Hayes v. The Queen

Hayes v. The Queen
Court (s) Database
Tax Court of Canada Judgments
Date
2003-09-09
Neutral citation
2003 TCC 93
File numbers
96-2573(IT)G
Judges and Taxing Officers
Campbell J. Miller
Subjects
Income Tax Act
Decision Content
Docket: 96-2573(IT)G
BETWEEN:
PAT HAYES,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
______________________________________________________________________
Appeals heard on common evidence with the appeals of Philip Hayes (96-2737(IT)G), (99-2414(IT)G), Stephen Stephens (97-653(IT)G), (97-749(IT)G), Gordon Rezek
(98-806(IT)G) and Muriel Scott (98-2507(IT)G) on October 28, 29, 30, 31, and November 4, 5, 6, 7, 18, 19, 20, 21, 25, 26, 27, 2002, at Toronto, Ontario, by
The Honourable Justice Campbell J. Miller
Appearances:
Counsel for the Appellant:
Geoffrey B. Shaw and Stevan Novoselac
Counsel for the Respondent:
Henry Gluch, David Chodikoff
and James Rhodes
___________________________________________________________________
JUDGMENT
The appeals from assessments of tax made under the Income Tax Act for the 1992 and 1993 taxation years are allowed, and the assessments are referred back to the Minister of National Revenue for reconsideration and reassessment in accordance with the Schedules attached hereto.
The appeal from the assessment of tax made under the Act for the 1989 taxation year is dismissed as the application of the conclusions set out in the Reasons for Judgment herein would result in a greater tax liability than that assessed to the Appellant, as outlined on the Schedule attached hereto.
Page: 2
The Respondent is granted 75 per cent of the costs calculated in accordance with the Tariff.
Signed at Ottawa, Canada, this 9th day of September, 2003.
"Campbell J. Miller"
Miller J.
Last Assessment
Court Decision
152(7)
Patricia Hayes
Patricia
Patricia
1989
1989
Employment
20,165.14
20,165.14
Dividend Income:
Abitibi
Alcan
Gulf
Placer
Trilon
Westar
Comp Dividends:
Abitibi
Alcan
Gulf
Hees
Laidlaw
(0.12)
Placer
Trilon
Westcoast
Unknown
Total dividends
-
Gross up @ 1.25
-
Interest Income:
TD Bank
352.27
Mutual Life
State Farm
Merrill Lynch
879.33
Dominion Sec
Other Income
4,528.00
Business Income (Loss):
Consulting
Haylon Inc
Securities:
Westcoast
Alcan
Total Income
20,165.14
25,924.74
Last Assessment
Court Decision
152(7)
Patricia Hayes
Patricia
Patricia
1989
1989
Total Income
20,165.14
25,924.74
Carrying Charges:
Rental Fees:
Hees
Westcoast
Trilon
(600.00)
Dividends Paid:
Abitibi
Alcan
Gulf
Hees
Laidlaw
(0.12)
Placer
Trilon
Management Fee
Accounting Fee
(480.00)
Net Income
20,165.14
24,844.62
Non capital losses
Taxable Income
20,165.14
24,844.62
Non Refundable Tax Credits
Personal
(6,066.00)
(6,066.00)
Married
CPP
(366.77)
(366.77)
UI
(393.22)
(393.22)
(6,825.99)
(6,825.99)
x 17%
(1,160.42)
(1,160.42)
Last Assessment
Court
152(7)
Decision
Pat Hayes
Patricia
Patricia
1992
1992
Employment
17,405.00
17,405.00
Dividend Income:
Abitibi
Alcan
Gulf
Placer
Trilon
Comp Dividends:
Abitibi
Alcan
Gulf
Dofasco
Laidlaw
(0.16)
Placer
Trilon
Total dividends
Gross up @ 1.25
Interest Income:
TD Bank
1,869.41
2,078.54
Mutual Life
Can Life Ass
T452 Refund Ind
28.59
28.59
Ivaco - WG
Wood Gundy
Dominion Sec
Taxable Capital Gains (Allowable Capital Losses):
Abitibi
Gulf
Business Income (Loss):
Securities:
Walker
Abitibi
Total Income
19,303.00
19,512.13
Carrying Charges:
Rental Fees:
Trilon
(600.00)
Dofasco
Accounting Fee
Accounting Fee- Paid in 1992
(963.00)
Net Income
19,303.00
17,949.13
Non capital losses
Capital gains ded.
