1 BEFORE THE CALIFORNIA STATE BOARD OF EQUALIZATION 2 450 N STREET 3 SACRAMENTO, CALIFORNIA 4 5 6 7 8 REPORTER'S TRANSCRIPT 9 SEPTEMBER 16, 2015 10 CORPORATE FRANCHISE AND PERSONAL INCOME TAX HEARING 11 APPEAL OF 12 JOHN NAFEH AND URSULA G. BURGER NAFEH 13 NO. 785086 14 AGAINST PROPOSED ASSESSMENT OF 15 ADDITIONAL INCOME TAX 16 17 18 19 20 21 22 23 24 Reported by: Juli Price Jackson 25 CSR No. 5214 26 27 28 1 1 P R E S E N T 2 For the Board Jerome E. Horton of Equalization: Chairman 3 4 Sen. George Runner (Ret.) Vice-Chairman 5 6 Fiona Ma, CPA Member 7 8 Diane L. Harkey Member 9 10 Yvette Stowers Appearing for Betty Yee, 11 State Controller (per Government Code Section 12 7.9) 13 Joann Richmond 14 Chief, Board Proceedings Division 15 16 For Board of Mai Tran Equalization Staff: Tax Counsel III 17 Legal Department 18 Grant Thompson Tax Counsel IV 19 Legal Department 20 21 For Franchise Tax Judy Hirano Board: Tax Counsel 22 Ciro Immordino 23 Tax Counsel 24 For Appellant: David B. Porter Attorney 25 John Nafeh 26 Taxpayer 27 Ursula G. Burger Nafeh Taxpayer 28 ---oOo--- 2 1 450 N STREET 2 SACRAMENTO, CALIFORNIA 3 SEPTEMBER 16, 2015 4 ---oOo--- 5 MR. HORTON: Good afternoon, Members and 6 guests. Let us reconvene the meeting of the Board 7 of Equalization. 8 Ms. Richmond, what is our next matter? 9 MS. RICHMOND: The Board Members met in 10 closed session. And they discussed settlements and 11 personnel matters. 12 So, our next item is B3, John Nafeh and 13 Ursula G. Burger Nafeh, please come forward. 14 And this taxpayer was granted an additional 15 five minutes for their opening presentation. 16 MR. HORTON: Thank you. 17 As the taxpayer comes forward, as well as 18 Ms. Tran, and settles in, we would ask that Ms. Tran 19 introduce the issues in this case, at her 20 convenience. 21 MS. TRAN: Good afternoon, Chairman, Board 22 Members. 23 The issue before us in this appeal is 24 whether the Appellants' corporation is considered a 25 qualified trade or business for purposes of this 26 qualified small business stock exclusion. 27 MR. HORTON: Thank you. 28 Welcome to the Board of Equalization. You 3 1 have 15 minutes to make your presentation. We will 2 return and allow you five minutes on rebuttal. 3 At your convenience. Please introduce 4 yourselves for the record, though. 5 MR. PORTER: Thank you, Chairman Horton and 6 Members of the Board. 7 My name is Dave Porter. I represent John 8 and Ursula Nafeh. And I'm appearing with both of 9 them sitting right next to me. 10 John and Ursula Nafeh were shareholders in 11 a company called HedgeStreet, which was the first 12 internet-based, fully non-intermediated market 13 exchange for futures contracts. 14 It was a computerized web-based exchange, 15 similar to a retail online business that sells its 16 own products. 17 When HedgeStreet was sold in 2007, the 18 Nafehs reported their gain and claimed the 50 19 percent exclusion of the gain on sale of a qualified 20 small business stock, Q. S. B. S., as allowed by 21 Internal Revenue Code Section 1202 and the 22 conforming California Revenue and Taxation Code, 23 18152.5. 24 The FTB is contesting whether HedgeStreet 25 is a qualified trade or business. That is the 26 primary question. 27 We have handed out three exhibits. And I'd 28 like to identify those. The first one is the 4 1 relevant subdivision of the statute. 2 The second is a Commodity Futures Trading 3 Commission press release dated February 20th, 2004, 4 providing a full description of HedgeStreet as a 5 marketplace exchange. 6 And the third exhibit is a declaration from 7 Gregory J. Robbins, HedgeStreet's former outside 8 legal counsel, and an expert in commodities laws and 9 future exchanges to serve as his testimony in this 10 hearing. 11 I would now like to ask John Nafeh to tell 12 you about HedgeStreet and explain how it functioned. 13 DR. NAFEH: Thank you. 14 I want to thank the Board that they give us 15 the opportunity to address the issue. 16 And I thank the Board again giving us 17 more -- five minutes more because I wanted to 18 explain what really the statute's about. 19 Once we understand what is the statute 20 about, all of those questions would be answered in 21 this statute. 22 So, the statute objectives, as old as Adam 23 Smith, in his book, "The Wealth of Nation." In 24 1776, he outlined what makes the economic prosperity 25 of a nation. He came with one thing, that new ways 26 to invent new revenue. And this is the foundation 27 of prosperity of any nation. 28 And, of course, for the Board to 5 1 understand, new revenue means new taxes. And this 2 was the whole thing. 3 I was told that Prime Minister Margaret 4 Thatcher had a paperback of this book in her handbag 5 all the time she was the Prime Minister of England. 6 And she renovated the whole structure in the UK. 7 This takes me about what is the legislators 8 did of bringing this statute? The legislators were 9 to encourage the creation of new revenue, 10 encouraging the creation of new revenue is 11 encouraging more taxes. 12 So, what they did in the statute, they -- 13 the statute intended to simulate -- stimulate 14 investment in a defined new small business by 15 affording the investor the opportunity to seclude or 16 defer some or all of their gain from sales of the 17 stock. 18 Because the investor at that time -- 19 because it's new revenue, has a lot of risk. And 20 the statute wanted to reward the investor that 21 they're investing in a very high risk position. 22 They said we are going to take care of you, give you 23 a tax break. 24 So, it was a quid pro quo. I believe the 25 legislators were, in their best, brilliant in 26 authoring this statute. 27 Okay. I go -- I look at the statute in 28 front of you. What's the statute? What the 6 1 legislator wanted to do? How they can list in new 2 revenue? And they don't know what is new revenue. 3 Thirty years ago if you told everybody the 4 new revenue would be the internet, nobody would have 5 known what is the internet. 6 And this is why -- what is unique about 7 this statute, they did it the other way. They said, 8 "Let us take all of the legacy revenue 9 out and it can't be part of the legacy 10 revenue." 11 And this is how they defined the new 12 revenue because they didn't know. And we don't know 13 what tomorrow's new revenue will be. 14 And the statute defined qualified trade or 15 business means innovative business other than. So, 16 they use the negation, not defining the business 17 itself. Trade or business involving a performance 18 of services in the field of health, law, 19 engineering, architecture, and so on. 20 All the worth -- the principal asset of the 21 trade of the business is the reputation of skill of 22 one or more employees. 23 If you look at all of this businesses, what 24 is common with them? All what is common with them, 25 performance of service. And their assets is the 26 scale and the reputation of one or more. 27 HedgeStreet was not performing of business. 28 HedgeStreet was the first regulated exchange of its 7 1 kind in the nation in the early years of the 2 internet. 3 It was -- and this is what C. F. T. C. 4 wrote in the exhibition, fully electronic. There is 5 no people serving anybody. It's fully electronic, 6 non-intermediated. So, there's no mediation in it, 7 and over the internet. 8 So, if anybody read fully electronic, 9 non-intermediated, over the internet and someone 10 said you're serving the people like law firm, like 11 accounting firm, you can't -- you can't prove false 12 negative. 13 And, on the top of that, HedgeStreet assets 14 was not the asset of one or more employees. 