
phantom tax issues.[2]

Though
Beneficiary “does not believe there will be any undue delay” from first conducting
the phantom tax phase, the Joint Report suggests some risk of delay if the fee
phase is tethered to the new phantom tax phase, and the Court has not been
provided sound reasons to delay the fee phase. Moreover, conducting the phantom
tax phase first would pressure the parties to rapidly complete discovery,
motion practice, and trial preparation despite being prepared to conduct the
fee phase. (See Joint Report, p. 5 ("It is also Former Trustees’
position that fact discovery . . . followed by expert discovery and
depositions, could well take substantially longer than six months…”)) Any unanticipated
pretrial issues can be more easily addressed without additional time pressure
on the parties and the Court.

Absent
any objection from the parties and per their agreement, the Court orders
discovery reopened as to phantom income tax liability issues. (CCP sec.
2024.050; see CCP sec. 2024.060 (“Parties to an action may, with the
consent of any party affected by it, enter into an agreement to . . . reopen
discovery after a new date for trial of the action has been set”); Joint
Report, p. 3 (“Without waiving the right to object to discovery that may be
served, the parties stipulate to reopen reasonable discovery in the manner set
forth” in the Report))

Discovery
is properly reopened as it is necessary to prepare for a new trial phase
concerning these issues; the parties did not conduct discovery related to phantom
income tax issues in preparing for the earlier-scheduled phases of trial
concerning lost profits, valuation of Tower Grove, and fees and costs of
litigation. (CCP sec. 2024.050(b)(1).) As discussed in denying Former Trustees’
Motion in Limine No. 10 to exclude argument relating to phantom income tax
issues, there was no showing of willful discovery misconduct by Beneficiary to
support a result as harsh as precluding him from seeking relief for belatedly
discovered but significant damages. (8/25/22 MIL Order, p. 5, 11-12.) Though
FTI arguably should have informed Beneficiary of phantom income tax issues,
there is no evidence suggesting Beneficiary was aware of phantom tax issues before
trial. (CCP sec. 2024.050(b)(2).) A new trial is appropriate—and for that,
discovery is required.

Sequencing
the phantom income tax phase after the valuation and attorney’s fees phases of
trial substantially reduces the “likelihood that permitting the discovery or
hearing the discovery motion will prevent the case from going to trial on the
date set, or otherwise interfere with the trial calendar.” (CCP sec.
2024.050(b)(3).) Permitting this discovery and resolving related discovery
motions will not cause “prejudice to any other party” where the parties’ Joint
Report expresses a preference to conduct discovery and prepare for a further trial
phase on this issue. (CCP sec. 2024.050(b)(3).) Finally, this discovery is
intended for a newly-scheduled phase of trial and thus will not delay
resolution of the other scheduled phases—hence, the “length of time that has
elapsed between any date previously set, and the date presently set, for the
trial” does not weigh against reopening discovery. (CCP sec. 2024.050(b)(4).)

In
summary, the parties agreed to reopen discovery and conduct pretrial motion
practice (specifically motions for summary adjudication, though discovery
motion practice may be necessary) in preparation for a new phase of trial
concerning phantom tax issues. The Court orders discovery reopened for that
purpose. The phantom tax phase of trial shall follow the next scheduled phase
of trial concerning attorney’s fees, and the parties shall prepare for the
phantom tax phase during the fee phase to avoid undue delays to either aspect
of the trial.

The
parties have different expectations regarding discovery—Beneficiary states
"discovery is not anticipated to take more than 6 months," whereas
Former Trustees assert discovery "could well take substantially longer
than six months." (Joint Report, p. 4-5.) However, Former Trustees do not
offer reasons why discovery could take “substantially longer than six months,”
which is a reasonable amount of time to complete discovery on these discrete
phantom tax issues.

Accordingly,
for purposes of scheduling trial, the Court assumes that discovery will take
roughly six months to complete. The parties agreed that cross-motions for
summary adjudication shall “be filed by no later than 45 days after completion
of discovery,” with “[o]ppositions due 30 days after” the motions are filed and
“[r]eplies due 14 days after the Oppositions.” (Joint Report, p. 4.) The
motions shall be heard “7 days after the Replies are filed.” Accordingly, the
Court schedules a hearing on the cross-motions for summary adjudication for
July 18, 2023—96 days after the anticipated close of discovery on April 13,
2023, which is six months after this hearing. The Court issues an OK to set
hearings on these motions on that date, and the parties are ordered to reserve
those hearings.

