Kruger Incorporated v. The Queen

Kruger Incorporated v. The Queen
Court (s) Database
Tax Court of Canada Judgments
Date
2015-05-26
Neutral citation
2015 TCC 119
File numbers
2003-3262(IT)G
Judges and Taxing Officers
Gerald J. Rip
Subjects
Income Tax Act
Decision Content
Docket: 2003-3262(IT)G
BETWEEN:
KRUGER INCORPORATED,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
Before: The Honourable Justice Gerald J. Rip
Appearances:
Counsel for the Appellant:
Louis Tassé
Roger Taylor
Marie‑Claude Marcil
Counsel for the Respondent:
Josée Tremblay
AMENDMENT TO REASONS FOR JUDGMENT
Pursuant to Rule 172 of the Tax Court of Canada Rules (General Procedure), these amended reasons for judgment are issued in substitution to the reasons for judgment issued on May 26, 2015.
Upon paragraphs [9] and [10] having been inadvertently inverted;
The reasons for judgment issued on May 26, 2015 are therefore amended so that former paragraph [10] now reads as paragraph [9], and former paragraph [9] now reads as paragraph [10], as per the attached amended reasons for judgment.
Signed at Ottawa, Canada, this 10th day of June 2015.
"Gerald J. Rip"
Rip J.
Citation: 2015 TCC 119
Date: 201500610
Docket: 2003-3262(IT)G
BETWEEN:
KRUGER INCORPORATED,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
AMENDED REASONS FOR JUDGMENT
Rip J.
Executive Summary The main issue in this appeal is whether, in computing income for the year, Kruger can mark to market foreign exchange option contracts at the end of its fiscal year. The Crown’s position is that foreign exchange contracts are to be valued only when realized. Expert evidence agree that for financial reporting purposes, mark to market is the appropriate method of valuing such options. The Income Tax Act ("ITA" or "Act") requires financial institutions, as defined, to mark to market what it defines as "mark to market property". Foreign exchange option contracts are not included in the definition of such property (section 142.2 of the ITA).
Nevertheless, for ease of administration of the ITA, the Canada Revenue Agency ("CRA") has taken upon itself to permit financial institutions to mark to market such option contracts. It also permits some regulated businesses that are not defined as "financial institutions" to mark to market property.
Kruger is not a financial institution and does not carry on a regulated business. However, it is one of the larger participants in the Canadian market. It values its foreign exchange option contracts on a mark to market basis for both tax and financial reporting. The mark to market values used by Kruger were the values it adopted from its co-contractors, various banks, the values of which may vary from bank to bank. The CRA did not allow the appellant to mark to market value its foreign exchange option contracts as at the end of its 1998 taxation year.
A taxpayer is to value its property on a consistent basis. Mark to market valuation may create income in one year and a loss in another year. A taxpayer is to include an amount in income for the year or deduct an amount in computing income for the year only if required or permitted by the ITA. Mark to market valuation should be applied only in the limited circumstances where it is sanctioned by the ITA, by section 142.2 and section 1801 of the Income Tax Regulations ("ITR").
Kruger’s alternative argument was that it was in the business of both writing and purchasing foreign exchange option contracts and that the contracts were inventory. Kruger did carry on such a business. However, the foreign exchange option contracts it wrote were liabilities and not inventory. The contracts it purchased were inventory and may be valued accordingly.
INTRODUCTION [1] The principal subject matter of this appeal from the income tax assessment for 1998 of Kruger Incorporated ("Kruger") is whether, in computing income for the year, foreign exchange option contracts should be valued mark to market at the end of the appellant's taxation year, as claimed by Kruger, or when finally realized, as assessed. Appellant's alternative submission is that in 1998 it carried on a business in which the contracts are property that is inventory and in computing its income from its business for 1998 the contracts are to be valued as such in accordance with subsections 10(1) and 248(1) of the Act and section 1801 of the ITR. In effect, mark to marketing the contracts and valuing them as inventory in accordance with section 1801 of the ITR would have the same result.