15 HedgeStreet asset was the internet platform that 16 people trade in it and the license from the 17 government, from the federal government, to operate 18 such platform, this is the only asset HedgeStreet 19 had. 20 And, by the way, it -- just for you -- for 21 me coming to the idea and has been recommended and 22 adopted and they encouraged to see if it -- to see 23 to approve this application was popular. Last year 24 Nobel prize winner and Phil McBride Johnson was the 25 formerly Chairman of C. F. D. C., both of them went 26 C. F. D. C. and said this is a new concept and the 27 whole country will benefit from it. 28 And when we look at personnel, there was 8 1 nobody advising anybody for investment. As a matter 2 of fact, HedgeStreet was like eBay, eliminating the 3 need for auction house, which eBay did. 4 HedgeStreet eliminated the need for any 5 kind of broker, of middleman. 6 The second part of the -- I don't know how 7 many minutes I still have? 8 MR. HORTON: Madam -- 9 MS. RICHMOND: You still have seven 10 minutes. 11 DR. NAFEH: Seven? 12 MR. HORTON: No, one, but do your best. 13 DR. NAFEH: Okay. The second part, which 14 is part -- Section B, saying have to include 15 banking, insurance, financing, leasing, investment 16 or any other business. 17 What is common in all of those businesses 18 is that they put capital at risk. This was what we 19 do. Any insurance, banking, financing, investing -- 20 they put capital at risk. 21 But the profitability of HedgeStreet was on 22 the volume of the trading. HedgeStreet never put 23 capital at risk, never invested for itself or 24 others, and never had any fiduciary obligation to 25 its member. 26 Any investment of insurance have obligation 27 to their investor. HedgeStreet, as an exchange, 28 doesn't have any obligation to their member. 9 1 And this really -- in -- in this respect, 2 HedgeStreet is much more like an internet company 3 selling the product, than it is like a bank, 4 insurance, financing and leasing. 5 And Exhibit No. 3 is done by Greg Robbins, 6 who is one of the few experts in the field in the 7 country. He was a lawyer handling this to see if -- 8 to see to HedgeStreet, but he left. He's now the 9 C. O. O. of a company, $13 billion company, and he 10 signed the declaration under the penalty of perjury. 11 If anybody can think somebody managing $13 12 billion company and perjuring himself on a cert, you 13 know, a hand -- anyway. 14 The last thing really I wanted to say, 15 because this took from us seven years now we have 16 been debating this. 17 And, unfortunately, the FTB denied our 18 protest. The conclusion is in violent contradiction 19 with the statute. 20 And I believe it's either due to that they 21 really didn't read or understood this statute or 22 they were more interested in raising tax revenue at 23 any cost, that they just didn't care what the -- 24 what did the statute mean. 25 My wife and I have been overwhelmed and 26 over burdened by FTB myriad of mysterious and 27 exhaustive argument for seven years about what 28 HedgeStreet was. I'm still wondering what they 10 1 think it was. 2 Given all the written brief we submitted, 3 expert witness, the exhibits you have and my 4 explanation about the genealogy of this statute, we 5 appeal to the Board to protect this unjust and wrong 6 assessment of the FTB and remove this burden on me 7 and my wife. 8 You are the nation's only elected tax 9 board. And I believe you are the good and just. 10 Thank you. 11 MR. HORTON: Thank you very much. 12 Does that conclude? 13 MR. PORTER: Our opening, yes. 14 MR. HORTON: Members, we'll now go to the 15 Department. 16 The Department has 15 minutes to make their 17 presentation, to the extent they need it. 18 We'd ask you commence your introductions 19 for the record. 20 MS. HIRANO: Mr. Chairman, Members of the 21 Board, I'm Judy Hirano. Beside me is Ciro 22 Immordino. We represent the Franchise Tax Board. 23 The issue here is whether HedgeStreet, an 24 online futures exchange, was a qualified trade or 25 business for purposes of a qualified small business 26 stock exclusion so that Appellants may exclude 50 27 percent of the gain from the sale their stock in 28 HedgeStreet. 11 1 The evidence is HedgeStreet was not a 2 qualified trade or business for several independent 3 reasons or grounds. 4 First, its principal asset was the skill 5 and expertise of Appellant husband. 6 Next it performed financial services. In 7 addition, it provided brokerage services. 8 Finally, it was an investing or similar 9 business. 10 Each of these is a separate and independent 11 ground on which your Board may determine HedgeStreet 12 was not a qualified trade or business. 13 HedgeStreet was formed in 2000. Appellant 14 husband, a co-founder with a Ph.D. from Stanford in 15 decision and risk analysis was instrumental in 16 developing the algorithms and software that created 17 the HedgeStreet internet electronic exchange. 18 Because the principal asset of 19 HedgeStreet's business was Dr. Nafeh's expertise and 20 skill in designing and developing the electronic 21 trading system, HedgeStreet was not a qualified 22 trade or business. 23 In fact, Dr. Nafeh received a patent for an 24 invention that is the HedgeStreet internet-based 25 electronic futures trading system. He first filed a 26 patent application in 2000 and in 2005 filed the 27 patent application that was approved in 2010. 28 HedgeStreet was the first internet-based 12 1 government regulated online exchange where traders 2 could purchase at low cost futures contracts based 3 on the performance of economic -- of the economic 4 index at a future time. 5 The traders interacted directly with the 6 trading facility, without a third party intermediary 7 or broker. 8 HedgeStreet also settled the futures 9 accounts, futures of contracts purchases sold on its 10 online exchange. 11 Only HedgeStreet -- Dr. Nafeh designed and 12 created the futures contracts. HedgeStreet offered 13 two types of futures contracts based on economic 14 indices, such as interest or mortgage and rates and 15 housing prices. 16 First, HedgeStreet offered binary options. 17 That is, there are only two possible outcomes and 18 the PL was either zero or $10. 19 And an option might be that the price of 20 gold on October 16, 2015 will be greater than $1200. 21 The two possible outcomes are the price of gold will 22 be greater than $1200 or the price of gold will be 23 less than or equal to $1200. 24 The option with the actual outcome will 25 earn a $10 payout; the opposing option will earn a 26 zero payout. 27 HedgeStreet also offered futures contracts 28 with a variable payout between zero and $10 13 1 depending on where the underlying economic index 2 finished in relation to the range. 3 Appellants purchased HedgeStreet stock in 4 2001 and sold the stock in 2007. In 2004 5 HedgeStreet obtained approval from the United States 6 Commodity Futures Trading Commission to operate as a 7 trading facility and clearinghouse under the Federal 8 Commodity Exchange Act. 9 In 2001 and again in 2005, dr. Nafeh 10 applied for patent for an invention that was the 11 HedgeStreet electronic trading facility. 12 Clearly HedgeStreet's principal asset was 13 Dr. Nafeh's expertise and skill in designing the 14 HedgeStreet electronic trading facility, thus, 15 HedgeStreet was not a qualified trade or business 16 for purposes of a qualified small business stock 17 exclusion. 18 Separate and independent reasons 19 HedgeStreet was not a qualified trade or business 20 for purposes of the Q. S. B. S. exclusion are that 21 it performed financial services and brokerage 22 services and it was an investing or similar 23 business. 24 Initially it is instructive to examine the 25 purpose of a Q. S. B. S. exclusion and to ascertain 26 the legislative intent in enacting the Q. S. B. S. 27 statute. 28 The California Q. S. B. S. statute is 14 1 modeled on the federal statute, which was enacted as 2 part of legislation providing tax incentives for 3 investment and jobs aimed at small businesses, 4 distressed communities, and the working poor. 5 In addressing what the legislature intended 6 in enacting the Q. S. B. S. exclusion, the first 7 step in determining the legislative intent is to 8 look at the language of the statute. 