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Full Opinion
*30 Decision will be entered under Rule 155.
A1 owned both A2, a wholly owned subsidiary in the oil and gas business, and 80 percent of the stock of N, another corporation in the oil and gas business. P1, also in the oil and gas business, wished to acquire N. As a first step in the acquisition, P1 offered to buy A1's N stock for $ 5 million. At A1's request, so that A1 would not be required, under the Securities Exchange Act of 1934, ch. 404, sec. 16(b), 48 Stat. 881, 896 (current version at
Approximately 6 months after buying A1's N stock, P1 acquired the minority shareholder interests in N in a stock-for-stock reverse merger. A former minority shareholder of N brought a class action against P1 on behalf of the former minority shareholders of N, alleging breach of fiduciary duty by P1 in misrepresenting and failing to disclose the true values of P and N for the *31 purpose of setting the exchange ratio in the merger. P1 incurred costs to defend that suit and deducted those costs as ordinary and necessary trade or business expenses.
C, a wholly owned subsidiary of S, owned oil leases L1, L2, L3, and L4. S wished to sell C. P1 agreed with T to cause C to sell L1 to T if P1 were to acquire C. T agreed to pay P1 $ 1,250,000 more for L1 than the amount that P1 would pay for C. P1, through N, purchased the stock of C for $ 6.5 million, and immediately thereafter caused C to sell L1 to T for $ 7,750,000. During the next 2 years, N continued to hold L2, purchased its coowner's interest in L4, and developed, operated, and then sold L3 and L4 to third parties.
C advanced N $ 1 million 7 months after the ownership change and $ 2,625,946 10 months after the ownership change, taking back interest-bearing demand notes. The advances were canceled less than 13 months after the ownership change, immediately prior to N's distribution of the stock of C to P1.
*586 BEGHE,
Unless otherwise indicated, section references are to the Internal Revenue Code in effect for the years in issue, and Rule references are to the Tax Court Rules of Practice and Procedure.
*587 OVERVIEW OF ISSUES AND CONCLUSIONS
Some issues have been settled, including the deductibility of certain expenses of preparing a registration statement for a postponed public offering of petitioner's stock. The issues remaining for decision are the "Afex option" issue, the "Wiegand litigation" issue, and the "
The Afex option issue concerns the deductibility of the $ 1.2 million ostensibly paid by petitioner to acquire an option that expired unexercised in 1987 to purchase certain Oklahoma gas leases. We hold the claimed loss nondeductible because we find that the payment*34 to acquire the option was in fact part of the purchase price of 80 percent of the stock of a corporation (Norris) acquired by petitioner in the same transaction as the option and from the same interests that granted the option.
The Wiegand litigation issue concerns whether petitioner may currently deduct as ordinary and necessary trade or business expenses the costs of defending a class action lawsuit for breach of fiduciary duty brought on behalf of the minority shareholders of Norris who sold their stock on the public market following petitioner's acquisition of control of Norris (selling class) or who exchanged their Norris stock for petitioner's stock in the merger in which Norris became a wholly owned subsidiary of petitioner (merger class). We find that the Wiegand litigation had its origins in petitioner's acquisition of the Norris stock, and hold that petitioner's costs to defend the Wiegand litigation are not deductible.
The
The parties have stipulated some of the facts, and the stipulations of fact and exhibits thereto are incorporated in our findings of fact.
At all relevant times, Berry Petroleum Co. (Berry or petitioner) was a Delaware corporation, maintaining its principal office in Taft, California. For 1987, 1988, and 1989, petitioner filed Federal consolidated income tax returns, including thereon its subsidiary, Bush Oil Co. (Bush), previously known as Norris Oil Co. (Norris). On the 1988 and 1989 returns, C.J. Co., a wholly owned subsidiary of Bush whose stock had been purchased by Bush in 1988, was also included.
At all relevant times, Norris/Bush had only one class of outstanding capital stock, designated as common stock. Effective December 1, 1986, petitioner purchased 80.56 percent of the stock of Norris from ABEG Hydrocarbons, Inc. (ABEG). Effective June 26, 1987, petitioner acquired the remaining Norris stock, and Norris became*36 a wholly owned subsidiary of petitioner when a new, wholly owned subsidiary of petitioner was merged into Norris. Immediately after the merger, Norris changed its name to Bush.