DEFINITIONS [2] These reasons refer to several foreign exchange option contract terms[1] which are summarized in the following paragraphs:
a) A "Derivative" is a contract between two or more parties whose price is dependent upon or derived from, one or more "underlying assets" or factors. Its value is determined by fluctuations in the price of the underlying asset or factor.
b) A "European option" is an option that may be exercised only on its expiry date. Kruger entered into European Options which constituted the bulk of the foreign currency market.
c) The "Holder" or "Purchaser" of a "call" option wants the price of the foreign currency to increase above the strike price; the holder or purchaser of a "put" option wants to price the currency to decrease to be less than the strike price.
d) The "Intrinsic Value" of a derivative contract is the difference between the current price of the derivative and the strike price, i.e. the gain that would be made if the option expired based on current conditions, also known as the amount by which the option is "in the money". Only "in the money" options have an intrinsic value. If the strike price of a call option is above the current price of the underlying asset, the call option is "out of the money". An option is "in the money" when the strike price is below the underlying asset's price because the holder could exercise the call option by paying the strike price and profiting on the balance. Put options are the exact opposite; it is "out of the money" when the strike price is below the current market price of the underlying asset and "in the money" when the strike price is above the current price.
e) "Mark to market" method of accounting is an accrual method of accounting by which both parties to the option, the option holder/purchaser and the option writer/issuer, recognize and value the option at its market value as at the date of the balance sheet, in this appeal, December 31, 1998, and recognize any changes in market value from the beginning to the end of the period as a gain or loss in the income statement. It is relevant for tax purposes when an option entered into in one taxation year expires in a subsequent taxation year. When a liquid security is traded in an open market, the mark to market value is easy to determine by reference to its most recently traded price. When there is no open market or exchange, the mark to market value is calculated in accordance with various pricing models.
f) A "Market Maker" is a person, usually a bank, who participates in transactions to facilitate the desire of clients to purchase or write options.
g) An "Option contract" is a derivative contract by which one party, the writer or issuer, sells (or issues) the contract to another party (the option holder or purchaser) for the payment of a premium. Under the contract the purchaser may have the right, but not the obligation to buy or sell the underlying asset, in the examples at bar, foreign currency, at a fixed price (the "strike" or "exercise price") on a specific date or during a specified period of time ("expiration" or "exercise" date).
h) "Over the counter" or "OTC" market refers to privately negotiated option contracts between the principals to the contracts, in the appeal at bar, between Kruger and its individual counterparty banks.
i) The "Premium" is the consideration or price paid for the option. The holder (or purchaser) of an option cannot lose more than the premium the holder paid for the contract, no matter what happens with the value of the foreign currency. The potential profit to the holder is unlimited in theory; the value of the foreign currency can increase based on the market. If the value of the foreign currency is less than the strike price, the holder would let the option expire. On the other hand the writer (or issuer) of an option cannot gain or profit more than the premium already received in value, the writer must absorb the increase. A premium has two components, "intrinsic value" and "time value".
j) "Realization" for accounting purposes is similar to cash basis accounting, as opposed to mark to market accounting which is an accrual method of accounting. In the realization method of accounting, a transaction is recognized as complete when an entity has a claim to be paid in cash or an obligation to pay cash. The realized value is certain and not subject to any estimate of value.
k) The "Strike Price" or "Exercise Price" is a fixed exchange rate in the contract at which the option may be exercised; i.e., that the purchaser of the option must pay the writer (or issuer) to exercise the "call" option to acquire the underlying asset, the foreign currency in this appeal, or the amount that the holder (or purchaser) will receive from the writer (or issuer) on the exercise of a "put" option to sell the foreign currency. The "Pay off" represents the value that flows from the writer to the owner of an option if and when exercised. European style options can only be exercised at the maturity date of the option at which date the "Pay off", if positive, is realized.
l) An option's "Time Value" is the difference between its market value and its intrinsic value.
m) The "Underlying Asset" in the options referred to in these reasons is foreign currency, primarily, if not wholly, United States dollars.
n) "Volatility" is the variation in price of an underlying asset during a specified period, the fluctuation in value of the underlying asset during the term of the option. It is a variable in option pricing formulas showing the extent to which the price of the underlying asset may fluctuate between the date the option is valued and its expiration date.