9 The legislature intended that certain types 10 of businesses would not be eligible for the 11 Q. S. B. S. exclusion and defined qualified trade or 12 business by exclusion. 13 The Q. S. B. S. statute excludes from being 14 a qualified trade or business a business that 15 performs services in specified fields, such as 16 financial services and brokerage services. 17 The statute also excludes from being a 18 qualified trade or business any banking, insurance, 19 financing, investing or similar business. 20 In addition, the statute excludes from 21 being an eligible corporation a regulated investment 22 company, a real estate investment trust and a real 23 estate mortgage investment conduit or R. E. M. I. C. 24 The statutory exclusions reveal a 25 legislative intent to exclude service industries and 26 financial investing businesses. 27 Here HedgeStreet was an investing or 28 similar business and provided financial and 15 1 brokerage services, thus, it was not a qualified 2 trade or business. 3 First, HedgeStreet's revenue was driven by 4 traders buying and selling financial instruments on 5 on the online trading facility, with a goal to make 6 a profit. Thus, it was an investing or similar 7 business. 8 Second, there were no third party 9 intermediaries or brokers on the HedgeStreet 10 exchange, thus the HedgeStreet electronic trading 11 system, in essence, provided brokerage services in 12 matching buyers and sellers of the futures contracts 13 traded on the online exchange and in charging an 14 exchange fee, comparable to a brokerage commission. 15 Third, as an automated clearinghouse, 16 HedgeStreet maintained and monitored traders' 17 accounts. 18 HedgeStreet settled the futures contracts 19 between the traders and adjusted their accounts 20 based on the outcome of the contracts. It also paid 21 interest on certain account balances. HedgeStreet, 22 thus, provided financial services. 23 In the context of the statutory scheme, 24 given the legislative intent disclosed in the 25 language of the statute, specifically the types of 26 businesses excluded from being an eligible -- being 27 eligible for the exclusion, HedgeStreet's business 28 was not a qualified trade or business for purposes 16 1 of the Q. S. B. S. exclusion. 2 HedgeStreet was not a qualified trade or 3 business on several independent grounds. 4 First, the principal asset of its business 5 was the skill and expertise of Appellant husband. 6 Second, it provided brokerage services. In 7 addition it provided financial services. 8 Finally, it was an investing or similar 9 business. 10 Your Board may determine HedgeStreet was 11 not a qualified trade or business on any one have 12 these independent grounds, thus, Appellants are not 13 entitled to a 50 percent exclusion of the gain from 14 the sale of their stock in HedgeStreet. 15 Respondent requests that your Board sustain 16 its action in this matter. 17 Thank you. 18 MR. HORTON: Thank you. On rebuttal, 19 please. 20 MR. PORTER: Thank you. 21 The FTB maintains that the intellectual 22 property algorithm and patent of John Nafeh falls 23 under the language of the statute that references 24 the skill of an employee being a principal asset of 25 the business. 26 Such a novel interpretation would subject 27 a company like Intel or eBay or Amazon to the 28 exception to the statute, since they probably have 17 1 thousands of patents. But they do not perform any 2 services at all. They sell things. 3 Look it comes down to whether consumers or 4 customers went to HedgeStreet because John Nafeh's 5 reputation and because they wanted him to provide a 6 personal service for them, or whether they went to 7 HedgeStreet at any time of the day or night to 8 purchase a product over the internet without talking 9 to anyone. 10 There are only three legal authorities in 11 existence and they all support the taxpayers. 12 The first is the statute itself. The BOE 13 acknowledged in a letter dated -- to the parties 14 dated October 21, 2014, the legislative intent and 15 many versions of the statute passed by Congress 16 contain the word "other," such that it says, 17 "Any business involving the performance 18 of services in the fields of health, law, 19 financial services, brokerage services or 20 any other business, where the reputation or 21 skill of one or more of its employees is 22 the principal asset of the business." 23 The only other authorities in existence on 24 our specific issue are private letter ruling 2014, 25 36001, issued by the Internal Revenue Service, and 26 an opinion by the United States Tax Court in John P. 27 Owen versus Commissioner, T. C. Memo 2012-21. 28 Both interpreted the performance of 18 1 services to mean services performed by a person in 2 the form of individual expertise, like advice, or 3 something somebody does for a customer. 4 The private letter ruling involved 5 a company that operated in the pharmaceutical 6 industry. It aided clients in the commercialization 7 of experimental drugs. The company's main business 8 activities were researching the effectiveness of 9 drug formulations, conducting clinical tests and 10 manufacturing drugs. The IRS explained that the 11 thrust -- the thrust of the statute is that 12 businesses are not qualified businesses if they 13 offer value to customers primarily in the form of 14 services and, quote, 15 "The company is not in the business of 16 offering service in the form of individual 17 expertise." Unquote. 18 Despite recognizing the company's clear 19 connections to the pharmaceutical industry, which is 20 a component of the health industry, a clearly 21 prohibited field, the IRS ruled that the company's 22 activities did not amount to the performance of 23 services in the health industry, like visiting a 24 doctor. 25 Similarly, HedgeStreet received its revenue 26 from third parties who bought and sold its products 27 over the internet. 28 It was not in the field of performing 19 1 financial services, like visiting an investment 2 advisor. 3 The Tax Court case, John P. Owen versus 4 Commissioner involved a company that created and 5 sold pre-paid legal service policies, tax-deferred 6 annuities, and insurance-related financial products. 7 The founder, Mr. Owen, was a seasoned 8 insurance salesman with forty years of expertise. 9 The Tax Court stated it had no doubt that 10 the success of the company was properly attributable 11 to Mr. Owen, however, the court said Mr. Owen did 12 not sell in his personal capacity. 13 Accordingly, even though the company 14 provided estate planning services, the Tax Court 15 held that the company qualified as Q. S. B. S. 16 because it earned its money by selling legal and 17 estate planning service policies and because the 18 taxpayer did not personally participate in the 19 selling. 20 Similar to Mr. Owen, Appellant John Nafeh 21 may have been instrumental in developing and 22 obtaining the patent and algorithm used by the 23 company for the automated internet clearinghouse. 24 But HedgeStreet received its revenue from 25 third parties who purchased its products over the 26 internet. Mr. and Mrs. Nafeh did not perform 27 selling services in their personal capacity. No one 28 performed any professional services. 20 1 In conclusion, the private letter ruling 2 and the Owen case both define the performance of 3 services in the subdivision of the statute to mean 4 personal, individual expertise. 5 We would ask that the Board please deny and 6 reject the Franchise Tax Board Notice of Action. 7 Thank you. 8 MR. HORTON: Thank you very much. 9 Discussion, Members? 10 Member Harkey. 11 MS. HARKEY: Hi, thank you. 12 These questions are for the taxpayer. 13 What -- you had employees? 14 DR. NAFEH: Yes. 15 MS. HARKEY: How many employees did you 16 have? 17 DR. NAFEH: Between -- it started few and 18 that's end 40, around 40. 19 MS. HARKEY: About 40 towards the end, 20 okay. 21 What was their function? 22 DR. NAFEH: They were engineers working on 23 the platform because the platform needs maintenance. 