At all relevant times, Harvey L. Bryant was president, chief executive officer, and a member of the board of directors of petitioner, and Jerry V. Hoffman was petitioner's vice president and chief financial officer.
A. FINDINGS OF FACT
ABEG was a Nevada corporation 100-percent owned by an Australian entity (Entrad, wholly owned by Abraham Goldberg) engaged in real estate development, textiles, and the oil and gas business. American Frontier Exploration, Inc. (Afex), a Delaware corporation, was a wholly owned subsidiary of ABEG engaged in the oil and gas business.
Joseph Stanley Dorobek II was president of both ABEG and Afex until they ceased to exist in 1990, and was also president of Norris until December 1, 1986.
*589 As early as 1983, petitioner had been aware of Norris and had become interested in acquiring Norris' principal asset, Rincon. Rincon consisted of four leases*37 of certain oil-producing properties located in the Rincon field in coastal waters off the coast of Ventura County, California. 1 At some time in 1983 or 1984, petitioner had contacted Norris and discussed the possibility of merging Norris and petitioner, but no action was taken at that time.
Prior to March 1, 1986, ABEG had acquired approximately 42 percent of the issued and outstanding common stock of Norris and had thereby become its largest single shareholder. As a result of Norris' financial difficulties, ABEG and Norris negotiated*38 a financial restructuring during the first half of 1986 under which Norris issued an additional 8,266,666 shares of Norris common stock to ABEG; ABEG in return paid Norris' principal lender $ 1,750,000 in satisfaction of an indebtedness of Norris, paid the California State Lands Commission $ 1 million to provide a sinking fund that would allow Norris to preserve its rights to Rincon, and reduced by $ 350,000 aggregate debt of $ 3,002,700 owed by Norris to ABEG. The restructuring became effective on June 30, 1986, and ABEG's aggregate payments of $ 3.1 million for the 8,266,666 Norris shares represented a per-share consideration of $ 0.375. At that point, ABEG owned 10,097,616 out of a total of 12,596,884 outstanding shares of Norris stock, or 80.16 percent. During July 1986, ABEG purchased an additional 50,000 shares of Norris stock (raising its total Norris holdings to 10,147,616 shares, or 80.56 percent) at a per-share price of $ 0.33.
In late March 1986, petitioner approached Norris' management to discuss a merger or other combination under which petitioner would acquire at least 80 percent of the Norris stock in exchange for shares of petitioner's common stock. Petitioner*39 initiated this approach as a result of publicity concerning Norris' negotiations with its principal lender and the California State Lands Commission. Mr. Hoffman had been familiar with the Rincon field for some time, and Mr. *590 Bryant had tracked the publicly available information. Norris and ABEG rejected petitioner's initial proposal for a stock-for-stock deal. At the time of petitioner's initial approach, ABEG still intended to conduct gas and oil operations through Norris and Afex.
Petitioner continued to seek a merger with Norris. On April 15, 1986, Mr. Hoffman sent a letter to Mr. Goldberg restating petitioner's desire to acquire ABEG's Norris stock in exchange for stock in petitioner. On or about July 24, 1986, Mr. Dorobek, on instructions from Mr. Goldberg, met Messrs. Bryant and Hoffman to discuss petitioner's possible acquisition of Norris. The negotiations which began at this time continued until late September 1986, when petitioner and ABEG entered into an agreement in principle whereby petitioner would acquire all of ABEG's Norris stock for cash.
Petitioner's first written offer for Norris, dated August 25, 1986, was for a merger in which petitioner, in exchange *40 for the issuance of its own common stock, would acquire all of the stock of Norris. The approximate total value of the shares in petitioner that ABEG would have received under petitioner's first offer was $ 5-6 million, a value of approximately $ .50-$ .60 per share of ABEG's Norris stock. After showing initial interest in the offer, Mr. Dorobek, on September 18, 1986, informed petitioner that ABEG did not wish to continue its involvement in Norris' business, and that a stock-for-stock exchange, as opposed to a cash sale, was therefore unacceptable.
