Wertheim Schroeder & Co., Inc. v. Commissioner of Revenue (March 12, 2001)

COMMONWEALTH OF MASSACHUSETTS

APPELLATE TAX BOARD


WERTHEIM SCHROEDER & CO, INC.	v.	 COMMISSIONER OF REVENUE
     

Docket Nos. F214608-F214610		 Promulgated:
							 March 12, 2001


 	These are consolidated appeals under the formal procedure pursuant to G.L. c. 58A, § 7 and G.L. c. 62C, § 39, from the refusal of the Appellee Commissioner of Revenue ("Commissioner") to abate corporate excises assessed against Wertheim Schroeder & Co., Inc. for the taxable years of 1985, 1986 and 1987. 
	Commissioner Scharaffa heard these appeals and was joined in the decision for the appellant by Chairman Burns, former Chairman Gurge and former Commissioner Lomans.
	These findings of fact and report are promulgated at the request of the appellant, pursuant to G.L. c. 58A, § 13 and 831 CMR 1.32.

	John S. Brown, Esq., Joseph L. Kociubes, Esq., George P. Mair, Donald-Bruce Abrams, Esq., and Matthew D. Schnall, Esq. for the Appellant.

Philip Olsen, Esq. for the Appellee.


FINDINGS OF FACT AND REPORT
	Based on the agreed statement of facts, testimony and exhibits entered into evidence at the hearing of this appeal, the Appellate Tax Board ("Board") made the following findings of fact.
	At all relevant times, the Appellant Wertheim Schroeder & Company, Inc. ("Wertheim") was a Delaware corporation, with its principal place of business in New  York, New York. During its tax years 1985, 1986 and 1987 ("tax years at issue"), Wertheim was engaged in the business of underwriting securities offerings.  
During the tax years at issue, Wertheim was a registered broker and dealer of securities and a member of the National Association of Securities Dealers, Inc. ("NASD").  Wertheim was also subject to regulation by the Securities and Exchange Commission (the "SEC"). 
 	The nature of Wertheim's underwriting business is illustrated by a 1987 public offering of the common stock of Questar Corporation ("Questar"), a Utah Corporation.  The parties have stipulated that this offering was typical and representative of the offerings in which Wertheim participated as underwriter during the tax years at issue. Further, the parties have stipulated that Wertheim's underwriting income from the Questar offering was typical and representative of Wertheim's underwriting income for the tax years at issue.  Accordingly, for purposes of this appeal, the parties have agreed that the treatment of the Questar underwriting income is controlling with regard to all of the underwriting income at issue in these appeals. 
In its 1987 offering, Questar planned to issue and sell 1,500,000 shares of its common stock to the public, with an additional 225,000 shares to be issued and sold at the option of the underwriters (the "Green Shoe" option) Questar hoped to raise at least $58 million dollars through this offering.   
Wertheim acted as the lead manager, known as the "book-running manager," of the underwriting syndicate, serving as the firm with primary responsibility for carrying out Questar's offering.  Wertheim's most important service, performed prior to the issuance of the shares, was to find the requisite buyers for the 1,500,000 shares and the shares allotted for the "Green Shoe" option. To achieve this goal, Wertheim was expected and required to render a wide range of additional professional services prior to, during and following the completion of the stock offering.  
As book-running manager, Wertheim participated in the drafting of the SEC registration statement, Questar's prospectus, and other documents related to the offering.  Wertheim also conducted a due diligence investigation of Questar and designed a "road show" presentation. In addition, Wertheim assembled a syndicate of almost seventy underwriting firms to participate in the offering and drafted the contract setting forth the agreement among the underwriters ("Agreement Among Underwriters").  
Approximately ten days before the scheduled offering date, Wertheim carried out a "book-building process," in which it solicited and tabulated orders for the Questar shares from prospective investors.  On the day before the scheduled offering date, Wertheim evaluated the level of demand for the offering and made price recommendations to Questar based on that demand.  Wertheim also determined that the "Green Shoe" option would be exercised. 
On May 22, 1987, Questar issued its shares to the public. The SEC registration statement became effective on that date and the "Underwriting Agreement," "Agreement Among Underwriters" and "Selling Agreement" were signed on that date. 
On June 1, 1987, Wertheim facilitated the settlement of the parties' obligations created by the Questar offering. As part of the settlement, Questar delivered a certificate for 1,725,000 shares of its common stock to the Depository Trust Company ("DTC"). As book-running manager, Wertheim notified DTC of the identities of the institutional investors who had purchased shares in the offering and the brokers whose customers had purchased the remaining shares. DTC recorded the institutional investors and retail brokers as the owners of the shares on its books through a book entry system. The purchasers of the Questar stock remitted to Wertheim, as book-running manager, payment of the public offering price of $38.625 per share, or a total of $66,628,125, for the 1,725,000 shares of Questar common stock issued in the offering.  Wertheim then gave Questar a check for $64,126,875, representing full payment for the shares sold, at an agreed net price of $37.175 per share.
	The difference between the amount paid by the purchasers of the Questar shares and the amount remitted to Questar by Wertheim represented the earned underwriting discounts and commissions in the aggregate gross amount of $1.45 per share (the "Underwriting Discount"). The Underwriting Discount, negotiated between Questar and Wertheim, represented the only compensation Wertheim and