24 None -- not one of them has brokerage 25 license. No one of them received a call and 26 answered it. 27 Nobody is in performing services. They 28 were electronic engineers, keeping the platform 21 1 alive. 2 MS. HARKEY: Okay. Were there any 3 employees licensed brokers or agents? 4 DR. NAFEH: No. 5 MS. HARKEY: Okay, thank you. 6 DR. NAFEH: Because this is Commissioner -- 7 any broker of anything they have a license. 8 We didn't have anybody has a license 9 because we don't need it. 10 We -- HedgeStreet was not a broker like FTB 11 saying for good reason, and this is very abundantly 12 clear for you. You wanted taxes. HedgeStreet was 13 not a broker because the brokers -- the balance 14 sheet is subjected -- if anybody sues them, the 15 balance sheet in this and also they have a fiduciary 16 responsibility to any consumer to do the basic 17 execution for -- exchange in general don't have 18 this. 19 MS. HARKEY: Okay, thank you. 20 HedgeStreet -- HedgeStreet did charge its 21 companies a fee per transaction. How much was the 22 fee and how did is that work? 23 DR. NAFEH: As I remember, it was $1 or $2. 24 It was not -- because the whole issue when I came 25 with the idea how to democratize selling futures and 26 so on. 27 And this why Bob Schiller and the Chairman 28 of C. F. T. C. acknowledged it, how do democratize. 22 1 And if you really look at the statute, the 2 statute -- there is no difference on its exchange 3 fees also noted above the clear intent of this 4 statute not to apply to businesses that generate 5 fees from commission, but instead to apply to 6 professional services -- a lawyer, an accountant. 7 And why -- why it became a (unintelligible) 8 because the professional of service of assets, 9 therefore, is the skill and reputation of them. 10 MS. HARKEY: Right. 11 DR. NAFEH: You go to a doctor because you 12 hear about a good doctor. 13 You go to a lawyer in a law firm, same 14 thing. 15 And this is why in this statute, having all 16 of this professional, first, it's very important 17 that its reputation of skill of the employee. 18 MS. HARKEY: Okay. This was -- this was, 19 in essence, just an online service? 20 DR. NAFEH: eBay. 21 MS. HARKEY: Well, let your -- 22 MR. PORTER: Can I add also that the one 23 fact that needs to be explained also is HedgeStreet 24 was selling its own products. It's -- the exchange, 25 so, nobody had to deal with anyone else -- go 26 through anyone else, an exchange, like the New York 27 Stock Exchange, N. A. S. D. A. Q., this is now the 28 new exchange over the internet. 23 1 But other products weren't on the exchange. 2 HedgeStreet developed its own products and sold the 3 products on its exchange. 4 MS. HARKEY: And one of the interviews that 5 was used to present the case, one of the interviews 6 it was stated by, I believe, the founder, that 7 HedgeStreet clients had an account at a bank, and 8 that they -- that there was a minimum amount for 9 this account. And they would set up a HedgeStreet 10 account, is how canDR. NAFEH: Trust account. 11 MS. HARKEY: -- yeah, a trust account. 12 And, so, you kept those accounts? And did 13 you pay then interest on -- on accounts? 14 DR. NAFEH: With the C. F. T. C., they said 15 we -- you cannot keep that account. The account has 16 to be trust account and is owned by the customer. 17 We paid interest for more than $1,000 18 because some people complained how come we have more 19 $1,000 and we didn't have any interest. 20 We just passed the interest the bank paid 21 to them, but we -- the question really -- did we 22 take their money and invested and paid their 23 interest? Was no. We would passing the interest 24 for operational purposes. 25 MS. HARKEY: Okay. So, you did take 26 accounts? You had accounts? 27 DR. NAFEH: Yes. 28 MS. HARKEY: You had trust account at the 24 1 bank -- 2 DR. NAFEH: Yes. 3 MS. HARKEY: -- and each person -- 4 DR. NAFEH: Yes. 5 MS. HARKEY: -- and you take care of the 6 accounts? 7 DR. NAFEH: Yes. 8 MS. HARKEY: And then when -- in essence, 9 the bank paid you interest on, you distributed that 10 on a pro rata share? 11 DR. NAFEH: Yes, because it wasn't 12 investment. 13 HedgeStreet never invested for itself or 14 others. 15 It's operation, it's platform. 16 MS. HARKEY: And the purpose of keeping the 17 dollars on file or in the account was for what? 18 MR. PORTER: The purpose of the -- keeping 19 the money in the account was the people had to -- to 20 put up money so that if they lost, the money was 21 there, available. 22 MS. HARKEY: Right. 23 DR. NAFEH: The purpose they put their 24 money because they come to the platform and trade. 25 The system it check if they have money or 26 not. If they don't have money, they cannot trade. 27 MS. HARKEY: Okay. Okay, but there was no 28 communication, no -- 25 1 DR. NAFEH: Not one single communication, 2 not an advice. 3 We are not performing advice, you know. 4 MS. HARKEY: You just set up a website? 5 DR. NAFEH: Yes. 6 MS. HARKEY: Okay. 7 DR. NAFEH: And they see -- the Commodity 8 Future Trading Commission, we were under their eyes. 9 We couldn't do anything. 10 And -- for just one more point here, if we 11 were broker or investment advisor, or all of those, 12 those are licensed by another government agency -- 13 in terms of future, it's National Futures 14 Association; in terms of stock and the other 15 investment, it's F. R. A., Financial Regulation 16 Agency. 17 So, we never had any one of those because 18 we are a C. F. T. C. umbrella, we don't care 19 about -- you know, we're not allowed. 20 MS. HARKEY: Okay, thank you. 21 DR. NAFEH: Thank you. 22 MR. HORTON: Thank you. Further 23 discussion, Members? 24 Member Ma. 25 MS. MA: So, let me ask the taxpayer. So, 26 I hear eBay? 27 DR. NAFEH: Yes. 28 MS. MA: So, Pierre -- who was the inventor 26 1 of eBay. 2 Pierre -- 3 DR. NAFEH: Omidyar. 4 MS. MA: -- Omidyar invented eBay in 1995, 5 right? 6 DR. NAFEH: Yes. 7 MS. MA: He, I'm sure, developed patents. 8 DR. NAFEH: Yes. 9 MS. MA: But people did not go to eBay 10 because of Pierre. 11 DR. NAFEH: Of course, they didn't even 12 know his name. 13 MS. MA: Okay. So, similar to your -- your 14 platform -- 15 DR. NAFEH: Yes. 16 MS. MA: -- they didn't come to because 17 Dr. Nafeh invented eBay and we're going to get some 18 sort of wisdom or be able to talk to him -- 19 DR. NAFEH: No. 20 MS. MA: -- or get some advice from him or 21 you send out, I don't know -- by being on 22 HedgeStreet they're going to get some sort of 23 advantage or advice from you? 24 DR. NAFEH: No. 25 MS. MA: I mean -- 26 DR. NAFEH: Never happened -- 27 MS. MA: It was -- 28 DR. NAFEH: -- never. Actually, most of 27 1 the people -- all of the people came, they didn't 2 even know John Nafeh existed. 3 MS. MA: Okay? 4 DR. NAFEH: For the -- in the same way they 5 never really knew Pierre existed. 6 MS. MA: Okay. So, when we talk about the 7 trade or service to the Franchise Tax Board, it 8 says, 9 "Or any trade or business where the 10 principal asset of such trade or business 11 is the reputation or skill of one or more 12 of its employees." 13 The Franchise Tax Board -- right? 14 So, when I read this paragraph it has to do 15 with professionals, like lawyers, accountants, you 16 know, all these people, financial service 17 consultants, athletes, people who have get a license 18 and who advertise their service where people will 19 actually go because they want to have that skill or 20 service by that person. 21 That's how I read paragraph A. I'm just 22 ask you -- I know you're -- you're saying that it is 23 the principal asset was Dr. Nafeh. 24 But what I'm hearing is that it is like in 25 eBay, people didn't go to their platform to trade 26 because of Dr. Nafeh. 27 MS. HIRANO: We're not saying that his 28 reputation was the principal asset of HedgeStreet. 