The Perils of the “Power of Substitution” Reviewed by Momizat on . For “Intentionally Defective” Grantor Trusts (Part II of II) In this second and final part of this article, the author provides illustrations that showcase pitf For “Intentionally Defective” Grantor Trusts (Part II of II) In this second and final part of this article, the author provides illustrations that showcase pitf Rating: 0
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The Perils of the “Power of Substitution”

For “Intentionally Defective” Grantor Trusts (Part II of II)

In this second and final part of this article, the author provides illustrations that showcase pitfalls to avoid when the power of substitution is exercised. Read Part I here.

Sometimes these substitution transactions can be circuitous or involve nonmarketable assets.  The following are some examples of pitfalls to avoid—or factors to consider—when the power of substitution is exercised.

The Texas Four-Step

In the following example, a grantor trust is initially funded with assets in exchange for a promissory note (Note #1) of equivalent value owed by the trust to the grantor. Subsequently, the grantor exercises its power of substitution to remove an asset in exchange for a promissory note owed by the grantor to the trust (Note #2), which the grantor pays down with cash two weeks later.

The trust then uses that cash to pay down the original note—Note #1—that it owed to the grantor when the trust was seeded.

Effectively, the result is that the asset is removed from the trust in exchange for the forgiveness of the debt owed since seeding.  Technically, was Note #1 or Note #2 the substituted property and was it equivalent value?  Or was the cash exchanged technically the substituted property, even though it was remitted two weeks later to pay down Note #2?

Step One—The Seeding

These assets—consisting of marketable securities, real estate investment properties, ownership interests in privately held operating and holding companies, and limited partnership interests in hedge funds and leveraged buyout funds—are valued by an independent appraiser at a fair market value of $100 million.

The valuation considered appropriate discounts for lack of control and lack of marketability.

These assets were paid for by the trust in exchange for Note #1 with a principal amount of $100 million, bearing interest at the AFR.  This note was owed by the trust to the grantor and was secured not by all of its assets, but rather by one of its largest assets—a 40 percent ownership interest in a holding company called XYZ Holdings, LLC, that contained various private equity investments.

Step Two—The Substitution with a Promissory Note

Several years later, on December 31, 2017, the grantor executes its power of substitution to swap an asset held by the trust (not the 40 percent membership interest in XYZ Holdings, LLC).  The asset fair market value was determined by an independent valuation analyst to be $150 million.

The asset was exchanged for Note #2 with a face value of $150 million and with interest at the AFR.  The valuation analyst was not asked to estimate the fair market value of Note #2.

The recorded value of the trust’s total assets did not change because an asset worth $150 million (assuming its recorded value was $150 million on December 31, 2017) was swapped for another asset of equivalent value—the promissory note owed by the grantor.

Step Three—Obligor Pays Down Promissory Note Owed to the Trust

The grantor initially paid for the $150 million asset with a promissory note.  This payment form was because the grantor did not have sufficient cash on the date of the transaction.

However, after two weeks, the grantor freed up $150 million in cash, which was remitted to the trustees of the trust to extinguish Note #2—$150 million promissory note.

Step Four—Trust Then Pays Down Promissory Note Owed to the Grantor

The trustees then use $100 million of the $150 million cash received to pay down Note #1, the principal of which was $100 million owed to the grantor.

Which Was the Substituted Property—Note #1, Note #2, or $150 Million in Cash?

The ultimate result of this series of transactions was that the trust had one asset worth $150 million removed and replaced with $50 million in cash as an asset, and $100 million fewer liabilities because Note #1 was paid down.

The trust first received Note #2, which was paid down two weeks later with $150 million in cash.  The trust was left with $50 million in cash after paying down Note #1 owed to the grantor.

A clue to solving the question as to which note (or cash) was the property substituted for the $150 million asset was that the trust also held other liabilities owed to third-party creditors.

However, the trust elected to pay down Note #1 owed to the grantor, a related party, rather than pay any other creditors.  It appears that the grantor desired to have Note #1 (owed to them by the trust) paid down as the upshot of these transactions.

The net effect of these transactions was that the power of substitution resulted in the grantor receiving an asset worth $150 million in exchange for extinguishment of Note #1 plus $50 million in cash to the trust.