the other underwriters  received  for the services rendered and the expenses incurred by them in the offering. Wertheim, therefore, was not paid separately by Questar for any of the underwriting services performed over the course of the offering, nor did it receive any separate commission from any investor for effecting the investor's purchase of the Questar shares. 
The total Underwriting Discount of $1.45 per share was comprised of three separate per-share components that included a management fee, a selling concession, and an underwriting discount.  The aggregate Underwriting Discount of $2,501,250 was divided among the underwriters, in accordance with agreements made between the underwriters (the Agreement Among Underwriters, the Selling Agreement and the Underwriting Agreement).     According  to    the uncontested testimony of the sole witness before the Board, Arthur Goldstone,  the   Wertheim   employee  specifically
responsible for the syndicate and marketing portion of the Questar offering at issue, underwriters are almost always used in the public issuance of stocks and bonds.  Mr. Goldstone testified that this is the case because the stock issuers want the expertise and services of the underwriter, and in particular want to be insulated from the risk of a failed deal.  Further, Mr. Goldstone testified that during the tax years at issue it was typical for underwriters to be compensated on the basis of the underwriting discount, as described above.
	While the Underwriting Agreement committed the underwriters to purchase designated allotments of the shares, the underwriter's obligations were subject to a number of conditions.  If any of these conditions were not fulfilled, the underwriters had a unilateral right to terminate the agreement.  These conditions included any material adverse change, or development involving a prospective change, in Questar's general affairs, management, financial position, or results of operations. The underwriters' commitment, therefore, was to purchase the shares in the event that the demand for Questar's shares evaporated because of some circumstances unrelated to Questar itself (i.e. a "market melt-down").  As highlighted by Mr. Goldstone, Wertheim would not have signed the Underwriting Agreement had it not been confident that there was more than sufficient public demand for the number of shares to be issued.
Through its offering, all Questar shares of stock issued were successfully sold to the public. Neither Wertheim nor any other underwriter, therefore, was required to or did purchase Questar stock pursuant to the Underwriting Agreement.
	For each of the tax years at issue, Wertheim timely filed a Massachusetts corporate excise return, Form 355B, and timely paid the excise shown to be due.  Wertheim included the underwriting income at issue in the denominator of its sales factor pursuant to G.L. c. 63, § 38(f).
	The Commissioner issued a Notice of Intention to Assess, dated December 18, 1989, for additional corporate excises, including interest and penalties, due for the tax years at issue. The Commissioner excluded the underwriting income at issue from the denominator of Wertheim's sales factor of its apportionment formula on the ground that such income constituted receipts from the sale of securities and therefore were not includible in the sales factor under    § 38(f).  On March 9, 1990, Wertheim and the Commissioner agreed, on Form A-37, to extend the period of assessment for the tax years at issue to December 31, 1990. 
By Notice of Assessment, dated February 17, 1991, Wertheim was assessed additional corporate excise deficiencies, interest and penalties for the tax years at issue.  On March 19, 1991, Wertheim paid all additional assessments, in full.
	On March 18, 1992, Wertheim seasonably filed an Application for Abatement, Form CA-6, of the additional assessment for each of the tax years at issue. On August 13, 1993, the Commissioner issued his Notice of Abatement Denial, denying the abatement application in full.  On October 12, 1993, Wertheim timely filed a petition with this Board, appealing the Commissioner's refusal to grant the abatements requested for the tax years at issue. 
On the basis of the foregoing, the Board consolidated the appeals, and found them to be in conformity with the requirements of G.L. c. 62C, §§ 37 and 39.  The Board, therefore, determined that it had jurisdiction to hear and decide this matter.
On the basis of the foregoing, the Board found that the underwriting income received by Wertheim in connection with the Questar stock offering represented compensation income to Wertheim for its underwriting services.  This income was comprised of fees and commissions for the professional management of the underwriting syndicate and the arrangement for the sale of the issuer's securities.  The Board further found that Wertheim, at no time during the offering process, took legal title to or had beneficial ownership of the Questar shares offered.  As such, the Board found that Wertheim did not purchase any of the shares of the offering.  The Board, therefore, found that the underwriting income in question constituted compensation income includible in Wertheim's sales factor and was not income from the sale of securities excludible from the denominator of the sales factor under G.L. c. 63, § 38(f). 
Accordingly, for the reasons detailed in the following Opinion, the Board found and ruled that the underwriting income received by Wertheim during the tax years at issue was properly includible in the denominator of Wertheim's sales factor.  The Board found and ruled that Wertheim was entitled to an abatement of its corporate excises for the tax years at issue. 
The Board, therefore, issued a decision for the appellant and granted abatements totaling $53,441.00: $26,097.00 for tax year 1985, $18,288.00 for tax year 1986, and $9,056.00 for tax year 1987, plus all statutory additions. 