28 1 We're saying his skill and expertise in 2 being able to develop this online trading facility 3 with -- it's called, I think, a time price priority 4 algorithm to be able to match these offers and bids 5 to sell and buy futures contracts, this is pretty 6 intricate work. 7 It's not just, you know, setting up a 8 website. And this -- this skill that he had was a 9 principal asset of HedgeStreet because without this, 10 there would have been no HedgeStreet trading 11 facility, without his skill and expertise. 12 MR. PORTER: If I may add -- 13 MS. MA: It could have been anybody that 14 developed the patents. 15 MS. HIRANO: Except Dr. Nafeh did. He -- 16 you know, he did apply for it and did receive the 17 patents for this -- this particular -- as a new 18 invention. 19 Because, you know, you can't just duplicate 20 and get a, you know, a patent for something that's 21 duplicative of what's already existing. 22 So, it was a new -- it was a new type of 23 trading facility with various -- he had worked into, 24 for example, what he mentioned that consideration 25 was the amount of funds available to the trader, so 26 the trading facility would not allow trades if a 27 trader did not have sufficient funds. 28 And, so, that was part of monitoring the 29 1 accounts. You know, it was a sophisticated, online 2 facility. Because there's no intermediary -- no 3 third party intermediary, the electronic system need 4 to do -- needed to do the matching between the 5 traders' contracts to know when, you know, they were 6 matched, and so forth. 7 It was not just a -- simply opening a 8 website. 9 DR. NAFEH: Can I just add one thing to the 10 lady? 11 MS. MA: Okay, Dr. Nafeh. 12 DR. NAFEH: I didn't develop the algorithm 13 or the trading system. HedgeStreet bought it -- 14 bought it from eSpeed. 15 I didn't develop any of this stuff. 16 HedgeStreet -- we -- we bought it from a company 17 called eSpeed, which is part of a major company 18 in -- in New York. 19 MS. MA: Okay. So, how does that change 20 your last response now -- 21 MS. HIRANO: Well -- 22 MS. MA: -- if he did not develop the 23 patent? 24 MS. HIRANO: He did not -- so, he got a 25 patent. 26 DR. NAFEH: No, I developed the patent. 27 MS. HIRANO: Is that what he's saying now? 28 I don't quite understand. 30 1 DR. NAFEH: No. The exchange -- she is 2 saying because my expertise I developed the 3 exchange. 4 I said I didn't develop the exchange. The 5 exchange was bought from a company in New York 6 called eSpeed. I didn't develop it. 7 MS. MA: Okay. So, he has no expertise 8 now. He didn't develop it. 9 So, how does that change your last 10 statement? 11 MS. HIRANO: Well, I think the patent 12 speaks for itself. 13 MS. MA: But he bought the patent. 14 MS. HIRANO: Pardon me? 15 MS. MA: He bought the patent, he didn't 16 develop -- 17 DR. NAFEH: No, no. 18 MS. HIRANO: No, no. He -- he was the -- 19 he applied for this patent. The patent is in his 20 name, John Nafeh, applying for the patent. 21 And he had previously applied for another 22 patent under his name, so -- 23 MS. MA: Okay. 24 DR. NAFEH: So, there is two things here -- 25 the lady said patents and the exchange. 26 And my expertise -- I am the one who 27 developed all of the sophisticated algorithms and so 28 on. 31 1 I'm saying, I applied and got the patents. 2 This is the idea. 3 But the exchange itself, I didn't develop. 4 The company bought the exchange -- all the intricate 5 things they're talking about -- from a company 6 called eSpeed in New York. 7 So, if -- if she claims I -- was my 8 knowledge on the patent and, so on, I was able to 9 develop the algorithms and the exchange and the 10 keeping everybody out that they don't have funds to 11 trades and all of that. 12 I didn't do any of this stuff. So, her 13 argument here, I am completely out of this. 14 And we bought it from eSpeed in New York. 15 MS. MA: Okay, so a couple of other 16 questions just to -- just answer whether you're a 17 financial services firm. 18 Were you a financial services firm? 19 DR. NAFEH: No, absolutely not. 20 MS. MA: To be a financial services firm, 21 what does that require to be a financial services 22 firm? 23 DR. NAFEH: Financial service firm, it is a 24 brokerage or helping customer for investment. 25 And all of those issues we were not because 26 we didn't perform an advice. We didn't put capital 27 at risk. 28 Because what the tax bought interested in 32 1 -- interested in taxes on the profit. 2 Our profit was coming only by the volume of 3 the trade. 4 MS. MA: Similar to eBay? 5 DR. NAFEH: Similar to eBay. 6 But the profit of the financial service 7 industry is coming that they put money at risk and 8 they get the return on the capital invested. 9 If -- if the Board had to look to the 10 international test for all the banks in the world, 11 they didn't come a bank has -- it's on the action of 12 doing. 13 They came to the conclusion the banks, they 14 earn their profit from putting money at risk, 15 capital at risk, not because -- any business -- and 16 when you go to a restaurant, you do a transaction. 17 Any business has a transaction, but the 18 trick is where did the business bring the profit? 19 Is it from the transaction or from putting capital 20 at risk? 21 MS. MA: Okay. So, when people got on your 22 exchange, they didn't call you? 23 DR. NAFEH: No. 24 MS. MA: Right? 25 DR. NAFEH: No. 26 MS. MA: Did they call any broker? 27 DR. NAFEH: No. 28 MS. MA: Like was there an 800 number 33 1 saying, 2 "If you need advice before you invest, 3 please call us here, and we will help you 4 and give you advice." 5 DR. NAFEH: Absolutely not, never, because 6 it's -- again, it's our designation by C. F. T. C. 7 MS. MA: Okay. And, so, all of your 8 employees were engineers -- 9 DR. NAFEH: Yes. 10 MS. MA: -- that just made sure that the 11 platform ran smoothly? 12 DR. NAFEH: Yes. 13 MS. MA: Didn't crash. 14 DR. NAFEH: Yes. 15 MS. MA: And that people got their trades 16 executed, right? 17 DR. NAFEH: Exactly, we are like -- you 18 know, if you look at the C. F. T. C., they saying 19 here, "fully electronic, not intermediated, over the 20 internet." 21 If the internet didn't exist at that time, 22 all of this would have been academic exercise. 23 MS. MA: Right. So -- 24 DR. NAFEH: It say here we will be 25 advice -- we will be financial service. We will 26 be -- this is the only function of the exchange. 27 MR. PORTER: It does not say that on -- 28 DR. NAFEH: It doesn't. 34 1 MR. PORTER: -- correct. 2 DR. NAFEH: Yes, right. 3 MS. MA: Okay. Those are my questions. 4 MR. HORTON: Thank you, Member Ma. 5 MS. STOWERS: Sure. 6 MR. HORTON: Member Stowers. 7 MS. STOWERS: Just a couple of questions to 8 the Appellant. 9 DR. NAFEH: Sure. 10 MS. STOWERS: So, you said that you didn't 11 design the exchange, but it was your patent? 12 DR. NAFEH: Yes, the patents -- 13 MS. STOWERS: Can you clarify to me what 14 the patent did? 15 DR. NAFEH: -- yes. 16 I didn't do the patent for this. I did the 17 patent in abstract, buying the option and 18 mathematical and so on is the patent. 19 But to take the patent and transform the 20 patent to exchange has all of this capabilities, 21 this exchange was bought from a company called 22 eSpeed -- Cantor Fitzgerald eSpeed. 23 MS. STOWERS: Okay. Now as far as whether 24 HedgeStreet was an investment-type business -- 25 DR. NAFEH: No. 26 MS. STOWERS: -- your -- HedgeStreet's 27 customers would buy various contracts? 28 DR. NAFEH: They buy and sell. 35 1 MS. STOWERS: Buy and sell. 2 DR. NAFEH: And we are the only -- 3 MS. STOWERS: For the purpose of making a 4 profit? 5 That's the question. 6 DR. NAFEH: -- when people buy and sell, of 7 course, the objective for each one is a profit, but 8 not for HedgeStreet. 9 We only charge the fee on the transaction. 10 Like eBay, when you go to eBay and you wanted to buy 11 and sell, you feel you did a good deed buying or 12 selling something you like. 13 It is not the interest of eBay, except the 14 fees they charge for you. 15 MS. STOWERS: I follow that. But -- but 16 the customers on HedgeStreet, they were -- in my 17 world -- buying some type of an investment tool. 18 MR. PORTER: Well, I want to add something. 