In the meantime, on September 9, 1986, Mr. Hoffman had consulted with petitioner's attorneys, and on September 12, 1986, petitioner's board of directors had met and authorized petitioner's management to negotiate with Norris. As early as September 12, 1986, petitioner had intended to form a partnership or joint venture to develop Rincon. Immediately after hearing from Mr. Dorobek of ABEG's rejection of the stock-for-stock deal, Mr. Hoffman and Mr. Bryant discussed a cash purchase. They decided petitioner would be willing to pay approximately $ 5 million in cash for ABEG's Norris stock, amounting to a price of $ .493 per share. On*41 September 18, 1986, Mr. Hoffman telephoned Mr. Dorobek and informed him that petitioner was willing to buy ABEG's Norris stock for $ 5 million in cash.
*591 On September 22, 1986, Mr. Dorobek contacted Mr. Hoffman by telephone and informed him that ABEG was subject to the short-swing profits provisions of the Securities Exchange Act of 1934, ch. 404, sec. 16(b), 48 Stat. 881, 896 (current version at
On September 24, 1986, ABEG faxed petitioner an agreement in *42 principle outlining the terms of the purchase by petitioner of ABEG's Norris stock for $ 3.8 million subject to the negotiation of a definitive agreement and the satisfaction of certain other conditions, including petitioner's guarantee of Norris' "approximately $ 2,800,000" debt to ABEG. This proposal included a provision that would have attempted to solve the section 16(b) problem by increasing the purchase price of the stock by any amount that ABEG would be required to pay to Norris under section 16(b), but this legally problematical provision was crossed out. ABEG also faxed petitioner a separate "Agreement #2 -- Option" by which petitioner would agree to purchase the Afex option for a nonrefundable payment of $ 1.2 million; the full sale price of the Afex properties was to be $ 10,715,215 (less the $ 1.2 million paid for the option, so that the exercise price would be $ 9,515,215), and the option was to remain in effect until March 31, 1987. The prices to be paid for the Afex option and its exercise were ostensibly based on "5 years production and the 10% discounted net cash flow of the proved reserves" of these wells. ABEG also faxed a reserve report by Geological Engineering*43 Consultants, Inc., documenting the valuation of $ 10,715,215 as of June 30, 1986 (GEC reserve report). On September 26, 1986, petitioner accepted ABEG's proposal under the first agreement faxed on September 24.
*592 From September 24 to September 29, 1986, Messrs. Hoffman and Dorobek negotiated the terms of the Afex option. On September 29, 1986, petitioner and Afex executed an agreement in principle under which petitioner was to make a $ 1.2 million nonrefundable cash payment to Afex, in exchange for the right extending over a year to purchase the Afex properties for a total consideration of $ 8,162,000, inclusive of the $ 1.2 million (so that the exercise price would be $ 6,962,000). The only term that remained unchanged from ABEG's initial proposal was the purchase price for the Afex option of $ 1.2 million, the difference between petitioner's initial cash offer of $ 5 million for ABEG's Norris stock and the $ 3.8 million agreed cash payment for ABEG's Norris shares.
As of October 6, 1986, ARCO had not shown any interest in exercising its option on Rincon, and petitioner's management believed that ARCO would not exercise its option. This belief proved accurate, inasmuch as ARCO*44 did not notify Norris of an intent to drill or otherwise exercise the option before its expiration.
Petitioner was concerned that a competitor might purchase ABEG's Norris stock before petitioner's purchase could be finalized and was therefore pushing hard to complete the transaction. On October 6, 1986, petitioner's board met and authorized management to negotiate definitive agreements for the purchase of ABEG's Norris stock and the Afex option. At that meeting, petitioner's management outlined a plan to acquire the remaining shares of Norris in early 1987 by means of a "second step" merger. Petitioner's board took no immediate action on that plan. Petitioner's management also informed petitioner's board that there were two companies interested in acquiring a working interest in Rincon after "the transaction is completed."
On October 8 and November 5, 1986, the closing date for petitioner's purchase of ABEG's Norris shares (and the Afex option) was extended by agreement. On October 10, 1986, Mr. Hoffman met with Dennis Hayes of Arthur Young & Co. to discuss Norris' net operating losses and to begin a tax analysis, which Arthur Young was asked to complete. On October 15, 1986, *45 Messrs. Hoffman and Bryant met with the California State Lands Commission to discuss the operation of the Rincon field. During October and November 1986, there were numerous telephone calls between petitioner's*593 and Norris' management and counsel to negotiate the definitive stock purchase agreement and Afex option and to conduct petitioner's due diligence investigation of Norris. Prior to December 1, 1986, Messrs. Hoffman and Bryant informed petitioner's board of directors that, because of the section 16(b) problem, the only way petitioner could buy the Norris stock was to structure the transaction in the form presented by ABEG, using the Afex option.