Taxable Income
19,303.00
17,949.13
Non Refundable Tax Credits
Last Assessment
Court
152(7)
Decision
Pat Hayes
Patricia
Patricia
1992
1992
Personal
(6,456.00)
(6,456.00)
Married
CPP
(340.76)
(340.76)
UI
(518.25)
(518.25)
(7,315.01)
(7,315.01)
x 17%
(1,243.55)
(1,243.55)
Last Assessment
Court Decision
152(7)
Patricia Hayes
Patricia
Patricia
1993
1993
Employment
20,662.00
20,662.00
Dividend Income:
Alcan
Placer
Trilon
Comp Dividends:
Alcan
Laidlaw
(0.16)
Placer
Trilon
Total dividends
-
Gross up @ 1.25
-
Interest Income:
TD Bank
1,360.00
1,486.29
Mutual Life
T Bill
First Marathon
Ivaco
Wood Gundy
Dominion Sec
Business Income (Loss):
Securities:
Unknown
Mark to Mkt 10(1)
FMV Adjustment
Total Income
22,022.00
22,148.29
Carrying Charges:
Interest Paid:
Horsham 20(14)
First Marathon
(172.16)
Merrill Lynch
Rental Fees:
Trilon
(600.00)
Dofasco
Net Income
22,022.00
21,376.13
Non capital losses
Taxable Income
22,022.00
21,376.13
Non Refundable Tax Credits
Last Assessment
Court Decision
152(7)
Patricia Hayes
Patricia
Patricia
1993
1993
Personal
(6,456.00)
(6,456.00)
CPP
(432.37)
(432.37)
UI
(619.86)
(619.86)
(7,508.23)
(7,508.23)
x 17%
(1,276.40)
(1,276.40)
Citation: 2003TCC93
Date: 20030909
Docket: 96-2573(IT)G, 96-2737(IT)G,
97-653(IT)G, 97-749(IT)G, 98-806(IT)G
98-2507(IT)G, 99-2414(IT)G
BETWEEN:
PAT HAYES, PHILIP HAYES, STEPHEN STEPHENS, GORDON REZEK, AND MURIEL SCOTT
Appellants,
and
HER MAJESTY THE QUEEN,
Respondent.
REASONS FOR JUDGMENT
Miller J.
[1] In the early-1980s to the mid-1990s, a number of people in southern Ontario became involved in a form of investment known as convertible hedging. A common fact in their involvement was that they received advice from Maguire & Associates, a business engaged in financial and tax consulting. The Appellants, who had varying degrees of understanding of this complex investment strategy, were led to believe the strategy was a win-win situation. They understood this meant they would win from the cash flow generated by the strategy and from an increase in the value of their investment, and also from tax refunds if they incurred losses. These cases are about the tax treatment to be afforded these convertible hedge strategies.
[2] At the outset, I should mention that the conundrum in applying tax principles to the financially innovative strategy of convertible hedging is that tax laws have not necessarily kept apace with the ingenuity of the financial community. It is therefore appropriate, when viewing the transactions through the tax looking glass, that the focus not be so finely adjusted as to preclude a broad, common sense, but equally innovative, approach to the application of our tax laws. A square peg does fit in a round hole if the round hole is big enough.
[3] While normally I prefer delineating the issues at the outset, in this case, I believe it would be beneficial to appreciate the nature of the transactions and the particular circumstances of each Appellant before more explicitly setting forth the issues. I intend, therefore, to organize this decision in the following manner. I will first set out the mechanics of a convertible hedge based primarily on the expert evidence of Professor Eric Kirzner and Mr. Richard Norman Croft, as well as on information gleaned from one of the Maguire consultants, Mr. Harry Johannes Sildva. This will clarify not just the concept of a hedge, but also the concepts of margin requirements and the mark to market approach to valuing a portfolio. I will go over a couple of actual hedging transactions. It is unnecessary to illustrate every hedge of every Appellant, though I did hear evidence of all of them. I will review each Appellant's situation relying primarily on their own evidence. The issues and my findings can then be presented in a manner which flows from this background and review.
[4] The nature of the issues has shifted somewhat over the many months and years these appeals have been in the system. This has resulted in consequential changes in the tax positions proposed by each side, from the positions taken at the time of the original assessments. I am satisfied that none of these changes have resulted in the Respondent attempting to increase any assessment. However, the changes have led to an Appellant proposing to bring a greater amount into income in a particular year than is proposed by the Respondent. In such a situation, the Appellant would be prepared to have that appeal dismissed.
