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C. The December 2, 1996, Debt Conversion Transaction
By October 1996, Crispin and Koehler realized that Cap Corp.
was insolvent with obligations that were several multiples of its
assets. They also realized that Cap Corp.’s poor financial
condition was negatively affecting CKS’s operations. Hence, they
formulated a debt conversion transaction whereby: (1) Crispin
and Koehler would establish a new corporation; (2) that new
corporation would assume substantially all of Cap Corp.’s
outstanding debt to petitioner, in exchange for receiving Cap
Corp.’s 100-percent stock ownership interest in CKS; and (3)
petitioner would cancel all but $100,000 of the Cap Corp. debt
assumed by the new corporation, in exchange for a preferred stock
in the new corporation.
On or about October 22, 1996, Crispin and Koehler
incorporated Crispin Koehler Holding Corp. (CKH), a California
corporation. Crispin’s and Koehler’s respective stock ownership
interests in CKH were the same as their then-respective stock
ownership interests in Cap Corp.--9 percent for Crispin and 91
percent for Koehler. CKH’s place of business was the same as
petitioner’s.
On December 2, 1996, Cap Corp., CKH, CKS, and petitioner
effected a debt conversion transaction relieving Cap Corp. of
$2.259 million of its debt to petitioner. This debt relief for
Cap Corp. was accomplished through the following two steps: (1)
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