19 You used the word "buy" and that is the key 20 thing. 21 I mean, let's go -- take an abstract. I 22 want to buy something. I go down to my local 23 grocery store. And I know the people there, but I'm 24 buying a product. 25 And the Franchise Tax Board has alleged, 26 first of all, there's financial services going on. 27 There is purchasing going on. There's no 28 professional services being offered. There's no 36 1 personal professional services being offered. 2 It's strictly, as you asked, which is 3 correct, buying a product over the internet -- not 4 talking to anyone, which is important, I think. 5 MS. STOWERS: Yeah, I understand. 6 But they are buying a product over the 7 internet. And that product is different 8 contracts that -- 9 MR. PORTER: Correct. 10 MS. STOWERS: -- come under the umbrella of 11 some type of an investment or hedging to see if the 12 price of gold is going to go up or down? 13 DR. NAFEH: Yes. It's in their mind. 14 It's like when you go and buy on eBay, you 15 buy something because you bought -- because it will 16 go up in price or you sell something because it 17 became out of fashion. 18 It is the same mentality. 19 MS. STOWERS: Okay. 20 DR. NAFEH: HedgeStreet was not investment 21 in any way, shape, or form. 22 Because, Madam, you have to look to one 23 thing, where HedgeStreet got its profit for you to 24 tax it. 25 It's a profit coming from the volume of 26 trade, not because they put capital and invested the 27 capital and the return on -- this is little mistake 28 between investment company and operating company. 37 1 MS. STOWERS: Okay, I understand your 2 position. 3 To the Franchise Tax Board, can you explain 4 to me your position again on why you think it's two 5 things, why you think it's a brokerage-type company, 6 and why you think it's an investment company -- an 7 investment-type company? 8 MS. HIRANO: Well, the statute does say 9 brokerage services and -- 10 MS. STOWERS: Brokerage service, excuse me. 11 MS. HIRANO: -- investing or similar 12 business. 13 MS. STOWERS: Right. 14 MS. HIRANO: Those are the grounds. 15 First of all, in terms of the brokerage 16 services, as was -- I think Dr. Nafeh mentioned -- 17 this was a non-intermediated electronic exchange, 18 which meant there were no third party brokers or -- 19 you know, to -- who would handle the purchase and 20 sale of these futures contracts. 21 And, therefore -- in general a broker is 22 one, for example, a real estate broker is one who 23 brings together a buyer and a seller and then 24 charges a commission on this transaction when -- 25 when it's consummated. 26 And, essentially, what HedgeStreet was 27 doing was matching the offers to buy and sell these 28 futures contracts, similar to a broker, and bringing 38 1 them together, and then charging this fee, which was 2 called an exchange fee, comparable to a brokerage 3 commission. 4 That's where the brokerage service is. 5 MS. STOWERS: Don't go any further. 6 But we don't have a person involved. 7 So, are you saying you can have a brokerage 8 service without having a human person? 9 MS. HIRANO: Well, there is no requirement 10 that there be a person who's a broker. 11 The function -- the statutory term is not 12 broker, but "brokerage services." And brokerage 13 services, in a broad -- in a general sense -- and 14 that's how the language of statutes generally should 15 be interpreted is giving them the general, ordinary 16 meaning, you know, in terms of brokerage, it's 17 merely bringing together a buyer and a seller, you 18 know, who -- who want to -- one who wants to buy and 19 the other who wants to sell an item. 20 MS. STOWERS: Okay. 21 DR. NAFEH: Can I just say -- 22 MS. STOWERS: I'm good -- I'm good. 23 Can you go and explain to me about why you 24 think it's an investment -- a business similar to 25 investment? 26 MS. HIRANO: Well, it -- it did engage in 27 selling these financial instruments. These are 28 essential -- essentially financial instruments sold 39 1 to traders who wanted to -- to make a profit, 2 similar to, you know, anyone else who makes 3 investments in the stock market or whatever. 4 And in this case HedgeStreet created its 5 own futures contracts, listed these on the exchange 6 and offered these to people who wanted to buy and 7 sell these, trade these, you know, to make a profit. 8 And in that sense, it was, for these 9 traders, an investing business. 10 MS. STOWERS: Okay. And just one final 11 question back to the Appellant. 12 In your exhibit -- your first exhibit, 13 Exhibit 1, Cap B, you have, 14 "any banking, insurance, financing, 15 leasing or similar business;" 16 Your exhibit does not have investing on 17 there. 18 Was that just an oversight? 19 MR. PORTER: Investing is in the part B? 20 MS. STOWERS: Uh-huh. 21 But your copy of the statute that you 22 provided as an exhibit, I don't see the word 23 "investing" here. 24 MR. PORTER: What's -- finance. 25 That's -- that is an oversight then. 26 Let me point out, though, that our copy of 27 the statute also does not include the word "other." 28 Because we think that that one word does 40 1 not matter itself, but certainly it does appear in 2 the legislative intent and the Internal Revenue 3 Code, which California conformed to. 4 So that it interprets -- helps you 5 interpret the statute. 6 DR. NAFEH: Can I just have -- 7 MS. STOWERS: Sure. 8 MR. PORTER: -- that was an oversight, 9 otherwise, it -- 10 DR. NAFEH: -- one minute? 11 MR. PORTER: -- is an oversight. 12 DR. NAFEH: FTB -- about the brokerage, the 13 difference between HedgeStreet and being a broker, 14 the broker, by definition, it is the provision -- 15 they give advice to the provision of investment. 16 HedgeStreet never did that. 17 The broker, they have fiduciary obligation. 18 When you go to a broker and you wanted to make a 19 transaction for the investment, you -- he has a 20 fiduciary requirement done by by N. F. A. or 21 (unintelligible). 22 We never had -- exchanges don't have 23 fiduciary requirement. 24 Second, if anything go wrong for the 25 brokerage, the balance sheet is subjected to this, 26 the government or the any other agency can plug the 27 balance sheet. Balance sheet is tied to the 28 performance for advising. 41 1 We never had this because we are exchange. 2 Exchanges don't have the balance sheet depending on 3 this or they don't provide advice for investment. 4 MS. STOWERS: Thank you. 5 DR. NAFEH: Thank you. 6 MR. HORTON: Member Runner. 7 MR. RUNNER: Yeah, I want to just try to 8 clarify, at least in the concept, the issue of 9 brokerage services. 10 DR. NAFEH: Yeah. 11 MR. RUNNER: So, FTB, you would understand 12 brokerage services as the responsibility of bringing 13 a buyer and seller together equals a brokerage 14 service? 15 MS. HIRANO: It's matching a buyer and 16 seller and then charging a fee for that, a 17 commission or fee, uh-huh. 18 MR. RUNNER: Does it depend what they did 19 for that fee? 20 I mean, for instance, I'm -- I am -- you 21 know, when I think of personal brokerage services, I 22 think of you -- you have somebody, they're managing 23 a portfolio of yours, or they're not managing a 24 portfolio, they've got information about a stock or 25 something that they're doing. And you're giving 26 them a fee because of their knowledge of what it is 27 that you are buying and selling. 28 That's -- to me, that's normally what -- 42 1 that I would think of as a brokerage. 2 You are talking about just the fact that 3 you have a mechanism that brings together a buyer 4 and seller, a platform -- 5 MS. HIRANO: That's correct. 6 MR. RUNNER: -- you believe that's a 7 brokerage service? 8 MS. HIRANO: Well, the statute does not 9 mention "broker" as -- 10 MR. RUNNER: It says, "brokerage service." 11 MS. HIRANO: -- brokerage services, yes. 12 MR. RUNNER: Right. 