Thus,
the Court schedules the phantom income tax trial to begin on August 25, 2023.
The Court discharges the OSC Re: Bifurcation of Phantom Income Tax Issues, but will
address the OSC Re: Phantom Income Tax further below.

The
parties’ Joint Report Re: Attorney’s Fees identifies potential items of damages
and defenses, as well as the anticipated witnesses and time required for live
examination of those witnesses (largely cross and redirect examination).

However,
the Court requested briefs from the parties, rather than a joint report, to
discern the specific claims and defenses the parties intend to present at
trial. In particular, the Court could not discern the defenses to be asserted
by Former Trustees beyond Beneficiary’s failure to mitigate and unclean hands in
objecting to the Dickens settlement; it is unclear whether Former Trustees
intend to offer other defenses, including defenses specific to different items
of damages (e.g., arguing specific fees incurred were unreasonable), which may
take some time to address.

Thus,
the Court sets a Trial Setting Conference Re: Attorney’s Fees for November 3,
2022, and orders the parties to submit their respective trial briefs for the
fee phase by October 27, 2022. The briefs should identify the positions the
parties intend to take and the witnesses that are expected to support those
positions. The Court also requires input from the parties as to (1) how many
days of trial this phase is expected to take, and (2) whether the parties have
preferred trial dates, including in light of (3) whether this shorter trial phase
could be reasonably addressed in November and/or December 2022 before the
valuation phase trial.

In
turn, the parties’ Joint Report Re: Valuation Phase identifies anticipated
witnesses, testimony expected from each witness, and the time required for live
examination of those witnesses (again, largely cross and redirect examination).
The Joint Report proposes that the valuation phase trial begin either in
November 2022 (Former Trustees’ position), or in January or February 2023
(Beneficiary’s position). The Court intends to use the January 2023 trial dates
presented by the parties, as the undersigned will be partially unavailable in
November and prefers a continuous trial for this phase, if possible, though may
be able to conduct a shorter trial on attorney’s fees depending on the parties’
time estimates and availability—as discussed above.

Notwithstanding
the scheduling of a trial phase on Former Trustees’ liability for phantom tax
liability incurred as a result of loans to Dickens, the Court must address
FTI’s administration of this tax liability. As Successor Trustee, FTI continued
to recognize and report as income the interest accruing on loans to Dickens,
resulting in significant tax liability for the Trust until early 2019, when FTI
ceased reporting accrued interest as income ahead of the foreclosure sale of
Tower Grove in August 2019.

To
obtain further input from FTI on the topics discussed below, the Court CONTINUES
the OSC Re: Phantom Income Tax to December 8, 2022. FTI shall file its further
response to the OSC by November 14, 2022, addressing (1) when it will be able
to review the Trust’s tax returns and determine whether (a) the Trust’s phantom
tax payments were leveraged to obtain other tax benefits, and (b) the Trust
recognized a gain on the 2004 sale of Tower Grove; (2) why FTI did not review
tax returns before responding to inquiries from the Court about the Trust’s
taxes; (3) whether FTI is required to submit accountings for court approval for
the years it was serving as Successor Trustee; and (4) whether an “automatic
pilot” approach to the Trust’s taxes was appropriate given the “madness” of
reporting and paying taxes on millions of dollars in uncollectable interest.

Moreover,
Beneficiary shall file a response by November 21, 2022 indicating whether
Beneficiary views FTI’s continued payment of taxes on phantom income as proper,
and if so, whether this impacts with Beneficiary’s claims that the same reporting
practice by Former Trustees damaged the Trust. Former Trustees shall file a
response to FTI and Beneficiary’s responses by November 28, 2022. The OSC Re:
Phantom Income Tax is CONTINUED to December 8, 2022.

The
Court questioned why Deloitte would use the “accrual method” by reporting
interest as income, which “generated tax liability on accrued (but unreceived)
interest income,” rather than using the “cash method” to report only income
actually received. (8/25/22 Order, p. 15.) The Court views it as “unlikely
Deloitte chose to use the accrual method without any benefit where using the
cash method would on its face avoid incurring tax liability on unpaid loans.” (Id.)

In
its Supplemental Response, FTI argues that the Trust was required to report this
unpaid interest as income due to OID (original issue discount) rules applying
to cash method taxpayers, which require taxpayers to report as income accruing
but unpaid interest on certain instruments. (Supplemental Response, p. 1.) FTI
asserts the IRS “extended” OID rules in 1984 to apply to debt obligations
issued for non-publicly traded property" in order to address transactions
where one party enjoys a tax deduction without a corresponding “recognition of
income by the other party . . . in the same year.” (Response, p. 4.)