OPINION
	The issue raised by the present appeal is whether income generated by Wertheim's underwriting activities represents compensation income for services rendered or receipts from the sale of securities.  The parties have agreed that if the income in question is compensation income and not "receipts from the maturity, redemption, sale, exchange or other disposition of securities" under § 38 (f), the income is includible in the denominator (but not the numerator) of Wertheim's sales factor and Wertheim is entitled to an abatement of all amounts at issue.
	A corporation with income from business activities conducted both within and outside Massachusetts is subject to an apportioned corporate excise.  G.L. c. 63, § 38(c). That corporation's apportioned income is determined by a three-factor formula, based on a ratio of its Massachusetts property, payroll and sales to its property, payroll and sales everywhere.  G.L. c. 38(c) through (f). 
The present issue relates solely to the sales factor, which is the ratio of sales inside Massachusetts to sales everywhere.  The sales factor is computed by dividing the corporation's total sales in Massachusetts during the taxable year ("the numerator"), by that corporation's total sales from all sources during the taxable year ("the denominator"). G.L. c. 63, § 38(f). 
For purposes of § 38(f), a corporation's "sales" are broadly defined as "all gross receipts of the corporation," with a limited exception for "interest, dividends, and gross receipts from the maturity, redemption, sale, exchange or other disposition of securities." See also 830 CMR 63.38.1(9).  
In the absence of any provision in either the statute or the regulations defining the exclusion, the phrase "receipts from the . . . sale . . . or other disposition of securities" should be given its ordinary and usual meaning.  "The general and familiar rule is that a statute must be interpreted according to the intent of the Legislature ascertained from all its words construed by the ordinary and approved usage of the language." Hanlon v. Rollins, 286  Mass. 444, 447 (1934), quoted in Industrial Finance Corp. v. State Tax Commission, 367 Mass. 360, 364 (1975). See also Commissioner of Revenue v. Franchi, 423 Mass. 817, 822 (1996). (Tax statutes are to be strictly construed according to their plain meaning).
The ordinary interpretation of the phrase "receipts from the . . . sale . . . or other disposition of securities" means the gross proceeds realized from the sale of securities owned by the taxpayer.  Exempting receipts from the disposition of securities, together with interest and dividends, indicates a legislative intent to exclude the proceeds of investment activities from the sales factor.  See e.g., Internal Revenue Code § 469(e)(1)(A)(i) and (ii) and Temp. Reg. § 1.469-2T(c)(3) (interest, dividends, and gains from the sale of securities treated as "portfolio" income).  
There are, of course, instances where securities are held and sold not as investments but as part of a taxpayer's trade or business.  For example, securities dealers who hold securities for sale to the public and "firm commitment" underwriters who purchase a block of stock as part of an initial public offering with the intent to sell shares of the stock to the public (see Revenue Ruling 78-294, 1978-2 CB 141) do not hold the securities as investments for their own accounts.  The exclusion from the sales factor of receipts from the sale of such securities would present a closer question than the one at issue in the present appeal because the securities would be owned by the taxpayer prior to disposition.  However, the issue in such cases, as in the present case, is whether the receipts constituted receipts from the sale of securities or were compensation for services.  Where, as here, the taxpayer never owned the securities in question, the fact that the receipts at issue constituted compensation for services is clear.
The Commissioner's apportionment regulations confirm this interpretation of the statute. The regulations do not define "gross receipts from the . . . sale . . . of securities." 830 CMR 63.38.1(9)(a)(3).  After reiterating the language of the statutory exclusion, however, the regulations set forth a number of categories of receipts that are included in the sales factor, specifically receipts from the provision of services, and in particular "commissions, fees, management charges and similar items". 830 CMR 63.38.1(9)(b)(3).  Cf. Commissioner of Revenue v. AMIWoodbroke, Inc. 418 Mass. 92, 95-97 (1994) (term "services" interpreted broadly as to include acts done for the benefit of or that assist another, including both labor and expenditures.
	The conduct of the parties to the Questar public offering establishes that the underwriting discounts and commissions at issue were compensation to Wertheim for its provision of an extensive range of professional services. Questar sought to raise approximately $58 million from the public sale of its stock.  Wertheim, therefore, was initially retained by Questar to act as the book-running manager for the public offering.   Wertheim, along with First Boston as its co-manager, assembled a group of underwriters to execute the sale of newly issued Questar shares to the public.  
Accordingly, upon its engagement and without purchasing any of the shares, as well as without entering into any agreement or commitment with respect to the offering, Wertheim began to work with Questar in order to facilitate the public offering.  As described above, Wertheim participated in numerous professional activities as book-manager, a leadership role which required the exercise of professional expertise and judgment. Wertheim participated in the preparation of the SEC registration statement, the prospectus and other documents relating to the offering.  Wertheim conducted a due diligence investigation of Questar.  Wertheim designed, organized and participated in a "road show."  Wertheim carried out the "book-building process," which included the determination of how the shares would be allocated among institutional investors and retail investors. Wertheim assembled a syndicate of underwriters to participate in the offering and drafted the agreement among the underwriters.  On the day before the public offering, Wertheim evaluated the level of demand for the offering and made a price recommendation to Questar, intended to ensure the successful distribution of the securities.
On the day of the public offering, assured that they in fact had sufficient buyers for the shares, the underwriters committed to underwriting the offering by entering into an Underwriting Agreement with Questar.  This commitment ensured that, in the event of a last-minute market "meltdown," and subject to a list of enumerated conditions, the underwriters guaranteed that Questar would receive the full amount of offering proceeds at the public offering price, even if the underwriters had to purchase the shares themselves.  The offering, however, was fully subscribed to by the public and neither Wertheim nor any other underwriter was called upon to honor its guarantee.  As a result, on the prescribed settlement day, Questar delivered all of the 1,725,000 shares sold in the offering directly to the purchasers or to their nominees. Wertheim never purchased any of the shares for itself nor took title to any of the shares.
Wertheim, therefore, was engaged to and did render services to Questar consisting of numerous tasks that required its professional expertise and judgment.  In consideration for these services, and as is typical in underwritten public offerings, Questar paid the underwriters the Underwriting Discount described above.  This fee was the only compensation the underwriters received in connection with the Questar offering. Further, the Questar syndicate underwriters shared the Underwriting Discount in a manner that reflected their activities in the offering, as described above. Under these arrangements, then, the income Wertheim realized from the Questar offering directly related to the nature of the services it provided. 
The compensatory nature of the Underwriting Discount is consistent with NASD and SEC rules, to which Wertheim was subject.  Under NASD rules, it was a violation for any underwriter 