Background on convertible hedging
[5] The Appellants presented two experts: Professor Kirzner, in the area of corporate and investment finance, and Mr. Croft, in the area of investment counselling and portfolio management, specifically as pertaining to convertible hedges. It is primarily from these experts that I intend to paint a general picture of the strategy developed by Mr. Maguire.
[6] The convertible hedge consists of two positions, a short position and a long position. The short position is the sale of common stock of a security with borrowed stock. While this is an awkward concept for the legally trained to get a grip on, it is an acceptable means in the financial marketplace for facilitating short sales. The brokerage house holds common stock for its clients in street name; such shares are not identified as being held by any particular customer. So, when an investor wishes to sell short, the broker uses that source of common stock held in street form to make a sale for its client. This is what is meant by the client "borrowing stock" to sell. The client has an obligation to cover that short position, or in other words, to return the stock at some point in the future. The advantage of this arrangement, in a convertible hedge, is that the investor can use the proceeds from that short sale to finance a long acquisition, and consequently to earn income, for example, on a dividend from a form of preferred share.
[7] This leads to the second aspect of the convertible hedge - the acquisition of the long position. This refers to the purchase by the investor of a security convertible into the same security sold short. If the convertible security is convertible into exactly the same number of shares sold short, this is considered a fully hedged position or a one-to-one position. This does not necessarily mean the convertible security is convertible on a one-to-one basis as the conversion rate may vary. For example, a short sale of 10,000 shares may be fully hedged by a purchase of 5,000 convertible preferred shares, convertible on a two-for-one basis.
[8] There are a number of types of convertible securities available in the convertible hedge strategy: convertible preferred shares, convertible debentures, warrants and rights. The key similarity is that they all have two elements attached to them: first, an option on the underlying security, and second, an ability to earn income. For example, on a convertible debenture, there is both the option to convert into common stock and an interest-producing feature. With a convertible preferred share, again an option to convert combined with the income-producing feature of the preferred dividend. With a warrant or right, the income-producing feature is the interest from a treasury bill acquired with the funds from the short sale of the underlying stock.
[9] The costs involved in a convertible hedge (or frictions, as Professor Kirzner called them) are the rental fee on the borrowed stock sold short, compensatory dividends on the borrowed stock (this refers to any dividends on the borrowed stock for which the short seller must compensate the lender) and commissions or fees. There are two avenues for producing income or gains on the convertible hedge: the first, a positive cash flow, being the difference between the income (interest or dividends) on the one hand, and the costs just described on the other; second, the increase in value of the convertible hedge itself arising from the market direction. In a downward market, that is the underlying stock is falling in value, the convertible hedge will gain. This is as a result of the underlying common stock falling faster than the convertible security, due to the characteristics of that convertible security. Neither of the experts referred to a tax refund from the potential deductibility of losses on the disposition of a short or long position as in any way forming part of the gain or income in a convertible hedge.
[10] The convertible hedge is commonly initiated through contingent orders. This means that the purchase of one security and sale of a separate security are contingent on both sides being executed at a limit price. The price is the difference between the value of the two securities. The securities cannot be identical to constitute a contingent order. The broker would accept contingent orders on a best efforts basis, so that if the broker is unable to put the entire position in place in one fell swoop, it is still acceptable to put something less in place as long as it still meets the price requirements. This is distinguishable from an all or nothing direction to a broker, where no part of a position can be put in place unless it all can be put in place; this would be a less likely approach. One reason a broker cannot fully complete a position is because the stock being sold short does not meet the up-tick rule. This rule, imposed by all exchanges, requires that if you are going to sell a stock short, the last sale price of the stock has to be higher than the next to last sale. In other words you can only sell short in an upward swing. If the broker cannot fill the position at once, then the position may be legged in; that is, put in place in portions over time. Mr. Croft went through an example involving Mr. Hayes legging in on his Trilon hedge.
[11] There was considerable testimony of risk in a convertible hedge. Clearly, neither the broker nor investor wants to be exposed, and indeed a convertible hedge strategy minimizes exposure in relation to the value of the underlying common stock. Although, as Mr. Croft indicated, the risk to the investor, though seemingly low, is not. This is because the entire amount of the actual outlay of a few thousand dollars, for a hedge position involving stock valued significantly higher, is at risk. For example, Mr. Rezek made a $3,000 payment for a short sale of Laidlaw common stock of approximately $613,000 and a long purchase of Laidlaw convertible preferred of approximately $616,000. His maximum amount at risk was his $3,000, his whole investment, ignoring for the time being the impact of a positive cash flow from the convertible hedge.