On December 1, 1986, the definitive agreements for petitioner's purchase of ABEG's Norris stock and the Afex option were signed, and both transactions closed on that date. Under the final terms of the agreements, petitioner paid $ 3.8 million for ABEG's 10,147,616 shares of Norris stock, guaranteed Norris' debt of $ 2,675,577.92 to ABEG, and paid $ 1.2 million for the Afex option, which was to be exercisable over the following year for an exercise price of $ 6,962,000. 2
*46 On December 1, 1986, the bid price for shares of Norris in the over-the-counter market was $ .50 per share. At this price, ABEG's 10,147,616 shares of Norris were worth $ 5,073,808. The $ 3.8 million price that petitioner ostensibly paid for the Norris stock represents $ .374 per share, which, if given effect, would have eliminated the section 16(b) problem.
Immediately after petitioner purchased ABEG's 10,147,616 shares of Norris stock, the remaining 2,449,268 shares (19.44 percent) (Norris minority stock) were widely held and publicly traded in the over-the-counter market. The headquarters of Norris and petitioner were combined, and petitioner assumed all administrative functions of Norris, including the preparation and dissemination of financial statements, Securities and Exchange Commission (SEC) filings, shareholder communications, and press releases. On December 2, 1986, a new board of directors of Norris was appointed. All members of the Norris' board were either members of petitioner's board, or shareholders of petitioner, or both. On the same day, December 2, 1986, petitioner issued a press release announcing its purchase of the Norris*594 stock and the appointment of*47 new Norris officers and directors.
On or about December 9, 1986, Norris filed a schedule 13D with the SEC. The schedule 13D stated that petitioner had acquired ABEG's Norris stock with the intention of exploring and developing Norris' oil and gas reserves. The schedule also stated that "Berry may purchase or otherwise acquire additional securities of Norris in the future, however, it has not formulated any purchase or acquisition proposals at this time."
On December 12, 1986, petitioner's board held a meeting. At that time, petitioner intended to sell a working interest in Rincon "after the Norris reorganization is completed." Petitioner's management told petitioner's board that in early 1987 petitioner would make presentations to three potential purchasers. 3 Petitioner's management also told petitioner's board that it "will be asked to approve a plan of reorganization of Norris, by which Berry Petroleum Co. will become a public company." Although Norris sent the Norris minority shareholders a letter and report dated December 15, 1986, neither the sale of an interest in Rincon nor the reorganization was mentioned in the letter or the report.
*48 During December 1986, petitioner had discussed with Exxon the possibility of swapping a 50-percent interest in Rincon for a 50-percent interest in another oil-producing property that a third party had purchased in January 1986 for $ 85 million.
In a memorandum dated January 12, 1987, petitioner's management informed petitioner's board of its plan to sell a 50-percent interest in Rincon to another company that would become a partner in the development of Rincon. The memorandum stated that petitioner would need to acquire the Norris minority stock prior to the sale of an interest in Rincon so as to ensure that the price of the Norris minority stock would not be increased. On or about February 18, 1987, Mr. Bryant sent a copy of the January 12 memorandum to a major shareholder of petitioner. The January 12 memorandum was not otherwise distributed outside of petitioner's board.
*595 In a letter dated January 27, 1987, to the California State Lands Commission, Mr. Bryant stated that preliminary budget-type estimates indicate at least $ 60,000,000 will be needed to recover the remaining proved reserves and develop the reserves that additional drilling will prove up. Our lenders are*49 extremely hesitant to lend us these amounts in spite of the strong financial position of Berry Petroleum Co. due to the short-term [sic] of the present royalty schedule -- 5 years commencing July 1, 1986. 4 We are asking that you and your staff recommend to the State Lands Commission that the term of the present royalty schedule be extended from 5 years to 20 years.
On January 30, 1987, petitioner's board met and authorized petitioner's*50 management to negotiate the reverse merger. The exchange values of Norris and petitioner as of March 1, 1987, were to be established by independent petroleum engineers, and the exchange ratio was to be based on those values. Also included in the exchange value of Norris (and therefore in the exchange ratio) were the tax benefits of Norris' net operating loss carryovers and investment tax credit carryovers. These carryovers were estimated to be $ 8.3 million and $ 200,000, respectively. The value of the tax benefit of the carryovers was calculated to be approximately 15 percent of the carryovers, $ 1.3 million.