ISSUES [3] After all is said and done, the principal issue in this appeal is whether Kruger, for purposes of computing its income or loss for the year under the Act, may value its foreign currency option contracts at the end of its financial year on a mark to market accounting method[2]. All of the options in issue were entered into Kruger's 1998 taxation year and were to be exercised in its 1999 taxation year. In the event it cannot value its derivative properties on the mark to market basis, then the appellant argues that the derivative properties were inventory, thus permitting Kruger to value the contracts, in accordance with section 10 of the Act in computing income for 1998 at the lower of their costs or fair market values, whichever is lower, or in accordance with section 1801 of the ITR, their fair market value.
[4] In filing its income tax return for its taxation year ending on December 31, 1998, Kruger claimed losses aggregating $91,104,379 from a business of trading in derivatives, applying subsection 9(2) of the Act[3]. The position of the Minister of National Revenue ("Minister") is that the amount of $91,104,959 was not deductible in computing Kruger's income for 1998, but the amount of $18,696,881 which Kruger had included in computing its income as the amortized portion of the net of premium income and premium expenses regarding the foreign exchange option contracts are to be excluded in computing its income for 1998, with the result that the appellant's income for 1998 was thereby increased by the net amount of $72,407,498, the difference between $91,104,379 and $18,696,881[4]. The Minister also included the amount of $91,104,379[5] in Kruger's taxable capital for purposes of the large corporations tax: subsection 181.2(3) in Part 1.3 of the Act. The appellant opposes such inclusion in its taxable capital.
[5] The Minister also says that Kruger was not carrying on a business of trading in derivatives and the derivatives were not inventory of the appellant[6]. The Minister considered the losses to be "merely a reserve or contingent amount", the deduction of which is prohibited by section 9 and paragraph 18(1)(e) of the Act. For income tax purposes Kruger is required to calculate its gains or losses from the derivative contracts on the realization method. Apparently, the purported fair market values of the contracts were less than their costs at year end. Therefore, if the contracts are inventory, they would be valued at fair market value, potentially producing the same result to income as valuing the contracts mark to market.
PLEADINGS [6] The parties agree that Kruger entered into foreign exchange option contract transactions as a speculator to profit from the sale or purchase of such options, anticipating, rightly or wrongly, on how foreign exchange rates would move in the future. The parties also agree that Kruger reported its income and losses from trading in foreign option contracts on income account.
[7] In her pleadings, at paragraph 20(4) of her Further Fresh Reply to the Notice of Appeal, the respondent referred to the appellant amortizing a portion of the net of premium income and premium expenses, $18,696,881, regarding the option contracts and as a result, the appellant’s income was thereby increased by $72,407,498, the aggregate being $91,104,379[7].
[8] The respondent submitted that the mark to market values recorded by Kruger were not in accordance with mark to market valuations since it amortized the premium paid. Respondent’s counsel referred to this as a “hybrid” method which created inaccuracies in computing income. Appellant’s counsel submitted that the respondent’s allegation that Kruger did not properly apply mark to market accounting was not pleaded and ought to be rejected.
[9] The respondent led evidence that the mark to market method requires that any premium on options should not be amortized over the life of the option but, rather, should be entered in the computation of income when paid and received. The appellant states that the respondent did not question the appellant's method of amortization in its pleadings and is therefore not permitted to raise the issue at trial.
[10] The respondent did question the appropriateness of amortizing a premium in mark to market accounting. The purpose of pleadings is to inform the other party of one’s position, not to take the other party by surprise. I do not believe the allegation in subparagraph 20(4) is sufficient to inform the appellant that the very foundation of its method of valuing its option contracts was being challenged. Accordingly, I did not consider this submission.
EVIDENCE Kruger's activities [11] Mr. George Bunze, Vice-chair and Director of Kruger as well as Chair of its Audit Committee, testified on the appellant's behalf. Kruger is a private corporation although one of its subsidiaries offers shares to the public. Its core business is the manufacturing of newsprint and coated paper products and tissue paper which, during the period 1997 to 2004, Kruger sold as to 80 per cent to the United States and the balance to the United Kingdom and South America. Canada is not one of its significant markets. Kruger is the third largest newsprint company in North America. Kruger also operates a lumber business selling to the U.S. market.