[12] Returning then to a convertible hedge that is legged in, this necessarily means that there will be times when the investor is in a naked position; that is, one side or other of the hedge is not fully covered. Professor Kirzner referred to this as a temporal risk. If any event occurred during that period that significantly impacted that stock, the result could be much greater than simply the outlay of the investor. Professor Kirzner indicated that time does not affect the degree of risk, as the unforeseen event can occur at any time. However, the exposure to the risk obviously is greater the longer a naked position is held. I was referred to no examples in the situations before me of any unforeseen event occurring, and indeed Professor Kirzner could only think of a couple of cases in the last forty or fifty years when there had been a short squeeze, one of the events which might expose an investor in a convertible hedge to risk.
[13] One cannot discuss risk in these investments without understanding the mechanics of margin requirements. Rules with respect to margin requirements are set by the Investment Dealers Association and stock exchanges, and are also subject to the review of the Securities Commission. Margin is akin to a secured loan. The broker allows the investor to borrow from the broker part of the cost of the investment to support a purchase. This is usually done by the broker providing a debit balance in the investor's account. The margin requirements ensure that the broker's capital is protected. Short positions are always margined. The general margin requirement in a short position is for the investor to have 150 per cent of the market value of the underlying stock sold short in the investor's account. So, for example, if an investor sells 1,000 Alcan shares short at $8 a share ($8,000 proceeds) he needs to supply an additional $4,000 cash to meet the 150 per cent margin requirement. If the share price drops to $5 a share, requiring margin of only $7,500, instead of the initial $12,000 requirement, the investor could withdraw $4,500 from the account. Normally the short positions are marked to market daily for purposes of ensuring compliance with these margin requirements. This simply means the brokers track the fair market value of the stock sold short on a daily basis.
[14] In the acquisition of a long position, the margin rules permit financing of 50 per cent, so again using the 1,000 Alcan shares at $8, the investor need only provide a cheque for $4,000. The investor has in his account stock valued at $8,000 plus a loan with the broker of $4,000 - the position is fully margined. Again, changes in the value of the stock would impact that margin requirement.
[15] When a short position and a long position are put together in a convertible hedge transaction, the combination takes on different characteristics vis-à-vis margin requirements. The margin requirements are much lower. If a short position is fully covered by the ownership of the underlying stock no additional margin is required. This is the same if the long position is held in another individual's account, if that other account has guaranteed the account of the investor who holds a short position. If an account is undermargined, the broker can make a margin call on the investor, looking to the investor to top up the account. Typically, this would not happen on a convertible hedge as the investor would always have put up the capital in the form of the convertible security to cover a worst case scenario.
[16] For the most part, this overview has concerned the convertible hedge where just one individual is involved. In many of the convertible hedges in these appeals, there is another party. That other party, a relative, has always provided a guarantee. In the event an investor disposes of one component of the convertible hedge, it is the guarantee that allows the broker to continue to not insist on the more stringent margin requirements just outlined. It is this facilitating of the margin requirement, combined with the broker permitting the client to use the proceeds on a short sale to acquire a convertible security that, according to Mr. Croft, makes the convertible hedge unique. Professor Kirzner referred to the other party (the 'Guarantors' or individually the "Guarantor' - Gloria Fahrngruber, Patricia Hayes, Terry Stephens and Patricia Scott) as holding naked positions; that is, not hedged positions, though he went on to acknowledge that if both parties were treated as a single entity the resulting position would be a convertible hedge. Further, Professor Kirzner confirmed Mr. Sildva's evidence that entering into transactions which result in the Guarantor stepping into the shoes of the investor on one side of the convertible hedge, were conducted to create a tax benefit. The tax benefit is the tax to be refunded on the deductibility of the loss created by the investor's disposition of one component of the convertible hedge.
[17] It is useful to go through the first example of the convertible hedge at this point, which is illustrated on Appendix "A" attached.