The Norris board did not hire independent legal counsel to represent Norris, appoint a committee of independent directors to negotiate with petitioner or to evaluate the fairness of the merger, or make the merger subject to a majority vote by the Norris minority shareholders. However, Wedbush Securities, Inc., was hired to issue a fairness opinion on the exchange ratio.
*596 Petitioner and Exxon entered a confidentiality agreement dated February 4, 1987, which was to protect information that Exxon provided to petitioner regarding a lease that was located 4 to 5 miles away *51 from Rincon.
On March 3, 1987, Norris announced that the boards of Norris and petitioner had authorized their respective managements to negotiate a merger agreement. Norris also announced that its estimates of proved developed and undeveloped oil reserves were reduced from 1,576,000 barrels at December 31, 1985, to 112,000 barrels at March 1987, and that its estimates of proved developed and undeveloped gas reserves were reduced from 20,473 million cubic feet at December 31, 1985, to 9,032 million cubic feet at December 31, 1986.
On March 19, 1987, Norris announced that it had suffered a net loss of $ 13,191,500 ($ 1.55 per share) for 1986 as compared to a net loss of $ 2,254,900 ($ .52 per share) for 1985.
On March 20, 1987, the boards of directors of petitioner and Norris discussed at length whether Norris had a claim against ABEG for section 16(b) short-swing profits. On "advice of counsel and management", no action to assert any rights of Norris against ABEG under section 16(b) was ever taken by Norris. The short-swing profits were not valued in the exchange ratio calculated for the merger of Norris and petitioner that occurred on June 26, 1987.
*597 On April 7, 1987, the boards*52 of Norris and petitioner held separate meetings at which each board approved an agreement of merger and an exchange ratio. The agreement of merger stated that Norris was to become a wholly owned subsidiary of petitioner by means of a reverse merger in which a newly formed, wholly owned subsidiary of petitioner, Berry Acquisition Corp., would merge into Norris. The approved exchange ratio was .0333 share of petitioner's stock for each share of Norris stock, and was based on an exchange value of $ .50 per share of Norris and $ 15 per share of petitioner. The most significant components of the calculation of the exchange ratio were the fair market values of the oil and gas reserves of the respective companies. The fair market value of Rincon's reserves on March 1, 1987, was estimated to be $ 2.2 million. This estimate did not include any value for the deep zone of Rincon.
On April 27, 1987, petitioner presented a proposal to Tenneco for a joint venture to develop Rincon. By letter dated May 29, 1987, Tenneco expressed an interest in the proposal, and on May 31, 1987, petitioner and Tenneco entered a confidentiality agreement. Tenneco began a preliminary investigation of Rincon*53 on April 27, 1987, but was not given access to Norris' records until the day after the merger proxy and prospectus were issued. Tenneco continued to investigate Rincon until sometime after June 26, 1987.
A proxy statement and prospectus, dated June 3, 1987 (Norris proxy/Berry prospectus), were mailed to the owners of the Norris minority stock. The Norris proxy/Berry prospectus explained the structuring of ABEG's sale of stock and described the Afex option as follows: During the course of negotiations, ABEG expressed concernts [sic] that, since it was subject to the "short-swing" profit recovery provisions of Section 16(b) of the Exchange Act, any profit it made on the sale of the approximately 8.2 million shares which it purchased as of June 30, 1986 from Norris might be recoverable by Norris if such shares were sold within a six month period. In light of this fact, ABEG informed Berry that it was willing to sell its Norris shares for $ 3.8 million ($ .374 for each Norris share) if Berry also agreed to purchase the AFEX Option described below. Because of Berry's continuing needs for a dependable long-term source of natural gas for its enhanced oil recovery operations, Berry*54 agreed to purchase the AFEX Option on the terms described below. On September 29, 1986 Berry entered into an agreement in principle with American Frontier Exploration, Inc., a wholly-owned subsidiary of ABEG, ("AFEX"), whereby Berry would purchase an option covering certain Oklahoma natural gas wells owned by AFEX. On December 1, 1986, Berry entered into a definitive Option Agreement with AFEX pursuant to which AFEX granted to Berry, for an option price of $ 1.2 million, the sole right to purchase (the "AFEX Option") such natural gas wells for an aggregate purchase price of $ 8,162,000, to be reduced upon exercise of the AFEX Option by the $ 1.2 million option price paid by Berry under the Option Agreement. The AFEX Option continues until November 30, 1987. Berry has not yet made a determination as to whether or not it will exercise the AFEX Option. Such decision will be based upon prevailing conditions in the natural gas market prior to the expiration of the AFEX Option. In the event the Option is exercised, Berry has sufficient unused credit line capacity to fund the purchase price. Berry is also considering selling its rights under the AFEX Option, although no assurance *55 can be given that a buyer will be found or that the price received by Berry would be equal to or greater than Berry's purchase price for the AFEX Option.