13 MS. HIRANO: And does not, therefore, 14 require that there be a broker, per se, uh-huh. 15 MR. RUNNER: Okay. 16 MS. HIRANO: Yes. 17 MR. RUNNER: You need the brokerage 18 services -- 19 MS. HIRANO: Brokerage services. 20 MR. RUNNER: -- that you -- because you 21 simply bring a buyer and a seller together? 22 MS. HIRANO: To match, yes. 23 MR. RUNNER: So, for instance, if it was a 24 room and somebody owned the building. 25 And you had in this building tables. And 26 you had in this -- and at this -- in this room you 27 had people who were selling and people who were 28 buying. 43 1 And you had them come to a table to talk to 2 each other, because you owned the building. You 3 would call that -- then you say that the building 4 owner is a brokerage service? 5 MS. HIRANO: I can't visualize that, so -- 6 MR. RUNNER: I'm just -- I'm trying to get 7 an analogy to -- to -- you know, kind of a -- kind 8 of a -- you know, a knowledge or a -- or a concept 9 that's non electronic, you know, in terms of -- it's 10 the same idea. 11 I mean, it's -- in my head, it's the same 12 idea. It's a building -- it's a room. You've got a 13 table. And you have people who are walking around 14 who are brokers and sellers. 15 And you have a table. And they sit down at 16 the table, because you own the table and the 17 building. 18 MS. HIRANO: Uh-huh. 19 MR. RUNNER: And they buy and sell. 20 You would say the people who owned the 21 building and the table are -- are a brokerage 22 service? 23 MS. HIRANO: I -- you know, I -- I would 24 say that this is -- this is more akin to just having 25 like -- what is that, like a white elephant sale or 26 something. 27 This is how I visualize it. And, so, it's 28 quite different from the situation where -- 44 1 MR. RUNNER: I don't -- help me understand 2 your white elephant -- 3 MS. HIRANO: -- well, you know, bringing 4 together just people who want to buy -- some people 5 who want to buy, some people who want to sell -- 6 just -- just that physical act itself is not 7 necessarily what we have here. 8 Because we have a very specialized, 9 highly -- you know, it's an electronic, very 10 sophisticated facility that brings together -- 11 MR. RUNNER: -- that's what I'm trying to 12 struggle with. 13 I'm trying to think -- and, you're right, I 14 mean, I'm -- obviously, I'm -- I've simplified that 15 with the issue of a table. 16 MS. HIRANO: Uh-huh. 17 MR. RUNNER: They have a very sophisticated 18 table. That helps - kind of give -- helps those 19 people make a decision. 20 Let me ask you, if you were a brokerage 21 service under -- and again, do we know -- if you 22 were actually a brokerage service, wouldn't you need 23 a license or something to operate? 24 DR. NAFEH: Absolutely. I would be in 25 jail. Today I would be in jail if I did the 26 brokerage service. 27 Because brokerage service for the license, 28 if you doing a stock, it's under (unintelligible). 45 1 MR. RUNNER: Let me go back to FTB. 2 Are we aware of any unlicensed brokerage 3 services that operate? 4 MS. HIRANO: No. You know, the issue in 5 this case is really not whether or not HedgeStreet 6 had the appropriate licenses or not. 7 I think the issue -- 8 MR. RUNNER: You think they may have a 9 needed one? 10 MS. HIRANO: -- I'm not -- I'm not an -- I 11 don't claim to be, you know, an expert in that area. 12 MR. RUNNER: But you've defined them as a 13 brokerage service. 14 MS. HIRANO: That's not the issue. 15 But that's not the issue, I think, in this 16 case, whether or not they had the necessary license. 17 I think that's kind of a red herring that's 18 maybe thrown in. 19 But, you know, whether or not they were 20 performing, in essence, these functions. 21 MR. RUNNER: I guess I don't know if it's a 22 red herring or an indication that they are not a 23 brokerage service. 24 MS. HIRANO: And I would say that brokerage 25 service -- brokerage services, as stated in the 26 statute, you know, isn't necessarily limited to a 27 particular kind of broker that you may visualize 28 that -- whom you consult for -- in terms of making 46 1 investments, perhaps, in mutual funds or stocks. 2 MR. RUNNER: So, you believe, they should 3 -- that brokerage services -- services in the 4 statute is a bit interpretive? 5 We can interpret what that means? 6 MS. HIRANO: Well, I think it's a very 7 broad -- it's a broad term. It's not necessarily -- 8 MR. RUNNER: So, brokerage -- you would 9 believe the brokerage services would include folks 10 that are licensed and folks that aren't licensed? 11 Or all folks should be licensed? 12 MS. HIRANO: -- well, I think that, you 13 know, generally when we think of like real estate 14 brokers and investment -- 15 MR. RUNNER: But, see, I don't like your 16 analogy in regards to real estate brokerage, 'cause 17 when I hire -- when I -- when I hire a realtor -- 18 MS. HIRANO: Uh-huh. 19 MR. RUNNER: -- I don't hire a realtor just 20 to put together a deal for me. 21 I hire a realtor for their expertise in -- 22 in getting me through the process, in getting me 23 through escrow and getting -- that's what I -- if it 24 was just putting the deal together, I don't need 25 them. 26 I need them -- they -- I need them to kind 27 of go and tell me -- and show me the market. Tell 28 me what's good. Tell me what the value of my house 47 1 is when I go to list it. 2 That's what I buy when I get a brokerage 3 service from a real estate broker. I get their 4 active participation in my sale. 5 So, I don't think your -- so, the idea that 6 they're like a realtor, a real estate broker, I 7 don't think holds. 8 Because they're -- I don't believe they 9 were active in interpreting and giving advice on the 10 sale. 11 MS. HIRANO: My understanding is that the 12 site was -- did provide information about some of 13 the economic -- economic indices that were -- for 14 which contracts, futures contracts, were being 15 offered. 16 And, so, if -- they were at least providing 17 this -- some information to the -- 18 MR. RUNNER: Well, let me ask you -- 19 MS. HIRANO: -- traders. 20 MR. RUNNER: -- what kind of information 21 were you providing that may or may not have had 22 you -- required you to have a brokerage license? 23 DR. NAFEH: The information we were 24 providing is a minimum set. 25 If we are listing a product to be sold, 26 exactly like the eBay, we described what it is, 27 which is duplicated in another 10,000 sites on the 28 internet. It is not unique. 48 1 Can I just take -- 2 MR. RUNNER: Well, hold on. 3 So, you would just provide -- the 4 information you provided is a description -- 5 DR. NAFEH: Yes. 6 MR. RUNNER: -- of what it is that is being 7 sold? 8 DR. NAFEH: Absolutely. We are 9 forbidden -- 10 MR. RUNNER: Okay. And, so, without advice 11 or without opinion, it is a description of what's 12 being sold? 13 Did you -- 14 DR. NAFEH: Yes, sir. 15 MR. RUNNER: -- did you come up with that 16 description? 17 DR. NAFEH: No. 18 MR. RUNNER: So, you carried -- you just 19 found that description somewhere else and that's 20 what it is? 21 DR. NAFEH: Absolutely. 22 MR. RUNNER: Okay. 23 You can give another comment, real quick. 24 DR. NAFEH: One minute. We talking about 25 brokerage services, which derives revenue. 26 And I think this is a little mistake for 27 taxes is the revenue from the provision of 28 investment advice. 49 1 And if you take this, therefore, have the 2 principal assets, the reputation or the skill of one 3 person, if you taking advice from somebody, you 4 wanted the best one, you get advice. 5 The second point, which you touched on it, 6 is if we have any other function in this services, 7 we would have gotten a license as a broker, as an 8 advisor. 9 As -- and there is two other major license 10 places, (unintelligible) and N. F. A. 11 MR. RUNNER: Okay, thank you. 12 DR. NAFEH: Thank you. 13 MR. HORTON: Question of the Appellant. 14 What was it that you got the patent for? 15 DR. NAFEH: The patent was a -- about 16 buying the options. 17 MR. HORTON: Okay. 18 DR. NAFEH: Which is a very strange way, 19 it's like digital option. 