to fail to make a bona fide public distribution at the public offering price of securities of a public offering which trade at a premium . . . . Therefore, it shall be a violation . . . for a member or a person associated with a member, to . . . [c]ontinue to hold any of the securities so acquired in any of the members accounts. 

Interpretation of the NASD Board of Governors on Free-Riding and Withholding.  Also, under SEC rules, Rule 10b-6, Wertheim, as the underwriter, was generally prohibited from purchasing stock for its own account.
	Further, the record establishes that Wertheim never in fact purchased and resold the Questar shares during the course of the offering.  Upon issue by Questar, title to the shares passed directly to the ultimate purchasers, as reflected in DTC's records.   Without ownership, Wertheim's income from the Questar offering cannot be a receipt from the sale of securities for purposes of Section 38(f).
	The Board finds and rules that the underwriting activities, relating to the Questar offering and undertaken by Wertheim, establish that Wertheim provided a professional service to Questar in assisting Questar with selling stock to the public in order to raise capital. Wertheim created a demand for Questar shares at a predetermined price, and effected the sale of those shares. The Board, therefore, finds and rules that the income Wertheim received from the underwriting activities was compensation income rather than gross receipts from the sale of securities within the meaning of § 38(f). 
	A person who claims to be aggrieved by the refusal of the Commissioner to abate a tax in whole or in part has the burden of establishing the right to an abatement.  Staples v. Commissioner of Corporation and Taxation, 205 Mass. 20, 26 (1940).  Based on the foregoing, the Board ruled that the Appellant Wertheim, for purposes of the apportionment formula of its corporate excises, met its burden of proving that the underwriting income received during the tax years at issue was properly includible in the denominator of its sales factor.

