The transfer pricing arrangements of defunct telecommunications giant Nortel Networks may dictate how the proceeds from the multinational’s liquidation are divided, according to documents filed in the U.S. Bankruptcy Court for the District of Delaware (In re Nortel Networks Inc.).
In a proceeding being tried simultaneously in Delaware and Canada, Nortel Networks Inc. (NNI), its Canadian parent and its European affiliates are battling each other and some 56,000 pensioners in the United Kingdom and Canada over the division of $7.3 billion in proceeds from the multinational’s liquidation. Of those funds, $2.9 billion was generated by the sale of individual lines of business, while $4.5 billion resulted from the sale of some 7,000 patents to a consortium of high-technology giants that included Microsoft Corp., Apple Inc. and Sony Corp.
On June 24, the U.S. Bankruptcy Court in Wilmington, Del., and the Ontario Superior Court of Justice in Toronto concluded six weeks of testimony from various parties who advanced radically different notions of how those funds should be allocated.
While the three debtor groups involved appear to agree that the allocation should be based on the value of the property transferred or surrendered by the debtors, they are deeply divided about the basis for the valuation.
The most extreme position, taken by the Canadian debtors, is that the bulk of the estate—including the entire patent portfolio—should be allocated to Canada because Nortel Networks Ltd. (NNL), the operating parent, held legal title to the property before the asset sale. The Canadian debtors argue that the appropriate allocation of assets would be 82.2 percent to Canada, 13.7 percent to the United States, and 4.1 percent to the European debtors.
‘One of the Greatest Heists of Value’
Such an allocation scheme would put NNL’s creditors at a significant advantage over the creditors of other debtor estates, including 36,000 pensioners in the U.K., and it is bitterly opposed by the other parties. According to the Ad Hoc Group of Bondholders, in a brief filed May 12, “the Canadian Debtors’ position, if adopted, would represent one of the greatest heists of value in history” and is a theory “concocted solely for this litigation.”
The appropriate allocation, the bondholder group says, is the one proposed by the U.S. interests, which is based on the fair market value of the affiliates’ licenses to the intellectual property.
The U.S. interests group represents NNI and related affiliates, along with the Official Committee of Unsecured Creditors. It argues that its valuation approach is consistent with the terms of the master R&D agreement (MRDA) that granted various Nortel subsidiaries exclusive licenses to exploit the company’s intellectual property within their territories.
According to the U.S. interests, nearly 74.3 percent of the patent portfolio and 70 percent of the business lines proceeds should be allocated to the U.S., while 9.7 percent of the patent portfolio and 11.9 percent of the business lines proceeds should go to Canada. The remainder of the portfolios—16 percent and 18 percent, respectively—should be allocated to the European debtors.
Positions of the Estates
The positions of the other debtor estates and creditor groups are laid out in court filings. Among them:
- Two economic reports indicate that while operating subsidiaries in Europe, the Middle East and Asia (the EMEA debtors) agree that allocation should be based on the transfer pricing arrangement, the allocation should reflect the “R&D spend”—the amount each entity invested in developing the IP under the terms of the MRDA. Thus, under this approach, 31.9 percent of the assets would be allocated to Canada, 49.9 percent to the U.S., and 18.2 percent to the EMEA debtors, based on the ratios of funds invested by the debtors between 1991 and 2006.
- An report by economist Paul Huffard on behalf of the EMEA debtors said an alternative allocation approach would look at fair market value of the licenses. One calculation under this scenario would grant EMEA debtors 30.9 percent of the assets, while the U.S. would receive 57.7 percent and Canada, 11.5 percent.
- Attorneys representing some 36,000 members of Nortel’s U.K. pension plan argue that allocation should be skipped altogether. Rather, the funds should be distributed to unsecured creditors on a pro rata basis—an approach that would grant each creditor some 71 cents on the dollar.
- The Canadian creditors committee, representing 20,000 pensioners, pension interests, and current and former employees, favors the allocation scheme of the Canadian debtors, but notes that, in the alternative, a pro rata approach would be fair.