[12] Consolidated sales by Kruger and its subsidiaries, Mr. Bunze testified, were "around $2,500,000,000" during the period 1997 to 2004. The sales by the appellant itself were "about a billion dollars". Accounts receivable of Kruger and its subsidiaries are "around the $175,000,000 to $200,000,000 at any point in time". Mr. Bunze estimated that 75 per cent of the receivables are in U.S. dollars.
[13] In the 1980s, recognizing its exposure to foreign currencies, Kruger started to purchase and sell foreign currency option contracts, principally United States dollars, on its own behalf and on behalf of a wholly‑owned subsidiary, Corner Brook Pulp and Paper Limited. At times when newsprint prices were rapidly declining, Kruger participated in hedging commodities but this was not done on a regular basis, according to Mr. Bunze.
[14] Kruger started trading in foreign currency contracts by hiring a trader to help make "more sophisticated" trades and maximize profits. Later Kruger was employing a group of four experienced and knowledgeable full‑time traders to trade derivatives on its behalf. Kruger's volume in dollars of purchases of derivate products, Mr. Bunze stated, placed Kruger in the top three or four non banking enterprises in Québec, after the Caisse de Dépôt and Hydro Québec. For the purpose of managing credit risk, Mr. Bunze said, Kruger in 1998 dealt with both Schedule "A" Canadian banks, led by the Bank of Montreal, Royal Bank, TD Bank and Banque Nationale, as well as Schedule "B" banks, foreign based banks, such as Citibank, Société Générale, Deutsch Bank, NatWest Bank and J.P. Morgan Bank.
[15] In 1992 or 1993, Kruger hired Richard Bradley, a former chief trader for the Toronto Dominion Bank in London, a person Mr. Bunze described as "a very sophisticated and knowledgeable individual involved in all aspects of foreign currency … and we built on that …".
[16] Mr. Bradley's mandate, Mr. Bunze explained, originated from meetings with Mr. Bunze and Mr. Lloyd Johns, who in 1998 was Assistant Treasurer of Kruger and at time of trial was Director, Taxation and Insurance for Kruger. Mr. Johns was also a witness in this appeal The meetings would review "whatever intelligence [Mr. Bradley] would bring to the table … through his own network" and determine the position Kruger would wish to take on currency exposure at the time. Mr. Bradley did not have a "blank cheque" to trade as he wanted, but he acted within parameters and recommendations that were discussed. Mr. Bunze described the trader's livelihood depending on his or her access to other traders and Mr. Bradley had such access. Mr. Bradley, Mr. Bunze declared, "knew how to make sure that we maximize our credit strength and also our contracts".
[17] As years went by Kruger increased what Mr. Bunze called its "trading treasury group" by hiring "some bond traders, some commodity hedge type traders for products like newsprint and lumber". Kruger also established a "backroom" to handle the trading style of Mr. Bradley. The "backroom" also supported Kruger's pension fund investments. In short, Mr. Bunze described it as "a many investment institutional trading floor".
[18] Mr. Bunze described the object of the trading team was "to mirror a sophisticated trading flow on a miniature scale …" with the "same sort of structure" as the trading flow of the Toronto Dominion Bank, "an open office concept where the traders were all exchanging information flow and so forth". The objective, he said, was "to generate and produce profits on an individual profit centre basis" for Kruger and with this purpose Kruger both bought and sold foreign option currency contracts.
[19] The person ultimately responsible at Kruger for the administration and control of the trading group during the period 1997 to 2004 was Mr. Bunze. The "ultimate decision maker" was the CEO and Chairman of Kruger, Mr. Kruger.
[20] Kruger's relationship with the banks was important, Mr. Bunze stated. He recollected that about 30 financial institutions were supporting Kruger directly through actual credit facilities, loan facilities or project financing. Mr. Johns testified that one of the reasons Kruger dealt with a multitude of banks was to expand Kruger's credit risk and get competitive prices.