[18] This is a Laidlaw convertible hedge entered into by Gordon Rezek. In referring to the Appendix, the areas shaded in grey represent the resulting positions after transactions have taken place. On April 27, 1988, Mr. Rezek sold short 30,704 Laidlaw common shares and coincidently bought 10,100 Laidlaw preferred shares. On May 20, 1988, Mr. Rezek sold the 10,100 convertible preferred shares and Ms. Fahrngruber bought 10,100 Laidlaw convertible preferred shares. The result was that Mr. Rezek held a short position in Laidlaw commons and Ms. Fahrngruber held a long position in Laidlaw convertible preferreds, convertible into 37,709 commons. Viewing the components separately, Mr. Rezek's sale created a $138,431 loss in his account - the tax benefit Professor Kirzner alluded to. In August 1988, Ms. Fahrngruber then converted the convertible preferreds into 30,709 Laidlaw common shares (note that there was a five share discrepancy from what Mr. Rezek held, so Ms. Fahrngruber simply sold the five shares). This left Mr. Rezek and Ms. Fahrngruber in what was referred to as a common-common position. The experts agreed that taken together there was absolutely no economic benefit to this position. It was clear that a common-long/common-short position cannot be held in one account, as they would simply cancel each other out.
[19] Before getting into the evidence from each of the Appellants, it is useful to review the evidence from both a Maguire associate, Harry Sildva, and a broker who handled convertible hedges for Mr. Maguire, Peter W. McCrodon.
Evidence of Harry Sildva
[20] Mr. Harry Sildva's evidence was common to all appeals before me. He worked in Mr. Maguire's office from January 1986 to December 1989 and was able to provide details of how these convertible hedges were handled by Maguire & Associates. Mr. Sildva has an MBA from the University of Toronto as well as having completed a variety of specialized courses in public finance, public accounting, options and securities. At Maguire & Associates, he had advised clients on hedge opportunities and was instrumental in creating the form of reports provided by the Maguire office. It was Mr. Sildva who generated the cash flow projections for the various hedges recommended by Mr. Maguire. He described Mr. Maguire as providing the tax consulting side of hedges. Mr. Sildva handled the administrative side of the hedges as well as later becoming adept in finding opportunities, relying very much on his computer skills. In 1989, he went to Richardson Greenshields as a broker, taking some clients with him. In 1992, he joined First Marathon as a broker and continued to handle hedged positions as well as investment advice generally.
[21] Mr. Sildva's understanding of the convertible hedge strategy conforms to the explanation provided by the experts described earlier, although Mr. Sildva emphasized the advantages of the tax-cushioning effect on a loss on a short position. He viewed his clients as wanting to be aggressively involved in the market and wanting to reduce tax. On cross-examination, Mr. Sildva acknowledged that the strategy itself was not aggressive, but the crystallizing of the loss on the losing side was. Any further investment objectives he left for the brokers to discuss with the clients.
[22] Mr. Sildva recalled meeting with Mr. Rezek and discussing tax preparation, tax strategies and the convertible hedge market. He indicated he would have referred Mr. Rezek to a broker to open a hedge account. He acknowledged the use of the term "win/win" by which he meant making money in a downward market and having a positive cash flow with a tax cushion in an upward market.
[23] In going over Mr. Rezek's Laidlaw convertible hedge, Mr. Sildva acknowledged that he recommended to Mr. Rezek entering into cross-guarantees with Gloria Fahrngruber as it would allow him to crystallize a loss on one side of his hedge, which Mr. Sildva believed to be deductible on Mr. Rezek's tax return. As Mr. Sildva indicated, they were doing December year end tax planning early. He referred to this as an adventure in the nature of trade loss. Mr. Sildva acknowledged that the ability to get $138,000 tax deductible loss on just a few thousand dollars investment was one of the reasons he got into this industry.
[24] Mr. Sildva met with Gloria Fahrngruber and discussed the convertible hedging strategy and guarantees with her, indicating how the guarantees would enable the use of margin in each account to cover transactions in the other account. He also introduced her to a broker. In involving Gloria through her acquisition of a long position in Laidlaw and the provision of a guarantee, Mr. Sildva explained this left Mr. Rezek exposed on the short position; that is, speculating on the downside. Mr. Sildva suggested that Gloria, on the other hand, was speculating on the upside, without having to invest any money, because of the margin excess in Mr. Rezek's account. As Mr. Sildva stated:
... we have Client A and Client B. One of them will do well in a scenario. The other will do well in another scenario, and there can only be one of two scenarios that will unfold, if you were to look at a strict analysis of it.
So I would always have one happy customer.
[Transcript page 1278 lines 7-13]
[25] Mr. Sildva confirmed that Gloria was concerned about being taxed on dividends she could not access. He eventually took steps to close Gloria Fahrngruber's activity in the market as he sensed there might have been a change of heart. She only was involved in the one transaction - the Laidlaw convertible hedge.