The Norris proxy/Berry prospectus went on to describe the expected activities of Norris after the merger as follows: *598 The reorganized Norris will continue the historic business activities of Norris, including the exploration, production, development and sale of oil and gas. Management anticipates that to fully develop the Norris reserves a substantial influx of capital into Norris will be required. Berry may contribute certain of its oil-producing properties to Norris to provide the operating cash flow and capital necessary to fully develop the Norris reserves. Many of the existing wells on the Norris properties must be abandoned or redrilled, and additional capital and qualified technical personnel will be required for the exploration and appraisal drilling needed to fully determine the development potential of the Norris properties. Management believes that the rehabilitation of the Norris operations and properties will likely require outside financing. Although no arrangements or agreements that would provide such financing*56 have as yet been made, various alternatives are being explored, including the use of venture partners to participate in the development of the Norris properties. Management has had preliminary discussions with several parties, including independent and major oil companies, to discuss the possibility of forming a joint venture for the exploration and development of Norris Rincon leases. Norris shareholders should recognize that no assurances can be given that management will be able to find a joint venture partner or other outside financing or to develop the Norris properties as intended. Declines in the price of crude oil could have a substantial adverse impact on Norris ability to obtain financing for its operations.
On June 26, 1987, the shareholders of Norris held a special meeting at which they approved the merger and exchange ratio. Of the 10,909,289 shares of Norris that were voted, 10,808,136 (10,147,616 of which were owned by petitioner) were voted in favor of the merger, 84,595 were voted against the merger, and 16,558 abstained. Not represented at the meeting were 1,686,595 Norris shares held by minority holders.
Effective June 26, 1987, Berry Acquisition Corp. *57 was merged into Norris (Norris merger), and the surviving corporation immediately changed its name to Bush Oil Co. (Bush).
At a meeting on or about July 1, 1987, Exxon proposed a joint venture to develop Rincon, including a cash payment to Bush. Bush counter-proposed a swap involving the same property discussed during December 1986, or $ 10 million in cash plus unspecified future obligations. Exxon was not interested in swapping property interests, but it did make cash offers, none of which petitioner accepted.
In a letter to Bush dated August 7, 1987, the staff of the State Lands Commission stated that it would recommend a reduced royalty rate schedule to the State Land Commission.
*599 In a letter dated August 14, 1987, Tenneco offered to buy a 50-percent working interest in Rincon for $ 12,150,000 and assumption of a disproportionate share of proposed development costs under which Tenneco would pay 75 percent of the first $ 48 million of development costs, amounting to $ 12 million of development costs that Bush would otherwise have been required to pay. Thereafter, following negotiations between Tenneco and Bush, and effective October 1, 1987, Bush sold a 50-percent working interest*58 in Rincon to Tenneco for $ 28.5 million, consisting of $ 13 million in cash and Tenneco's assumption of a disproportionate share of initial development costs under which Tenneco agreed to pay 75 percent of the first $ 62 million of development costs, amounting to $ 15.5 million of development costs that Bush would otherwise have been required to pay.
During the time over which petitioner acquired Norris, petitioner did indeed require natural gas for its operations and was contracting for natural gas supplies from various suppliers in 1986 and early 1987.