Inappropriate Transfer Pricing
In their pre-trial brief filed May 11, U.K. pension claimants—the U.K. Pension Trust Ltd. and the Board of the U.K.'s Pension Protection Fund—said they face a $3 billion shortfall in Nortel Networks U.K.'s (NNUK’s) pension plan. They are bringing a claim against the entire group—not just NNUK—because they maintain that Nortel’s transfer pricing was designed to shift funds away from the U.K. subsidiary to its Canadian parent, to the ultimate detriment of the pensioners.
According to an expert report by Steven Felgran, economist for the U.K. pension claimants, NNUK should have received transfer pricing adjustments of $2.1 billion between 2001 and 2008, while Canada was due $4.2 billion and the U.S. should have paid out $6.3 billion. NNUK did not receive any payments between 2003 and 2007, resulting in what were effectively interest-free loans from NNUK to NNL, Felgran said.
He noted that the Internal Revenue Service and the Canadian tax authorities reached a settlement in July 2010 over Nortel’s 2001-05 advance pricing agreement application, leading to a $2 billion adjustment to NNL’s taxable income. The IRS and the Canada Revenue Agency are no longer party to the bankruptcy proceedings.
However, Felgran stressed, “that settlement between the taxing authorities does not mean that the reallocation of taxable income between NNI and NNL achieved arm’s-length results.”
Further, he noted, Nortel’s restructuring costs should have been shared across the group. Instead, the transfer pricing of those costs prejudiced NNUK in the amount of $500 million to $600 million between 2001 and 2008, substantially to the benefit of the Canadian parent.
Since the bankruptcy petition was filed in 2009, the U.K. pension claimants noted, legal wrangling has run up $1.3 billion in fees. That sum will come out of the bankruptcy proceeds, reducing funds available to pay claims. However, they noted that the U.K. pension claimants are the only party whose legal expenses will not be paid out of the bankruptcy proceedings; the pensioners are bearing their costs directly.
A ruling in favor of the U.K. claimants would establish a more equitable procedure for international insolvencies going forward, they argue.
“The Courts have an opportunity to set a precedent that will avoid the moral hazard that has plagued the Nortel proceedings for more than five years and has cost $1.3 billion in professional fees to date from occurring again in the future,” the U.K. pension claimants said.
“Territorial wrangling significantly diminishes value for stakeholders in a global insolvency involving a highly integrated multinational enterprise whose assets are entangled, and ought not to be condoned or rewarded.”
Pensioners Face High Bar
The U.K. claimants’ position reflects, in part, the obstacles faced by pensioners in any corporate bankruptcy. As unsecured creditors, pensioners do not enjoy a favored position under U.S. law, according to Robert Fishman, a business bankruptcy attorney with Shaw Fishman Glantz & Towbin LLC in Chicago.
While it makes sense that the pension groups would favor a pro rata distribution of assets—as such an approach would give them a better chance of a significant recovery—they will have a hard time making a case for it, Fishman said.
The first stage of any bankruptcy involving multiple entities, Fishman said, is to allocate the remaining assets among the debtors.
“Who the creditors are and what their claims are is irrelevant to that consideration,” he said. “You first figure out whose value is being transferred and then you figure out who gets the money.”
The various debtor estates are responsible only to their own creditors, he noted, and they have a fiduciary duty to try to maximize value for those creditors.
In bankruptcy proceedings where one group of creditors seeks a substantive consolidation of assets, the court must determine that doing so will not disadvantage other creditors, he said.
The U.K. pension claimants maintain that their proposal is not a substantive consolidation—the cases would not be combined into a single action, and the proposal would affect only the funds held in escrow, not the assets that are still vested within the individual bankruptcy estates.
Nevertheless, it is certain that North American creditors stand to benefit significantly better under the U.S. or Canadian allocation schemes and that they would lose ground under a pro rata distribution.
In that respect, Nortel’s bankruptcy is wrestling with a question that is fundamental to many bankruptcies, Fishman noted.