[26] Although Ms. Fahrngruber did not enter any investments herself, in Mr. Rezek's other two hedges, Royal Bank and Westcoast, Mr. Sildva suggested that Ms. Fahrngruber's account may have been relied upon when Mr. Rezek's was undermarginalized.
[27] Mr. Sildva prepared Mr. Rezek's tax returns for 1988 and 1989. In the statement of business income and expenses in each year, Mr. Sildva indicated that the type of business was "speculation", claiming Mr. Rezek was engaged in an adventure in the nature of trade. In 1992, he recorded Mr. Rezek's gain on the disposition of part of his Laidlaw short position as a capital gain. Mr. Rezek's holdings were not shown in his tax returns as inventory. A copy of a subsection 39(4) election signed by Mr. Rezek for 1992 dated April 1993 was produced as an exhibit.
[28] Mr. Sildva's contact with Mr. Hayes was not while he was at Maguire's, but while he was a broker in 1993 with First Marathon. He handled transactions involving the Ivaco and Dofasco convertible hedge, though confirmed he only spoke to Mr. Hayes and never with Mrs. Hayes.
[29] He also confirmed that he prepared the synopses of convertible hedges which Maguire & Associates sent to its clients. A synopsis would provide the following information:
- description of short position with price;
- description of long position with price;
- conversion ratio;
- hedge fee;
- commission;
- treasury bill yield if applicable ;
- spread; and
- multi-month cash flow projection.
For example, on the Laidlaw hedge, Mr. Sildva's projections indicated that for an investment of $8,349 to acquire the Laidlaw short and long position, the investment would yield a cash flow return over eight months of $6,190, or approximately a 75 per cent return on investment. These synopses were normally sent to the investor along with a cover letter from Maguire & Associates which read as follows:[1]
The attached synopsis summarizes your recently transacted trade in the Laidlaw Transport B convertible hedge, and forecasts the cash flow to be generated by the trade on the assumption that the position is maintained and the income and expense parameters do not substantially vary. We will, of course, be looking for profitable opportunities to unwind this position as soon as conditions are favourable to doing so.
I trust you find this of some value and the annexed tax-deductible invoice #20858 to your satisfaction.
There was evidence that all Appellants, except Mrs. Hayes, received such letters from Maguire & Associates.
[30] Mr. Sildva also emphasized that the conversion feature was critical:
A. The convertibility feature is everything in this case.
Q. Is critical?
A. Yes, because that affects the marginability of the account, and once it passes, then the margin changes drastically.
Q. You don't have a hedge?
A. Exactly.
[Transcript page 1383, lines 18 to 25]
Evidence of Mr. McCrodon, the broker
[31] Turning to Mr. McCrodon, although he had limited contact with the Appellants, having handled only one hedge for each of the Hayes, a transfer of accounts for Mrs. Scott, and opening accounts for the Stephens, he had handled many other Maguire convertible hedges during the years under appeal. Mr. McCrodon worked as a broker for Nesbitt Thomson from 1979 to 1989. He indicated that 90 per cent of his revenue during the years 1983 through 1989 came from Mr. Maguire's convertible hedging clients.
[32] Mr. McCrodon's usual practice with Maguire clients was to receive advice from Mr. Maguire to set up an account for a new client. Most of Mr. McCrodon's contact with the client was by phone or mail. Whenever he executed a trade, he would send a duplicate copy of the transaction to Mr. Maguire. The hedges would be initiated either by Mr. McCrodon suggesting certain hedges to Mr. Maguire within parameters determined by Mr. Maguire, or by Mr. Maguire contacting Mr. McCrodon to see if he could accommodate hedges identified by Mr. Maguire. As Mr. McCrodon handled more of these he was able to track their potential viability.
[33] Mr. McCrodon went through the hedge he handled for the Hayes which is outlined in Appendix "B". This is the second hedge I wish to describe.
[34] Mr. McCrodon described the opening position of Mr. and Mrs. Hayes as follows:
Q. Looking at these two statements here, can you tell me whether this is something that you would have done as a convertible hedge?
A. Yes. It looks like it, because they're for the same month end, to start with. One of them has a long position in Hiram Walker Resources, 8½ percent debenture, which is a convertible debenture, with a large debit in the - in the account as a net balance.
And the other - the other account has a short position in Hiram Walker Resources common shares, with a large credit in the account.
And since these are offsetting positions, convertible to common, I would identify it as a convertible hedge.