For
example, an “accrual basis borrower” and “cash basis lender” could arrange a
loan enabling the borrower to “deduct the deferred interest it did not actually
pay" on an accrual basis, while the cash lender "would not have to
recognize [unpaid] interest as income because it did not actually receive
payments.” (Response, p. 4.) To avoid short-term impacts on tax revenue from
immediate deductions and delayed reporting of income, FTI asserts the IRS requires
cash taxpayers to "include OID in income as it accrues each year, whether
or not you receive any payments.” (Response, p. 6.) Though FTI recognizes many "commentators
and bar associations" have criticized this rule, FTI asserts it merely
followed the law as interpreted by the IRS and the reporting practices of
Former Trustees. (Response, p. 11.) Indeed, FTI states its “OID income reporting
was essentially on automatic pilot . . . and simply continued”
consistent with Former Trustees’ reporting of such income. (Reply, p. 12
(emphasis added).)

But
this “automatic pilot” tax strategy is noteworthy where internal emails from
Deloitte in February 2020 describe the reporting of phantom income as “insanity.”[3] (Stolyar Decl., Exh. 1
(February 10, 2020 internal Deloitte emails by Jessica Karantonis and Bina
Patel) (Karantonis states that Michael Blinder “said to absolutely accrue NO
interest for all of 2019 – no matter what – given the fact that we now know,
beyond a doubt, that we are NEVER getting paid for any of this interest. His
direct quote was to ‘stop the insanity’…”); (Patel comments, “Sounds good to
me. Agreed! Let’s stop this insanity.”)) Patel also refers to the “madness of
accrual” in discussing phantom income. (Id. (February 11, 2020 internal
Deloitte email by Patel))

On
the other hand, it is unclear when FTI learned of Deloitte’s views on ending
the “madness of accrual.” (Id. (February 11, 2020 email by Patel)
(“Sounds hopeful so far, but let’s not tell the Trustees just yet.”)) FTI’s
Reply only comments on the email to point out that the email followed the
foreclosure sale of Tower Grove, which guaranteed uncollectability, but does
not express any opinion on Deloitte’s views regarding the “insanity” of
accruing substantial phantom income. The Court requires further input from FTI
regarding this exchange.

In
the same email, Blinder and Karantonis questioned whether the Trust
“recognize[d] a gain back in 2004 when it sold” Tower Grove, indicating that the
Trust “may not have tax basis in the principal of the notes” if it did not
recognize a gain. Patel responded that the Trust “recognized gain in 2004.” In
reviewing the Trust’s tax returns (which FTI has apparently not done, as
discussed below), FTI should determine whether the Trust indeed recognized a
gain on the 2004 sale, as this may affect the calculation of capital gains tax
relating to a future sale of Tower Grove, and thereby affect the calculation of
damages.

FTI
also concedes that it did not inform Beneficiary of its ongoing phantom tax
payments before this trial. FTI represents
that "the Beneficiary has never been involved in or consulted concerning
the Trust's taxes and/or tax filings, and was not informed of the tax on
phantom [income] respecting the Tower Grove Notes until his counsel
investigated capital gains tax issues earlier this year." (Response, p.
18.)

But FTI does not
explain why it adopted this policy of silence, simply stating that taxes are
"a matter solely of Trust administration" to be "treated as
confidential to the Trust." (Response, p. 18.) An assertion that taxes are
matters “of Trust administration” does not wholly justify confidentiality where
FTI and Beneficiary communicated about the consequences of the Tower Grove deal
(as reflected by the parties’ common defense agreement) and cooperated (to some
extent) in litigation over the same—which appear to be matters of “Trust
administration.” It is unclear why tax issues in particular should be “treated
as confidential” despite other coordination regarding Trust matters between FTI
and Beneficiary.

FTI indicates it
"views the timing and disclosure issues as fact issues to be developed” by
Beneficiary and Former Trustees.” (Response, p. 17.) But only FTI is capable of
explaining why it did not inform Beneficiary of years of phantom income tax
liability "until earlier this year (after the scheduled trial date),"
after Former Trustees raised a distinct capital gains tax issue. FTI’s Reply
essentially states that it did not “discuss[]” telling Beneficiary due to
other, more pressing Trust administration matters, such as the recovery of
Tower Grove. (Reply, p. 12.) The Court does not consider Beneficiary
responsible for this—indeed, a trial has been set on phantom tax issues despite
the mid-trial introduction of these issues.