[21] Kruger had contracts and credit agreements with individual banks as well as with bank syndicates. These contracts, Mr. Brunze explained, had specific covenants and restrictions as to what Kruger could do with the proceeds. A typical credit arrangement would include an actual term loan or a credit facility or a "revolver" that permitted Kruger to "borrow up and down" but with a limit to the maximum it could borrow not only with that bank but with others, as well.
[22] The bank syndicates dealing with Kruger required Kruger to report to the lead lender — Mr. Bunze believed this was the Bank of Montréal at the time — all of the foreign exchange contracts it entered into and outstanding "on a quarterly basis derived on the basis of mark to market and based on the individual institutions confirming in writing that the mark to market values were calculated by them", that is, each bank would have to confirm the actual mark to market value of the contracts it had with Kruger.
[23] Mr. Bunze recalled that the accounting profession had prepared drafts on how to treat financial investments in the financial statements and "somewhere in '97 we were notified by Price Waterhouse … we will have to start reporting in '98 and onwards the financial trading that we were doing as it's not hedging on a mark to market basis … " Mr. Bunze agreed with respondent's counsel that the purpose of this requirement was for the consortium of banks to follow the credit risk of Kruger.
[24] Kruger's financial statements for 1998 and subsequent years state and reflect that derivative financial instruments were held for trading purposes. Kruger's trades, Mr. Bunze stated on cross‑examination, allowed the trader to "actually speculate and take … any side of the transaction they deemed fit", both writing options and purchasing options, always dealing with banks.
[25] Mr. Johns corroborated much of Mr. Bunze's evidence. When he joined Kruger in 1982, Kruger "already" had a currency trader. By 1998 Kruger had four traders including Mr. Bradley as well as three bond and security traders. Only Mr. Bradley traded in currency.
[26] Mr. Johns managed and supervised Kruger's treasury back office approving and authorizing daily transfers and monthly treasury reports which would summarize the various transactions. The "back office" included a person responsible for day to day banking, including preparation of daily bank reports, a person working in the money market and a third person dealing in the foreign currency market. Mr. Johns prepared the quarterly officer certificate for loan agreements and ensured that all the debt repayments and debt rollovers were performed. He was also responsible for Canadian corporate tax for Kruger and its major subsidiaries.
[27] The following is Mr. Johns' description of how the "back office" functioned:
… a trader would produce a trade ticket and that trade ticket would go to the Back Office and the Back Office would then verbally confirm all the trade details with the counterparty. Should they agree, then the Back Office would input it into the Treasury System, and the Treasury System would then produce a trade ticket number that couldn't be altered or deleted and it's a – it was a unique number and the Back Office would put that on the trade ticket and that's how we accounted for all the trades.
The Back Office would then prepare a monthly summary that would go to myself and Accounting of all the opened transactions, closed transactions and outstanding transactions for the month.
[28] Kruger's financial results from its derivative trading activities were kept separate from the financial results of its manufacturing activities, according to Mr. Johns. The results of these two activities were kept in separate ledger books, each having its own separate General Ledger.
[29] Appellant's counsel directed Mr. Johns to a statement by Mr. Richard Poirier, an expert witness, that the currency option contracts could be closed prior to maturity. Mr. Johns recalled that "very few" would have closed prior to maturity in 1998 because of the "drastic changes" in the Canadian dollar. Management had decided "to roll these over".
[30] Kruger both issued and acquired option contracts with the banks but not at the same level, according to Mr. Johns. "We would have sold more then we would have bought … in 1998, I think it was close to four to one" and that at all relevant times Kruger's books would have about three times more written or sold contracts than bought options. The reason for the sales was that management believed the Canadian dollar was grossly undervalued and that the value would be coming back and that it would be a good time to sell options within the year, the "bad ones, we would roll them over."
[31] In 1999, Mr. Johns explained, the options would have been rolled over because they were at a loss, or "under water". In 1998 the Canadian dollar (to the U.S. dollar) fell from 1.40 to 1.5750, a historical loss, said Mr. Johns. In 1999, the Canadian currency strengthened to 1.44.