Q. Now, you also have in front of you document 2.3. And 2.3 is a document which simply summarizes a lot of the information contained in the broker statements.
In the middle portion under Philip Hayes' account is the activity in Mr. Hayes' account and in the right-hand portion, under Patsy Hayes' account, is the activity in her account.
Do you see that, sir?
A. Yes, I do.
Q. So when we look at the first two unshaded lines under 30th July of 1985, you see that those are the two trades that you've just been looking at in the broker statements?
A. Yes, I do
Q. Now, can you explain to us how this would have been initiated?
A. It would have been initiated like any other convertible hedge. We would have determined that the Hiram Walker Resources debenture was at an attractive premium relative to the common shares and that it would make a good convertible hedge candidate. And then we would have proceeded to establish the long position with an offsetting short position.
Q. We've heard the expression, contingent orders. Are you familiar with that?
A. Yes.
Q. And can you tell me how or whether they apply to these circumstances?
A. I can't remember exactly in this circumstance if we used a contingent order. My practice was to do so whenever possible, because it limits the risk in the trade.
There are circumstances where you can't use a contingent order, because the long position might be a new issue position, for example. And you know, you may know the price, but you may have had to make a commitment to it before you actually were in receipt of it and were able to short sale the common against it.
I don't know what the specific circumstances here were, but most of the time we were able to put in a contingent order.
[Transcript page 2114, line 18, to page 2116, line 23]
[35] Mr. McCrodon also stated that in initiating a hedge, the two tickets for a buy and sell would be sent to the trading desk clipped together with an indication of the amount of spread. He explained that in August the warrants in the Hayes' convertible hedge were stripped from the debenture to be traded separately but the position remained fully hedged. From February 11 to February 18, he described the Hayes' transactions as replacing the debenture and warrants position with a convertible preferred share position, remaining as of February 18 in a fully hedged position. On April 22, 1986, Mr. McCrodon put through a cross-order, that is, a single transaction from the same firm, for Philip Hayes to buy 4,650 commons to cover his short position and for Patricia Hayes to sell 4,650 commons. This was done at market price. On April 30, Philip Hayes traded his convertible preferreds for 4,650 common shares. At this point, the Hayes held offsetting positions in a common-common manner.
Evidence of Gordon and Gloria Rezek
[36] Mr. Rezek worked as a sales representative for 27 years, a job he was doing in the years under appeal, 1988 and 1989. In 1987, Mr. Rezek met Gloria Fahrngruber. By late spring of 1988, Ms. Fahrngruber and Mr. Rezek moved in together in Mr. Rezek's home. Ms. Fahrngruber paid Mr. Rezek $500 a month rent, representing approximately one-third of the household costs. In 1992, Mr. Rezek sold the home and they moved into a new home, carrying on the same arrangement until February 1993 when they were married. For the years 1988 to 1992, Mr. Rezek and Ms. Fahrngruber held no joint bank accounts, no assets jointly, transferred no property between themselves, each had their own car, had their own phone line and on vacation shared the costs.
[37] In 1987, Mr. Rezek became aware, through a fellow employee, Mr. Larry Hillman, of a financial advisor, Mr. Harry Sildva. Mr. Rezek met with Mr. Sildva to find out more about making money. From his meeting with Mr. Sildva he believed there was a form of win-win investment strategy. By this he meant he would earn income, receive a tax benefit or both. This was the extent of Mr. Rezek's understanding of the investment strategy. He had a high school education and had no familiarity with the financial investment environment.
[38] Mr. Rezek believed he could enter the market with as little as a $3,000 investment. He understood that he was required to open a broker account, which he did with Walwyn Stodgell in the spring of 1988. Mr. Sildva made all the arrangements. At that time, May 3, 1988, there was no one else authorized on the account nor any Guarantor of Mr. Rezek's account.
[39] On April 27, 1988, Mr. Rezek, through the auspices of Mr. Sildva, made two transactions for which he paid, again through Mr. Sildva, $3,000; he sold short 30,704 Laidlaw common shares for $612,925 and coincidentally bought 10,100 Laidlaw convertible preferred shares for $615,506. This is the convertible hedge described earlier in the background of convertible hedges. Mr. Rezek entered into these transactions without any discussion with Ms. Fahrngruber. He believed these transactions represented the win-win situation. He did not understand what a short sale was nor how a convertible hedge worked. His intent, as he put it, was simply to make money. He paid a $600 commission on these transactions.
