Gregory Germain (Syracuse) follows up on Thursday’s post on the proper tax treatment of Oracle CEO Larry Ellison’s payment of $100 million (over 5 years) to a charity of his choosing to settle insider trading charges involving his sale of $900 million of Oracle stock before the share price sank 50% when it announced it would fail to meet earnings expectations:

I’ve been thinking about how Larry Ellison’s $100 million settlement of the California securities fraud case should be treated for tax purposes. I think there are a number of separate things going on.

1. Ellison is making a constructive payment of $100 million to Oracle to settle the 10b-5 lawsuit – which is a claim for misappropriating or misusing Oracle’s confidential information in breach of his fiduciary duty to Oracle. The normal remedy for breach of fiduciary duty is disgorgement of profits. As Gregg Polsky, I think correctly, pointed out, if he received LTCG treatment on the income from selling the stock, then under the Arrowsmith case he should have LTCL treatment when he disgorges some or all of the income. So, presumably, Ellison would be entitled to a $100 million LTCL.
2. Oracle constructively receives $100 million on its claim, and therefore has $100 million of ordinary income. It had no basis in the misappropriated confidential information. If the money is received as a windfall instead of for damages for use of its confidential information, it would be windfall income. Either way, I think it’s ordinary income to Oracle.
3. Oracle is then constructively paying $100 million to Ellison’s favorite charity. This should be a constructive payment of $100 million of compensation to Ellison under North American Trust and cases like BofA v. Giannini. Unlike Giannini (at least according to the Ninth Circuit’s opinion in the case), Ellison has complete control over who gets the charitable contribution. Oracle therefore should get a $100 million compensation deduction.
4. Ellison has $100 million of compensation income from Oracle under 3.
5. Ellison should qualify for a charitable deduction when he gives the $100 million to his favorite charity (subject to all applicable rules on charitable deductions). It’s only by mixing the two transactions (the settlement and the charitable contribution) that a question arises concerning the qualification of the charitable contribution.
6. Oracle’s $100 million income and $100 million compensation will set each other off. What’s left is (1) Ellison’s $100 million LTCL, (2) Ellison’s $100 million of compensation income, and (3) Ellison’s $100 million charitable deduction.

I still suspect that Ellison will argue, essentially, that the settlement agreement is a sham – he was planning to make a $100 million charitable contribution before entering into the settlement, the case had no merit and was settled for nuisance value (paying the plaintiffs’ lawyers’ fees), and that the $100 million charitable contribution was mere window dressing to help justify a settlement that only really rewarded the plaintiffs’ attorneys. Factually, Ellison may have a pretty good case. The Delaware courts ruled that the identical claims against him were so weak that they would not survive summary judgment. The Court stated:

[N]o rational trier of fact could find that: 1) Ellison or Henley possessed material, nonpublic financial information as of the time of their trades; or 2) Ellison or Henley acted with scienter, by consummating trades in part because they believed, on the basis of the nonpublic information they had received, that Oracle would materially fall short of the Market Estimates.

He sold his stock January, and the quarter did not end until February 28. Ellison and the other defendants in the Delaware case argued that quarterly results are not known until the end of the quarter, when a substantial amount of the sales are made. While it is certainly possible for someone like Ellison to know before the quarter ends that the predictions for the quarter are unlikely to come through (he could, for example, have received information from large customers that they were not going to order planned software), the Delaware court considering the same claim granted summary judgment because the plaintiffs were able to produce no credible evidence to support a claim against him. Maybe the California lawyers had more evidence, and maybe the Delaware court closed its eyes to evidence, but it does not seem like a very strong claim. However, even if Ellison could prove that the $100 million charitable contribution was mere window dressing for the settlement, I don’t think he should be able to avoid the terms of his own settlement agreement. The government can claim that the settlement was a sham, but he should be estopped from doing so since he was a party to it.

I think we’re making a mistake by focusing on the bona fides of his intent regarding the charitable contribution. Instead the charitable contribution and the settlement should be treated as to separate transactions.