	Accordingly, the Board issued a decision for the Appellant and granted abatements of the additional corporate excises assessed by the Commissioner plus statutory additions.  

						 APPELLATE TAX BOARD

					By:			______		
					   Abigail A. Burns, Chairman




A true copy,



Attest:_____________________
        Clerk of the Board

 During the tax years at issue, Wertheim also earned income from the sale of securities that it purchased for its own account and held for investment apart from its underwriting activities. Wertheim separately recorded and accounted for such "trading income" apart from its "underwriting income."   The instant appeal concerns only Wertheim's underwriting income and not its trading income. 
 As an NASD member, Wertheim was subject to its Rules of Fair Practice, which included a limitation on the total underwriting compensation it could receive in connection with a securities offering.
 As in force during these years, SEC Rule 10b-6, as well as NASD Board rules, generally prohibited Wertheim from trading for its own account in the securities that it underwrote.
 Wertheim itself underwrote a total of 340,113 shares: 295,750 of the 1,500,000 shares plus its pro rata portion of the exercised "Green Shoe" option.  Pursuant to the Underwriters' Agreement, Wertheim had no obligation with respect to any of the shares whose sale was underwritten by the other underwriters.
 The "co-manager" of the offering, the firm with secondary responsibility in executing the transaction, was First Boston Corporation.  The other "participating underwriters" underwrote a much smaller number of shares than the book-running manager and co-manager.  
 The due diligence investigation was necessary to ensure that every statement of fact in the prospectus was accurate.  The due diligence investigation required interviews with Questar's officers, auditors, clients and customers.
 The "road show" presentation was designed to effectively introduce Questar to prospective investors.  Wertheim planned the itinerary for the road show and accompanied senior Questar officers as they traveled to each destination to make their presentations.
 As part of the book-building process, Wertheim was responsible for determining how the shares to be issued would be allocated among institutional investors and retail investors.  Because retail investors purchased their shares through brokers, the sales effort required to locate retail investors often required additional lead time of five to six working days.
 As is standard in the securities industry, all securities were cleared through the Depository Trust Company.
 	As set forth in the Agreement Among Underwriters, Wertheim and First Boston, as managing underwriters, collectively earned a management fee of 29 cents per share, or a total of $500,250, for managing the offering. As was standard in public offerings, this management fee was equal to 20% of the Underwriting Discount. 
      As provided in the Agreement Among Underwriters, and as specified in the Selling Agreement, underwriters participating in the offering earned a selling concession of 85 cents per share for the sale of shares directly to the public at the public offering price.  The selling concession received by each underwriter was based on the number of shares initially reserved for and subsequently sold for that underwriter's account, plus the number of shares subsequently designated as sold for that underwriter's account. These numbers, however, did not bear any relationship to the number of shares that the particular underwriter underwrote.  Wertheim earned selling concessions for 1,036,500 of the 1,725,000 shares.
      The remainder of the Underwriting Discount, amounting to 31 cents per share, was applied first to the payment of all of the expenses of the offering, approximately $414,245, with the excess allocated to the underwriters in proportion to the number of shares whose sale they underwrote. Wertheim's share was $105,435.03 for the 340,113 shares whose sale it underwrote, net of its $81,700 pro rata share of the expenses of the underwriting.	Wertheim, as book-running manger, and First Boston, as co-manger, by agreement, shared their total underwriting income, as described, sixty percent to Wertheim and forty percent to First Boston.
 At most, Wertheim had an obligation (i.e. in the case of a "market meltdown") to purchase 340,113 shares, or approximately 19.7 percent of the total number of shares.  Wertheim, however, was entitled to receive management fees with respect to 100 percent of the shares sold, and a selling concession for more than sixty percent of the shares sold.  Wertheim also had the right to receive sixty percent of the amounts otherwise allocable to First Boston in the underwriting and had correspondingly agreed to share forty percent of its own income with First Boston.   While one component of Wertheim's services, its underwriting guarantee, was tied to the specific number of shares guaranteed, Wertheim's income traceable to that component was minute. However, even this small amount represented compensation for services and not a receipt from the sale of a security.
 While Wertheim had agreed to purchase the Questar shares under certain circumstances, that agreement did  not convert the actual events into a purchase and sale of securities, particularly since those circumstances never took place.  The underwriting commitment made by Wertheim, then, was more in the nature of a guarantee. 

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