It is evident that the substituted property was Note #1, much as it is evident through generally accepted accounting principles that the values of both sides of a transaction are equal to each other.  Therefore, a case could be made that the paydown of Note #1 plus the residual $50 million in cash were the substituted property.

If one were to contend that the actual cash of $150 million was the substituted property, one would have to somehow debunk the fact that when the transaction was effected, the consideration was Note #2, despite how long it took for the obligor to pay down that note.

Further, Note #2 bore interest at the AFR, well below what a typical market rate of interest would have been.  Therefore, Note #2, even if completely secured, would have had a fair market value below its principal amount and would not have met the standards of being an asset of equivalent value to the $150 million asset.

As for the contention that Note #1 plus $50 million of cash was the substituted property, were they of equivalent value, worth $150 million?  Exhibits 1 through 5 present the calculations for estimating the fair market value of Note #1.

Applying an Appropriate Market-Based Interest Rate to Note #1

Note #1 had a principal amount outstanding on the date of the substitution of $100 million and was secured by one of its largest assets—a 40 percent membership interest in XYZ Holdings, LLC.

After analyzing the assets held by XYZ Holdings, LLC, and estimating the fair market value of the 40 percent noncontrolling, nonmarketable membership interest, it is determined that the security interest is less than the $100 million principal amount of Note #1.  Therefore, it is partly secured.

Exhibit 1 presents the appropriate risk-adjusted yields for two scenarios:

  1. If the note were completely secured (Scenario 1)
  2. If it were completely unsecured (Scenario 2)

Exhibit 1

Fair Market Value of $100 Million Promissory Note

Market Yield Analysis

As of December 31, 2017

Upon analysis of XYZ Holdings, LLC, the valuation analyst determines that for Scenario 1, an appropriate S&P rating is BBB+/-, or 4.72 percent.  This is in line with the median yield for asset-based loans, which was 4.68 percent.

For Scenario 2, based on the time to maturity of Note #1, it is determined that an appropriate S&P rating is BB+/-, whose yield for a seven-year maturity date was 6.43 percent.

For each scenario, an additional 0.5 percent was added to reflect additional risk factors for XYZ Holdings, LLC, relative to the guideline company obligors.  This resulted in a risk-adjusted yield for Scenario 1 and Scenario 2 of 5.22 percent and 6.93 percent, respectively.

Fair Market Value of $100 Million Promissory Note—Scenario 1

As presented on Exhibit 2, the note had a principal amount of $100 million and bore interest at a rate of 3.5 percent.  Under Scenario 1, the note is assumed to be completely secured by the 40 percent membership interest in XYZ Holdings, LLC.

Exhibit 2

$100 Million Promissory Note Substituted for Asset with Fair Market Value of $100 Million

Scenario 1—Note Fully Collateralized and Perfected

Fair Market Value of Promissory Note

As of December 31, 2017

In other words, the fair market value of this ownership interest was equal to $100 million, and the security interest was not only attached, but also perfected.  However, the market-based interest rate for Scenario 1 was 5.22 percent.

This resulted in a fair market value of Note #1 under Scenario 1 of $90.1 million, or 9.9 percent less than its face value.

Fair Market Value of $100 Million Promissory Note—Scenario 2

As presented on Exhibit 3, under Scenario 2, the note is assumed to be completely unsecured.  Although it bore interest at a rate of 3.5 percent, the market-based interest rate for Scenario 2 was 6.93 percent.

Exhibit 3

$100 Million Promissory Note Substituted for Asset with Fair Market Value of $100 Million

Scenario 2—Unsecured Note

Fair Market Value of Promissory Note

As of December 31, 2017

This resulted in a fair market value of Note #1 under Scenario 2 of $81.5 million, or 18.5 percent less than its face value.

Fair Market Value of Security Interest

As presented on Exhibit 4, the security interest consisting of the 40 percent membership interest in XYZ Holdings, LLC, was meaningfully less than the $100 million principal balance of Note #1.