[40] Subsequent to these transactions, he did discuss with Ms. Fahrngruber the possibility of her guaranteeing his account. This was on the recommendation of Mr. Sildva, as it would allow for greater investment opportunities. Having heard of Mr. Sildva from Mr. Rezek and Mr. Hillman, and upon the encouragement of Mr. Rezek, Ms. Fahrngruber contacted Mr. Sildva and arranged to meet him, which she did in May 1988. She came away from that meeting also with the impression that she could be in a win-win situation - make money and save taxes. She was advised by Mr. Sildva to open an account with Walwyn which she did on May 17, 1988, after having checked on both Maguire and Sildva through the Better Business Bureau and Ontario Securities Commission. On May 17, she signed a form opening her account. At the same time, both she and Mr. Rezek signed guarantees, guaranteeing to the broker each other's account. Neither Mr. Rezek nor Ms. Fahrngruber had a detailed understanding of the nature of the guarantee. Ms. Fahrngruber signed it on the advice of Mr. Sildva that it would allow her greater investment opportunities.
[41] On May 20, Mr. Rezek sold his 10,100 Laidlaw preferreds for $477,075. He did not discuss this with Ms. Fahrngruber. This resulted in a loss on the disposition as described earlier of $138,000, which Mr. Rezek claimed on his 1988 tax return, resulting in a tax refund of approximately $80,000 received in early 1990. Mr. Rezek confessed to not appreciating the tax intricacies of the situation. He had his return prepared by Mr. Sildva. At this point, in May 1988 Mr. Rezek held only a short position in Laidlaw. Although he sold preferreds for $477,075, he understood he could not take the funds out of his account because as he put it "Gloria's account offset that".
[42] On May 20, Gloria Fahrngruber acquired 10,100 Laidlaw convertible preferred shares. She did not put up any money for this investment but indicated her understanding was that she could do so because of her guarantee. Upon receipt of a statement, she realized she owed $477,375 for the shares. This was all being arranged by Mr. Sildva. In August 1988, Ms. Fahrngruber converted the preferred shares to common shares. She also sold five shares but had no idea why. She left everything to Mr. Sildva.
[43] Mr. Rezek acknowledged that he had been made aware of the risks from a review of risks set out in the broker's hedge agreement. The risks were identified as follows:[2]
0 Contingent orders can only be taken on a best efforts basis. There may be liquidating problems.
0 Forced conversions may result in lost premiums. Forced buy-backs will result in further commission charges.
0 Supply of shares can be affected by a tender offer.
0 Conversions can take time and cause buy-ins on short positions while the security is being converted.
0 Dividends which will be charged for the short positions can be increased unexpectedly.
Mr. Rezek was led to believe these would never happen. Ms. Fahrngruber had a similar understanding.
[44] As a result of Ms. Fahrngruber's investment, she was subjected to tax on dividends on the Laidlaw convertible preferred shares. She expressed her displeasure to Mr. Rezek about the additional tax burden and requested that he reimburse her for any additional tax. She blamed him for getting into this Laidlaw investment which was only causing her an additional tax obligation. She was not able to access the dividends which were simply credited to her account, but never paid to her. Mr. Rezek consequently had Mr. Sildva's office determine how much more tax she was having to pay, and reimbursed her this amount.
[45] In November 1988, Ms. Fahrngruber signed an option account. The form indicated she was not involved in a partnership, she did not hold the account jointly with anyone and no one else had authority on the account. It also indicated that the account was exclusively for hedge trading.
[46] Mr. Rezek subsequently entered into two more convertible hedges involving Westcoast and Royal Bank stock but without any involvement of Ms. Fahrngruber. He did not know whether she was doing anything similar with such stock. In fact, she was not. She had no involvement with either the Westcoast or Royal Bank convertible hedge. The only stock she ever held was the long position in the Laidlaw securities. Mr. Rezek believed the Royal Bank and Westcoast convertible hedges were the same as the Laidlaw investment.
[47] When Mr. Sildva left Maguire to go to Richardson Greenshields, Mr. Rezek moved his account to that firm. In February 1992, Mr. Rezek acquired an additional 1,000 shares in Laidlaw stock. He had no idea why. At the same time, Ms. Fahrngruber sold 1,000 shares and likewise had no idea why. There was some discrepancy as to whether the next transaction took place in February 1995 or 1994 but at that time the Laidlaw shares were transferred from Ms. Fahrngruber to Mr. Rezek. There was no payment by Mr. Rezek for these shares. He did not understand why this was done but acknowledged the effect was to bring his accoun