But FTI has a statutory
“duty to keep the beneficiaries of the trust reasonably informed of the trust
and its administration.” (Probate Code sec. 16060.) Section 16060 requires
disclosure of information that is “‘reasonably necessary to enable the
beneficiary to enforce the beneficiary's rights under the trust or prevent or
redress a breach of trust.’” (Babbitt v. Superior Court (2016) 246
Cal.App.4th 1135, 1145 (quoting Salter v. Lerner (2009) 176 Cal.App.4th
1184, 1187).) The Court is of the view that accrual and payment of over $32
million in phantom income tax would be information “reasonably necessary” to
Beneficiary’s efforts to redress Former Trustees’ breach of trust. (FTI
Response, p. 12 (“The Trust already has been required to recognize
approximately $80,000,000 of OID that constituted ordinary taxable income and
the Trust paid over $32,000,000 in tax on the OID at ordinary income rates.”)) Indeed,
Beneficiary argues this tax liability should be addressed as a consequence of
Former Trustees’ breaches of trust relating to the Tower Grove transaction. The
information likely should have been disclosed earlier.

Notably, as
trustee, FTI’s “duty to provide information under section 16060 'is independent
of, and potentially even broader than(,) the duty to report [requested
information] under . . . section 16061 or to account under . . . section
16062.'" (Babbitt, supra, 246 Cal.App.4th at 1145.) FTI had
a duty to determine whether information is so “reasonably necessary” for a
beneficiary that it should be disclosed, regardless of whether there was some
request for information under Section 16061 or specific obligation to account
for those payments under Section 16062.

The
Court recognizes that FTI may not be required to submit accountings for
approval by the probate court, and Beneficiary has only objected to the
accountings submitted by Former Trustees. As a result, FTI’s management of the
Trust’s phantom income tax liability may not be at issue absent some objection
by Beneficiary. But if FTI is required to obtain court approval for
accountings, further inquiry may be appropriate regarding FTI’s “automatic
pilot” reporting of phantom income and substantial tax payments. Hence, the
Court requires further input from FTI as to whether it is required to submit
accountings for court approval.

Most
significantly, FTI states it does not know whether the Trust’s phantom tax
liability was used to offset other gains because it has not reviewed the
relevant tax returns. FTI asserts it has not reviewed “15 years of tax returns”
for the Trust—impliedly including returns for the years while it was Successor
Trustee, as the first loan to Dickens occurred in 2004 and FTI ceased reporting
phantom income on loans to Dickens in 2019. (Reply, p. 9.) The Court has
questioned several times whether the Trust’s payments of phantom income tax
“were used to offset tax gains from other transactions” or “offset other forms
of income” from various Trust-owned LLCs. (8/25/22 Ruling, p. 16; 7/15/22
Order, p. 30-31.) The Court cannot give much weight to FTI’s assertions that
the Trust did not use phantom income tax payments to offset other gains where
it has not reviewed the underlying tax returns.[4]

As a result, it
is still unclear whether the Trust received tax benefits or offsets related to
phantom income tax payments. But FTI has indicated these payments may result in
future tax offsets from a future sale of Tower Grove. (Response, p. 3 (“phantom income [payments] would increase, and [have]
increased, the Trust's basis in the Tower Grove property and might someday
reduce future taxes payable if and when the Tower Grove property is sold."))
However, FTI states that it “cannot be determined whether the higher tax basis
will offset taxes and, if so, in what amount" at this time. (Response, p.
3; see also Stolyar Decl., Exh. 1 (February 5, 2020 Deloitte internal
email by Jessica Karantonis) (“Presumably we may actually have a gain to
recognize, if we sell at greater than $200M.”))

The Court
requires further input from FTI regarding (1) the time required to review the tax
returns and determine whether the Trust’s phantom tax payments were leveraged for
other tax benefits and whether the Trust recognized a gain on the 2004 Tower
Grove sale; (2) its failure to review tax returns despite answering inquiries
from the Court about the Trust’s taxes; (3) its obligation (if any) to submit
accountings for court review and approval; and (4) how the referenced Deloitte
exchange reflects on FTI’s “automatic pilot” approach to tax strategy. FTI
shall file a further response to the OSC by November 14, 2022. Beneficiary
shall file a response by November 21, 2022 indicating whether Beneficiary views
FTI’s continued payment of taxes on phantom income as proper, and if so,
whether this impacts with Beneficiary’s claims that the same practice by Former
Trustees damaged the Trust. Former Trustees shall file a response to FTI and
Beneficiary’s responses by November 28, 2022. The OSC Re: Phantom Income Tax is
CONTINUED to December 8, 2022 at 8:30 a.m. in Department 1.