[32] Mr. Johns stated that Kruger's sold options had "an intrinsic value, worth nothing". But because the options had staggering maturity dates over the year‑end past the year, the options had time value, not just an intrinsic value, he stated. He estimated the time value to be "anywhere from 16 to 20 million" even if the intrinsic value was nil. And, therefore, management decided to roll these options over but hoping the dollar would strengthen in the shorter term.
[33] The financial statements for 1999 show a decrease in the notional and adjusted fair value of the written options, the latter amounts decreasing substantially due to the improvement in the exchange rate, according to Mr. Johns. He stated that Kruger continued to believe that if the Canadian dollar was "way under valued … that eventually would get back" to normal. Currency rates in 1998 were "unheard of" and the dollar fluctuation was very volatile. Management was of the view that the loss contracts be rolled over until currency rates "would come back down, which, in fact, did happen".
[34] Mr. Johns confirmed that the market values applied by Kruger were the mark to market values from its counterparty banks. He stated that Kruger did not have the ability or capability at that time to value mark to market and by Kruger adopting individual bank values, the individual banks could not dispute the values.
[35] During the years subsequent to 1998 Kruger continued entering into both written and purchased option contracts until 2004 when there was a significant decrease in the number of both option contracts. According to Mr. Johns, the Canadian dollar in 2004 was trading at $1.35 and continuing to decrease. A "lot of the so‑called options expired worthless and in August of 2004 we basically closed out a lot of our positions" before maturity.
[36] Kruger received mark to market values from the banks on a quarterly basis and used them for officers' certificates for the banks and for the audited financial statements until it leased a system that was "basically" used by the Laurentian Bank, called "Super Derivatives". (The date when Kruger started using Super Derivatives is not in evidence.) Super Derivatives, said Mr. Johns, essentially monitors every transaction on the market in real time. It permitted Kruger itself to value mark to market. However, for year‑end purposes, Kruger used the counterparties' mark to market values "to be consistent and to make sure that there was a third party mark to market … to alleviate any requirement by anybody that we were falsifying our mark to market …"
[37] Mr. Johns declared that there was no attempt on Kruger's part to match the option contracts with its receivables.
Kruger carried on a business [38] I find that Kruger carried on a business of speculating on foreign exchange currency options that was separate from its manufacturing business. It was a leading trader in such options in Québec. It entered into a large number of contracts and the amounts of the contracts were substantial. Kruger created a facility and hired experienced personnel to operate the business in a manner similar to that undertaken by sophisticated traders in foreign exchange options. Decisions to write or purchase was carried out in a businesslike manner. The parties agreed that Kruger was a speculator when acquiring or writing options and was not hedging its receivables or payables from its principal business. Kruger reported its income and loss from the option contracts on revenue account. Kruger's speculation in foreign exchange options, by writing more options than it would purchase, Prof. Klein, an expert witness for the respondent, opined, carried significant risk but also chances for large profits. This was all part of a business entreprise undertaken by Kruger to earn income separate and apart from its manufacturing business.
Mark to Market v. Realization [39] In addition to Messrs. Bunze and Johns, there was an additional lay witness for the appellant, Mr. Douglas Watson, a CRA official. There were also four witnesses who were qualified to testify as experts in their field of endeavour, Mr. Richard Poirier and Mlle Chantal Leclerc, CPA.CA for the appellant and Professor Peter Klein and Ms. Patricia O'Malley, CPA.CA for the respondent.
Options market evidence [40] At time of trial Mr. Poirier, who was qualified as an expert on the operation of foreign currency option markets, carried on his own business but in previous years was director general of several foreign currency funds operated by the Banque Nationale du Canada and was also a trader in foreign currency markets. He described himself as a "mainteneur de marché", a market maker. Kruger was a client of Mr. Poirier when it dealt with the Banque Nationale du Canada.