20 MR. HORTON: Uh-huh. 21 DR. NAFEH: You buy instrument, like the 22 interest rate going up or down. 23 If you buy it for five and you are right, 24 you get ten. If you are wrong, you get zero. 25 Digital means zero -- is all or nothing. 26 MR. HORTON: And how is that algorithm 27 used? 28 I mean, how -- how would I use it? 50 1 DR. NAFEH: It's really -- 2 MR. HORTON: What value would it have to 3 me? 4 DR. NAFEH: -- big banks use it, like J. P. 5 Morgan and Goldman Sachs, use something like this 6 between them. 7 But I thought people would be interested in 8 something retail. Our -- our contract bundle was 9 $10 and then $100. I thought it's retail, kind of 10 to see the direction if the interest rate going up 11 or down. 12 MR. HORTON: So, that what have gotten the 13 patent for -- 14 DR. NAFEH: Yes. 15 MR. HORTON: -- has nothing to do with the 16 service provided? 17 DR. NAFEH: No, no. 18 MR. HORTON: And to the Department, how -- 19 how's that distinguished -- how do you distinguish 20 what eBay does from what the Appellant's doing? 21 Are you -- are you of a mind that something 22 is happening other than just a willing buyer going 23 online, seeing a particular product, and buying 24 it -- without any participation from the Appellants 25 or his his patent idea? 26 MS. HIRANO: Well, first -- in relation to 27 eBay, it was previously briefed that, you know, 28 HedgeStreet was similar to eBay. 51 1 But, in fact, you know, eBay is not a 2 securities or futures exchange. And, so, it's 3 really quite unlike HedgeStreet, which was -- 4 MR. HORTON: My apologies for interrupting 5 you. 6 MS. HIRANO: -- oh, yes. 7 MR. HORTON: I want to get to the point. 8 MS. HIRANO: Okay. 9 MR. HORTON: The question is -- is not the 10 entities or what they're called, it is the service 11 that's being provided. 12 So, how do you distinguish the service 13 provided by eBay, which is a general listing of 14 stuff that you can go in and buy? 15 eBay doesn't participate in that. You just 16 put it on the site and you just go in and choose 17 whatever you want. 18 What's so different about what the 19 Appellant's doing? 20 MR. IMMORDINO: Well, you know, eBay does 21 create the products that it -- it sells. 22 And in this case HedgeStreet does create 23 the products which people will purchase and sell. 24 In addition, the patent for -- that 25 Dr. Nafeh got, he notes that the patent's for a risk 26 hedging contract trading system. 27 And in the declaration of Mr. Robbins, he 28 notes in paragraph 10 that, 52 1 "HedgeStreet's principal assets are its 2 systems used to match buyers and sellers 3 and its regulatory licenses." 4 You know, what was developed, our 5 understanding, is the core of the business. This 6 goes back to the principal asset analysis, that this 7 is what the business was and that's what the Owen 8 case talks about. 9 MR. HORTON: So, to try to simplify it for 10 myself here, is it -- your argument is because of 11 his knowledge, skills, and the use of this patent 12 idea, he's able to research the market and develop 13 risk, and then, as a result of developing risk and 14 analysis of values and investments and potential for 15 returns, then make recommendations to folks? 16 And then folks go and in either accept or 17 his recommendations or not? 18 MS. HIRANO: No, no, he did not -- 19 MR. HORTON: That's not what he's saying he 20 does. 21 MS. HIRANO: -- right, he's not making 22 recommendations. 23 But just the creation of the whole system, 24 it's a very sophisticated system of, you know, 25 taking into account his specialty is risk management 26 and that was key in his coming up with the 27 algorithms to figure out how to, you know, create a 28 system where people could purchase and buy these -- 53 1 these options or futures contracts, but without the 2 system itself, the facility itself, incurring undue 3 risk in terms of economic loss. 4 And, so, he did -- this whole system does 5 take into account that, therefore, you know, the -- 6 the resources of the traders to ensure that they 7 don't exceed their resources. 8 MR. HORTON: Maybe I'll go to the 9 Department. 10 I'm just trying to distinguish -- there's a 11 lot of different things we're sort of talking about 12 here. 13 And you're talking about the income derived 14 from the transaction. And you're trying to 15 determine if there is a qualified qualified small 16 business stock exclusion. 17 And, so, I guess you're talking about 18 the -- the stock investment in the business and 19 whether or not there's a qualified exemption of 20 something like that. 21 But I'm having a bit of a challenge 22 distinguishing what the Appellants' doing in just 23 providing that service. 24 So, if your argument goes to the qualified 25 business stock exclusion and it goes to the value of 26 that the individuals investing are investing in 27 that, and they're investing in the knowledge and so 28 forth and so on, as opposed to all of the individual 54 1 transactions that are going on, maybe that's a 2 different argument. 3 But I don't hear that argument on the 4 floor. 5 So, a generic question to Appeals, can -- 6 can you, based on your understanding of the briefs 7 and so forth, can you provide some clarity here as 8 to what FTB is alleging happened and why it's not -- 9 you don't have to say why, but just -- I know you 10 can't do that, but let them try to do that. 11 MS. TRAN: So, you're asking me what -- 12 what my impression of what the FTB's -- 13 MR. HORTON: Yeah. 14 MS. TRAN: -- position is? 15 MR. HORTON: Yes, yes. 16 MS. TRAN: Oh, okay. 17 MR. HORTON: It's a very difficult thing to 18 understand. 19 My apologies for putting you in this place. 20 MS. TRAN: From what I understand, it 21 sounds like -- thank you. 22 From what I understand, it sounds like 23 they're arguing that the taxpayers' business, 24 HedgeStreet, was in -- was providing services in the 25 field of -- which one was that -- of financial 26 services or brokerage services. 27 And then they also argue that -- 28 alternative arguments for not allowing the exclusion 55 1 is that their principal asset is the skill of 2 Mr. Nafeh. 3 Then the other argument they're making is 4 that they're an excluded investing or similar 5 business. 6 The problem here is that financial 7 services, brokerage services, investing or similar 8 services, all those words aren't defined. 9 So, it's a factual determination of how you 10 guys want to determine whether or not the specific 11 activities that HedgeStreet is performing falls 12 within these categories. 13 MR. HORTON: Yeah, that's a little help. 14 And thus say you, Department? 15 MS. HIRANO: Do you have a -- I'm sorry, do 16 you have you a specific question? 17 I'm not certain what you would like. 18 MR. HORTON: No, I think I'm good. 19 Thank you very much. 20 Further discussion, Members? 21 Member Stowers. 22 MS. STOWERS: Move to take the matter under 23 submission. 24 MR. HORTON: Member Stowers moves to take 25 the matter under submission. 26 Second by Member Runner. 27 Without objection, Members, such will be 28 the case. 56 1 Thank you very much for appearing before us 2 today. The Board will take your matter under 3 submission and send you a written report of our 4 decision. 5 ---O0O--- 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 57 1 REPORTER'S CERTIFICATE 2 3 State of California ) 4 ) ss 5 County of Sacramento ) 6 7 I, JULI PRICE JACKSON, Hearing Reporter for 8 the California State Board of Equalization certify 9 that on SEPTEMBER 16, 2015 I recorded verbatim, in 10 shorthand, to the best of my ability, the 11 proceedings in the above-entitled hearing; that I 12 transcribed the shorthand writing into typewriting; 13 and that the preceding pages 1 through 57 constitute 14 a complete and accurate transcription of the 15 shorthand writing. 16 17 Dated: NOVEMBER 19, 2015 18 19 20 ____________________________ 21 JULI PRICE JACKSON 22 Hearing Reporter 23 24 25 26 27 28 58