The Court is not attempting
to draw conclusions about the merits of the tax strategy employed by FTI or
Deloitte—simply gathering more information. A petition to settle an account
"trigger[s] the probate court's duty to scrutinize the prudence of [the
trustee's] administration of the Trust." (Schwartz v. Labow (2008)
164 Cal.App.4th 417, 428.) The phantom tax issues were raised in mid-trial on Beneficiary’s
objections to accountings filed by Former Trustees, not FTI. But Beneficiary seeks
relief for damages partially based on years of taxes paid by FTI on phantom
income, requiring scrutiny of FTI’s administration of the Trust to some extent.
The Court agrees with FTI that these issues will be developed in discovery by
Beneficiary and Former Trustees, but also requires input from FTI as the Trustee
paying the Trust’s phantom taxes between 2013 and 2019.

Former Trustees
move to strike FTI’s Reply to their September 30, 2022 Response, arguing the
Reply is unauthorized and prejudicial. Former Trustees dispute FTI’s analysis
of its OID tax obligations, arguing they would be “unfairly prejudiced” if the Court
considers FTI’s analysis.

But it is unclear
how Former Trustees could be prejudiced by the Court’s consideration of that
analysis. Former Trustees’ Motion to Strike exclusively focuses on FTI’s tax
analysis, but the Court is merely continuing the OSC Re: Phantom Income Tax for
further input from FTI about its obligation to account, asserted policy of
confidentiality as to tax matters, and failure to review the Trust’s tax
returns—issues unrelated to FTI’s analysis of OID rules. The Court is not making
a ruling arguably adverse to Former Trustees in connection with the OSC Re:
Phantom Income Tax. Moreover, Former Trustees will have an opportunity to
respond to FTI’s further response to the OSC. In sum, the Court perceives no
prejudice to Former Trustees from consideration of the Reply. The Motion to
Strike is DENIED.

The
parties are ordered to prepare for a fourth phase of trial concerning phantom
income tax liability incurred by the Trust as a result of loans made in
connection with Tower Grove. The Court orders discovery reopened as to phantom
income tax issues, consistent with the Joint Report filed September 29, 2022,
as necessary to prepare for this new trial phase.

The
phantom income tax liability trial phase shall follow the scheduled third phase
of trial concerning attorney’s fees and costs incurred by the Trust in Tower
Grove-related litigation. The Court schedules trial to begin on October 16,
2023. The Court schedules, and issues an OK to set, hearings for July 18, 2023
on cross-motions for summary adjudication.

The
Court discharges the OSC Re: Bifurcation of Phantom Income Issues. However, the
Court CONTINUES the OSC Re: Phantom Income Tax to December 8, 2022. FTI shall
file its further response to the OSC by November 14, 2022. Beneficiary shall
file a response to FTI by November 21, 2022. Former Trustees shall file a
response to FTI and Beneficiary by November 28, 2022.

[1] The parties
disagree whether Former Trustees can conduct discovery "as to whether the
Beneficiary knew about the phantom tax liability issue in advance of
trial." (Joint Report, p. 3.) However, the Report makes clear that the
parties "have not agreed on the precise scope of appropriate
discovery" and may "object . . . once discovery is propounded."
(Joint Report, p. 3.) In turn, objections to discovery may require motion
practice to resolve—at which point the Court can address specific disputes over
the scope of discovery.

[2]
Former
Trustees are represented by Loeb & Loeb, LLP and Beneficiary is represented
by Greenberg Traurig, LLP.

[3] The Court
recognizes that these emails were “designated as 'Confidential' by Deloitte”
during discovery. However, the exhibit has not been sealed—though the parties
are free to move for that relief if appropriate. A confidential designation in
discovery does not require sealing or redacting court orders. (See CRC
2.550-CRC 2.551.)

[4] It is also
troubling that FTI apparently did not review the returns before making earlier
representations about their contents. (8/30/22 Supp. Response, p. 1 ("FTI
confirms that over $80,000,000 of Original Issue Discount . . . was reported on
the Trust's tax returns for tax years 2004 through 2018 . . . result[ing] in
over $32,000,000 of taxes paid thereon…”); see 8/17/22 Response, p. 3-4,
8, 11 (discussing unreviewed tax returns filed by Former Trustees and FTI); compare
10/10/22 Reply, p. (conceding that “[t]o account properly for the OID income
and any potential offsets, all of the tax attributes, returns and tax laws
would need to be reviewed on a year by year basis…”))