[41] Professor Peter Klein, a Professor of Finance at the Beedie School of Business at Simon Fraser University in Burnaby, B.C., testified as an expert on derivative instruments, in particular foreign currency contracts, from a financial perspective. Professor Klein has a Ph.D. (Finance) degree from the University of Toronto and LL.B. and M.B.A. (Joint Program) degrees from the University of Western Ontario. He is a Certified Financial Analyst, amongst other designations. During the period 1984 to 1992 he worked at C.I.B.C./Wood Gundy Inc. at several positions, including Chief Trader, Capital Markets in London, which included derivative trading. He has written extensively and has delivered academic papers and speeches on option valuation and the effect of credit risks on options. He has been the recipient of research grants and teaching awards in financial matters.
[42] Both Mr. Poirier and Professor Klein described and explained the nature of, and market for, foreign currency option contracts, how they are purchased and sold, how they are exercised, how a gain or loss is calculated, etc. Several strategies in trading option contracts were also described. The options Kruger entered into were European style options. Kruger's option transactions were "over the counter" puts and calls on U.S. and Canadian foreign exchange rates. Since Kruger wrote many more options than it purchased, it was exposed it to the risk of being forced to make large pay offs, according to Professor Klein.
[43] Mr. Poirier described the foreign currency option market as a large market and the most liquid of all option markets, that it is possible to close a position at any moment during the term of an option. Professor Klein agreed that the size of the primary market for OTC currency options is considerable when transactions by all market participants are considered. But he cautioned that "overall market size should not be confused with liquidity available to any single market participant". A European option, Prof. Klein explained, can be settled[8] in several ways: by cash or physical delivery of a forward contract of equal value or by "rolling the option" into a new option. Professor Klein stated that markets for settling prior to expiry or for rolling the option are illiquid because they consist of a single participant who is the party on the other side of the original contract and the party wishing to settle before the expiry date has little negotiating power. Ms. O'Malley agreed that because it may not be possible to dispose of a contract in the OTC market, it is possible to close a contract before expiry through negotiation with the other party, in particular when the subject matter of the contract is "deep liquid and active like the market for major currencies". Instead of closing the original contract, “the contract can be rolled over.”
[44] Professor Klein testified that prior to a party agreeing with a bank to enter into a relationship to trade foreign exchange option contracts, the party and the bank would put into place a ISDA Master Agreement[9] to regulate their relationship. Kruger was a party to an ISDA Master Agreement with each of its counterparty banks. A ISDA Master Agreement, Prof. Klein explained, allows the parties to trade options in an efficient way by agreeing orally to each option contract and then following up with a written confirmation of the trade. An ISDA Master Agreement governs most OTC options, including the OTC options by Kruger and its counterparties.
[45] An ISDA Master Agreement, Prof. Klein stated, does allow European options to be transferred before Expiry Date provided the non transferring party consents to the transfer. He added that the requirement for such consent is "well known" by writers and buyers of OTC options.
[46] According to Prof. Klein, Kruger entered into options that generally represented "unique property" because of their specific terms and because of Kruger's credit risk as a writer.
[47] Mr. Bunze described the various banks who were Kruger's counterparties. Mr. Poirier explained that the banks always consider the credit of a customer to be a risk and is a factor in the bid/offer spread with the client. Professor Klein stated that the credit of the customer is an input into the bank's pricing model. Banks, Mr. Poirier stated, used the same pricing models to determine the value of options during the term of a contract. Professor Klein does not agree. He testified banks disagree on mark to market value because their respective pricing models may differ. Evidence also established that these models were not identical. In valuing a derivative or counterpart on a mark to market basis, Kruger adopted the model used by the bank that was its counterparty for the particular derivative. The values of contracts with different banks for the same amount and on identical terms may vary depending on the input variables in the particular bank's model. Several examples were discussed at trial.