Exhibit 4

$100 Million Promissory Note Substituted for Asset with Fair Market Value of $100 Million

Fair Market Value of Security Interest Attached to Promissory Note

Security Interest: A 40 Percent Membership Interest in XYZ Holdings, LLC

Asset-Based Approach—Adjusted Net Asset Value Method

As of December 31, 2017

The first step was to ascertain whether the recorded values of the assets held by XYZ Holdings, LLC, were at fair market value and were appropriately discounted for lack of control and lack of marketability.  In this example, let’s assume that they were not.  Furthermore, there is an entity level discount due to the ownership interest being a 40 percent membership interest.

As presented on Exhibit 4, appropriate discounts for lack of control and lack of marketability are applied to each class of assets in succession.  This assumes the entity level discount is included in each discount.

The sum of the discounted asset values is then compared to the undiscounted total value to arrive at a combined discount for lack of control and lack of marketability equal to 26 percent.

After subtracting this discount ($77.2 million) from the indicated value of total assets ($300 million), subtracting total liabilities ($50 million), and multiplying by the membership interest (40 percent), we arrive at a fair market value of the 40 percent membership interest equal to $69 million.

Because Note #1 had an outstanding principal balance of $100 million, it was only partly secured.  It may have seemed, initially, that Note #1 was entirely secured because, as presented on Exhibit 5, the indicated value of total assets, less liabilities, multiplied by 40 percent was equal to $100 million.  However, that figure is not based on fair market value.

The next step was to reconcile the fact that Note #1 was somewhat secured, but not entirely.

Concluded Fair Market Value of Note #1—Weighted Average of Scenario 1 and Scenario 2

As presented on Exhibit 5, the fair market value of Note #1 was based on a weighted average of the fair market values under Scenario 1 and Scenario 2.

Exhibit 5

$100 Million Promissory Note Substituted for Asset with Fair Market Value of $100 Million

Fair Market Value of Promissory Note

As of December 31, 2017

To arrive at the percentage weights, the fair market value of the security interest, or $69 million, was subtracted from the principal outstanding, or $100 million.  The unsecured amount of the principal was, therefore, $31 million, or 31 percent of the outstanding principal.

The next step was to multiply the fair market value of Note #1 by each of the two weights—a 69 percent weight to Scenario 1 as if it were fully secured and a 31 percent weight to Scenario 2 as if it were entirely unsecured.

Adding these two values resulted in a fair market value of Note #1 equal to $87.4 million, or 12.6 percent less than face value.

The substituted property had been determined to have a fair market value of $125 million, and the upshot of the transactions was that Note #1 was extinguished and the trust was left with $25 million in cash remaining ($125 million less an eliminated liability of $100 million plus $25 million in cash).

Therefore, the actual consideration for the substituted property, based on the fair market value standard of value, was not $125 million, but rather $87.4 million plus $25 million, or $112.4 million.  Accordingly, the consideration for the substituted property was deficient by the amount of $12.6 million.

Conclusion

In Condiotti, the finder of fact considered the intent of the grantor when the trust was established.  Therefore, heavy emphasis was placed on the language of the trust instrument—which forbade the grantor from obtaining any loan from the trust corpus.

Similarly, in the “Texas Four-Step” example presented above, if “intent” is the operative word for determining which note (or cash) was the substituted property, the intent appeared to be the ultimate paydown of Note #1 by way of first Note #2 and then cash to retire Note #2, which was used to retire Note #1.

When a transaction is based on the fair market value standard of value and involves a promissory note; the promissory note at fair market value may not necessarily be worth its face value even on the date of the transaction.

This phenomenon also occurs when a bond that trades publicly may be worth less than its face value, if current, market-based interest rates paid by companies of similar levels of risk are higher than the stated interest rate of the bond.  This conclusion is relevant to estate planning whereby promissory notes often bear interest rates at the AFR.

This article was previously published in Willamette Insights, Spring 2018 Issue.

Samuel S. Nicholls is a manager at Willamette Management’s Atlanta practice office.

Mr. Nicholls can be reached at (404) 475-2311 or by e-mail to ssnicholls@willamette.com.

The National Association of Certified Valuators and Analysts (NACVA) supports the users of business and intangible asset valuation services and financial forensic services, including damages determinations of all kinds and fraud detection and prevention, by training and certifying financial professionals in these disciplines.

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