“Any time you have somebody buying a collection of assets in which multiple creditors have competing interests, you have price allocation disputes,” he said
The operative question in Nortel is how to value an asset owned by one member of a multinational group and used by many others, he said.
“Does the value go to the parties that own it or to the party that created the value by being able to use the asset to generate sales?” Fishman asked.
That is essentially the divide between the Canadian parent and its subsidiaries.
In its heyday, Nortel Networks was the a global supplier of telecommunications and computer networking products, providing “end-to-end solutions,” including design, engineering and marketing, sales, installation and support. In 2008, it employed some 30,000 people worldwide and was organized into a number of different legal entities.
The company adopted the MRDA in 2001 to replace cost sharing arrangements. The MRDA provided that five residual profit entities (RPEs) shared all the risks of the group, including the development of IP, and split the residual profits. The RPEs, which also performed significant sales and distribution functions, consisted of NNL, which was the direct or indirect parent of more than 100 Nortel subsidiaries; NNI, the lead U.S. debtor; NNUK, which controlled the majority of operations in the EMEA region; Nortel Networks SA, a French corporation; and NNIR, an Irish corporation.
Other entities, which handled the day-to-day relationships with customers within their territories, generally did not contribute to the creation of IP. However, some of these distribution entities were involved in IP development and are included among the three debtor groups with insolvency proceedings underway in Canada, the U.S. and the U.K.
The U.K. proceeding centralizes administration of the EMEA debtors, which consist of 19 subsidiaries operating in those regions. Five Canadian companies are involved in the Canadian bankruptcy, and 18 U.S. companies are involved in the U.S. bankruptcy.
The insolvency proceedings began Jan. 14, 2009, when NNI and affiliates filed for Chapter 11 reorganization in the U.S. bankruptcy court. The petitioners soon determined, however, that the group could not be restructured and that liquidation would be necessary.
In order to bring about the sale of assets, the RPEs entered into an interim funding and settlement agreement (IFSA), which required them to relinquish their rights in eight lines of business and in a residual patent portfolio. The primary assets of the business lines was intellectual property; the residual patent portfolio consisted of patents that either were not being used or were being used in more than one product and, thus, could not have been sold to any individual buyer of the business lines.
Under the terms of the IFSA, any funds generated by the sale of assets would be held in escrow until the parties could arrive at a means of distributing them.
Five years later—following the failure of three court-ordered mediations—the parties are in court to argue for various theories of distribution. Each theory has the backing of economic experts who have filed multiple reports laying out in detail their rationales for allocation.
Canadian Monitor’s Position
In a pre-trial brief filed May 12, EY, as court-appointed monitor of the Canadian estate, argued that allocation should be based on the value of the property rights transferred or surrendered by each debtor in connection with the sales of assets. That value turns on legal ownership, according to EY.
“It was ownership of IP that was transferred to the purchasers in the various sale transactions and, accordingly, it was ownership for which the purchasers paid,” EY said, stressing that the license rights of the U.S. and EMEA debtors were not transferred to the purchasers in any of the sales.
Those license rights were set forth in the MRDA, which provides that legal title in the IP is vested in NNL. Under Ontario law, a license grants no property interest, but is a contractual consent to grant rights for a limited term, EY said.
In this case, the licenses granted the subsidiaries the use of IP in connection with the manufacture of Nortel products, EY said. Because there was no value attributable to the license rights “over and above the value that has already been ascribed to them in the context of the business sales,” any residual value should be assigned exclusively to NNI.
Denunciations From Other Debtors
This argument met with vitriolic denunciations from the U.S. interests, which argued that the exclusive rights to exploit Nortel’s IP, as set forth in the MRDA, meant that NNI owned all of the valuable rights to Nortel’s IP in the United States.
“The MRDA describes these rights as ‘equitable and beneficial ownership,' ” the U.S. interests said. “Consistent with this, both NNL and NNI consistently represented to tax authorities that the [RPEs] owned Nortel’s intellectual property in their respective territories.”