[48] An example used by Prof. Klein were identical options owned by Morgan Guaranty Bank and the Bank of Nova Scotia. Both were written by Kruger. Each contract was written on May 13, 1998 for US$ 10,000,000 with an exercise price of 1.46 exercisable on May 13, 1999. The Bank of Nova Scotia valued its option at $797,736 while Morgan Guaranty valued its option at $612,200, both as at December 31, 1998, a difference of over 20 per cent. Professor Klein stated that on May 13, 1998, when the Canadian‑US exchange rate was 1.443, the market value of the option was CAD$ 125,500, approximately. On December 31, 1998 the exchange rate increased to 1.5305, roughly 6 per cent, yet Kruger recorded the mark to market value on that date at CAD$ 612,000, four times larger than the value of the option when it was written. Then, during the final half of 1999, the U.S. dollar weakened approximately 5 per cent to 1.405, a change sufficient to reduce the actual Pay Off on May 13 1999 to CAD$ 5,000, a 99 per cent decline in the five months between December 31, 1998 and May 13, 1999. The mark to market values are, Prof. Klein concluded, very sensitive to changes in the input variables in estimating value.
[49] Professor Klein compared several other pairs of options by different banks having similar trade dates, amounts, rates and expiry dates and found that there were differences in December 31, 1998 values based on the particular banks' valuation models, ranging from 29 per cent to − .03 per cent[10].
[50] In Professor Klein's view, Kruger's mark to market valuations at the end of 1998 were not based on a market or a traded price, "they represented theoretical estimates determined by sophisticated pricing models where market values of other securities were used to determine some of the input variables." The bank's pricing models are "very mathematical and rely on highly idealized assumptions" with respect to how securities markets operate. Mark to market values are unreliable.
[51] Professor Klein stated that there are a number of models banks may choose to price a foreign currency option and the result will depend on which model is chosen and, as stated above, leads to bank disagreements on mark to market value. The weakness in the mark to market method, Professor Klein declared, is that the list of input variables to the models themselves as well the "estimation" methods for the input variables can differ, causing further uncertainty as to the best estimate of risk to market value. Different banks can value as at different times of the day for example. The mark to market value is very sensitive to small changes in the input variables and are poor estimates of the value of the option that is ultimately realized. Banks caution that they do not represent the value at which options could be terminated. The difference between a mark to market value for an OTC option on its realized value and expiry date of the option, Professor Klein stated, is very large. The only clear value for Kruger options, in Professor Klein's opinion, was realized value that was determined by payment on the expiry date of the option.
[52] Professor Klein did not agree that Kruger's activities were similar to those of banks notwithstanding Ms. Leclerc's evidence that banks also speculate in foreign options. He stated that a bank facilitates trades for its clients, to facilitate demand and supply of options from these clients. Kruger is one such client and Kruger's position "consisted primarily of well‑known speculative trades". However, there was evidence that banks do speculate at times.
Accounting experts [53] Ms. Leclerc is Senior Manager and Partner, Assurance and Advisory Services at Deloitte & Touche. She is also leader of the firm's Montréal complex accounting group and a Financial Instruments National Subject Matter Expert at Deloitte dealing with hedging and derivative matters. She has worked at Deloitte's San Francisco's office as a member of the firm's U.S. Financial Investment Specialist Group. At time of trial, Ms. Leclerc was the Deloitte representative in the Office of the Superintendent of Financial Institutions, Auditor Deposit Taking Institutions Committee and during 2003 to 2007 was on the Canadian Institute of Chartered Accountants Financial Investments Implementation Committee.
[54] Ms. Leclerc was engaged by the appellant's counsel to report on the application of Canadian generally accepted accounting principles ("Canadian GAAP") to the transactions in issue for the period January 1, 1998 to December 31, 1999 inclusive.
[55] Ms. O'Malley was a partner with the national office of KPMG in 1999 when she left the partnership to become the first full‑time Chair of the Canadian Accounting Standards Board ("CASB") which was authorized by the Canadian Institute of Chartered Accountants ("CICA") to set accounting standards that are applied as GAAP for chartered accountants. The CICA Handbook, she testified, is the product of the work of the CASB.
[56] Ms. O'Malley also served as Vice‑chair of the CASB and as a member of the emerging issues Committee of the CICA which dealt with the interpretation of standards. Gradually, she said, she developed a specialty in accounting standards for financial instruments. In the late 1990s she represented the CASB as part of the Canadian delegation to the Joint Working Group on Financia