ABEG did not believe that petitioner desired to purchase the Afex properties, but did believe that petitioner strongly desired to acquire ABEG's Norris stock. ABEG therefore made petitioner's entry into the Afex option a condition of selling its Norris stock to petitioner. At the time Mr. Dorobek asked petitioner to buy the option, petitioner had done no due diligence on the value of the Afex properties. This was because the Afex option did not enter the negotiations until ABEG conditioned the sale of its Norris stock on petitioner's purchase of the Afex option. By September 29, 1986, when the Afex option was negotiated and *59 entered into, ABEG had only provided petitioner with the GEC reserve report, and petitioner had not done its due diligence on the Afex properties. Mr. Dorobek therefore did not consider $ 8,162,000 to be a firm price. Although negotiations regarding the Afex option had resulted in a lowering of the exercise price and an extension of the option period, the cash price of $ 1.2 million remained constant. After petitioner counter-proposed, in place of the original $ 10,715,215 asking price, the $ 8,162,000 total purchase price for the Afex properties, there were no further negotiations on price. Mr. Dorobek did not believe that petitioner would pay the agreed-upon exercise price of*600 $ 6,920,000, because it was too high and "nobody's going to pay off a reserve report."
The Afex option was unusual in that neither petitioner nor anyone else would have wanted to enter into it as proposed, but petitioner was forced to enter into it in order to be able to purchase ABEG's Norris stock. Gas prices were already substantially depressed by June 1986, but continued to decline slightly from June 1986 to December 1987. 5 The gas contracts on the Afex properties "all had out clauses", which allowed*60 the gas purchaser to get out of the contract; these contracts reduced the desirability of the Afex properties, especially at the relatively low spot price of gas then current.
*61 Petitioner conducted a careful due diligence investigation of Norris' Rincon leases, but only the most perfunctory investigation of the Afex properties. It was not until February 1987 that Raymond L. Hatch, petitioner's manager of engineering, sought the most basic information regarding the Afex option properties, and later that month that answers to some of his questions began to arrive. However, petitioner never attempted to renegotiate downward the $ 6,920,000 exercise price of the Afex option, as Mr. Dorobek expected and would have been amenable to.
In 1987 or 1988, after the Afex option had expired, Afex sold the Afex properties to another buyer, Harken Oil Co., for approximately $ 2 million.
*601 Petitioner's Federal consolidated corporation income tax return for 1987 reported a loss of $ 1.2 million on the lapse of the Afex option, an $ 8,102,283 gain from the sale of the interest in Rincon, and deduction of $ 6,561,927 for the Norris/Bush net operating loss carryovers. 6
*62
The sale of Rincon was publicly announced on September 29, 1987. On October 2, 1987, Jeff Wiegand, a former Norris shareholder, filed a class action lawsuit (Wiegand litigation) in the Court of Chancery of the State of Delaware against petitioner and the directors of Norris. The complaint alleged that Wiegand and the former minority public owners of Norris had been "irreparably damaged by the [Norris] Merger and sustained a substantial loss as a result thereof". In November 1987, petitioner filed an answer to the complaint.
On January 24, 1989, Wiegand filed an amended complaint, which read in part: Plaintiff, by his attorneys, alleges upon information and belief, except as to paragraphs 2 and 3, which are alleged on knowledge: 1. This breach of fiduciary duty - merger fraud class action: (a) (b) (c) Is the result of the fraud on the Norris minority shareholders, perpetrated by defendant Berry - in the "Berry Prospectus" and continuously thereto from December 1, 1986 to the "Norris Merger," as hereafter defined - by misrepresenting and concealing the actual values of Norris, including valuing Norris' Rincon oil field at a mere $ 2.2 million when immediately after the merger, Berry sold a 50% Rincon interest to Tenneco*602 Oil and Production Co. ("Tenneco") for $ 13.5 million plus $ 47.5 million for development costs (the "Rincon Deal"). * * * 5. This action is properly maintained as a class action, in that the Selling Class consists of more than 500 former owners of Norris minority shares; the Merger Fraud Class consists of more than 2,000 former owners of Norris minority shares; and both classes are so numerous that*64 the joinder of all members of each Class is impracticable; Plaintiff is a member of each Class, was irreparably damaged, as herein alleged, and sustained a substantial loss as a result thereof. Plaintiff is committed to pursuing this action, has competent counsel experienced in litigation of this nature, and, accordingly, plaintiff will fairly and adequately represent and protect the interests of each Class and its respective members; there are questions of law and fact common to members of each Class, and plaintiff's claims are typical of the claims of the members of each Class; th