The licenses were not dependent on the products Nortel was making or selling, and the exclusive territorial rights of the RPEs did not come to an end until they surrendered those rights in order to facilitate the sale of the patent portfolio, the U.S. interests said.
Richard Cooper, an economist for the EMEA debtors, took issue with EY’s theory in an expert report filed Jan. 24. Cooper noted that the theory is inconsistent with established transfer pricing and arm’s-length principles. It also conflicts with the provisions of the MRDA and with prior representations made to tax authorities in the U.K., the U.S. and Canada, he said.
The mere holding of legal title cannot be equated with entitlement to all economic benefits, Cooper said.
“Transfer pricing principles examine the economic substance of relationships among entities in a corporate group in order to determine their respective rights and confirm that relations are conducted on an arm’s length basis,” he said.
If the Canadian debtors’ allocation position were upheld, he added, it would result in a “huge windfall” far beyond what those companies had contributed toward the creation of the IP or could have reasonably expected to receive based on pre-insolvency agreements.
“This would result in a transfer of wealth from the other [RPEs] to NNL without payment by NNL,” he said.
Residual Profit Split
Cooper also noted that Nortel adopted a residual profit split method for its transfer pricing in 2001, after many years of relying on cost sharing arrangements for its intangibles. Two primary reasons for the switch were that the company recognized its IP had become a principal value driver and that the R&D that led to the development of the IP was “interrelated, shared, and performed jointly.”
Cooper added that the distinction between legal title and ultimate economic entitlement “is very important in the field of transfer pricing,” pointing to guidelines of the Organization for Economic Cooperation and Development, which provide that the “question of legal ownership is separate from the question of remuneration under the arm’s length principle.”
Cooper stressed that “arm’s length parties never would have agreed to the arrangement that the Canadian debtors now put forward. In order to properly claim the proceeds of all of the IP Sale Proceeds, NNL would had to have paid for all of the R&D that created that IP, not just its cost share from 1992 through 2000 and RSPM share from 2001 through 2008.”
The other affiliates contributed billions to the R&D, he said. If the Canadian debtors’ position were correct, then those affiliates would have given their investments away for nothing.
“Of course such a give-away cannot be reconciled with the arm’s length principle,” Cooper said.
Most Valuable Asset
The bondholder group’s brief affirms Cooper’s conclusions. While the asset sale was pending, the Canadian debtors never raised its theory that the license rights would be rendered worthless, the bondholder group said. Had it done so, the sale would never have gone through.
“Had the Canadian Debtors ever indicated that they were going to later argue that they were entitled to all the Patent Sale proceeds, the Bondholder Group and the other parties would have acted differently,” the brief said. “At a minimum, the other Nortel Debtors and the Bondholder Group would have sought a judicial determination on the scope of the exclusive IP licenses before agreeing to the asset sales. If that was not available, they would have continued to aggressively pursue alternatives to an asset sale.”
According to the U.S. interests, NNL’s most valuable asset, prior to insolvency, was not its intellectual property but its equity in its U.S. subsidiaries. In the five years preceding the bankruptcy, NNI accounted for more than 65 percent of Nortel’s revenue and more than 75 percent of its cash flow, the U.S. brief said.
“At bottom, NNI was the engine that drove the Nortel group, generating most of its revenue and cash flow, controlling the most valuable customer relationships, funding Nortel operations worldwide (including research and development), and guaranteeing most of Nortel’s public debt,” the U.S. brief said.
When Nortel filed for bankruptcy, “the ability of the Canadian Debtors to extract value out of NNI and transfer it up the corporate chain to NNL came to an end,” the U.S. brief said. “And, after insolvency, NNL’s equity in NNI lost its value because equity takes last [place]” in the priority of claimants.
With testimony concluded, the Canadian and U.S. courts will accept further written submissions and oral argument from the attorneys on the allocation issue through the summer.
The next phase of the trial is scheduled to begin July 7 in Ottawa Superior Court of Justice, which has scheduled 15 trial days to take testimony on the claims of the EMEA debtors’ and the U.K. pension claimants against the Canadian estate.
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