S.D.N.Y. Judge Permits Novel Theory And Allows SEC To Use Unpaid Taxes As Measure Of Disgorgement In Securities Fraud Case

by Eversheds Sutherland (US) LLP

In a case against Dallas billionaires Sam Wyly and the estate of his late brother, Charles, Judge Shira Scheindlin of the U.S. District Court for the Southern District of New York agreed with the U.S. Securities and Exchange Commission (SEC) that the defendants were liable for unpaid taxes as additional disgorgement on a theory never before argued in this country. Faced with the fact that the Wylys profited by $1.4 billion from the offshore trading at issue, yet would only have to repay the small fraction of that amount that could be causally connected to their alleged wrongdoing, the SEC sought an unprecedented $600 million in unpaid taxes, including prejudgment interest, as additional disgorgement.  The SEC did so despite the fact that the Internal Revenue Service (IRS) had declined to pursue the Wylys on the tax issues.  This appears to be the first case involving violations of the securities laws in which taxes that had not been assessed by the IRS were part of the monetary sanctions.    

On September 25, Judge Scheindlin ordered Sam Wyly to disgorge $123.8 million and Charles’ estate to disgorge $63.8 million plus prejudgment interest. Judge Scheindlin based the order on two different types of disgorgement measures: unpaid taxes on offshore trusts and illicit profits on the sale of unregistered securities. In determining the amount of unpaid taxes for the offshore trusts, the court held that the “reasonable approximation” of disgorgement for Sam Wyly was $111,988,622.76 and $58,896,281.97 for Charles Wyly.1 Regarding the sale of unregistered securities, Judge Scheindlin ruled that it would be inequitable to order disgorgement on total profits because the Wylys received the securities at a discounted rate.2 Instead, Judge Scheindlin calculated disgorgement based on the average discount received on the unregistered securities.3 Thus, the court ordered that the Wylys disgorge 25% of their total profits, resulting in a disgorgement for the sale of unregistered securities in the amount of $11,848,336 for Sam Wyly and $4,985,462 for Charles Wyly’s estate.4 The court also found an “alternative” disgorgement amount based on unpaid taxes that would have been slightly lower than the amount of the illicit profits.5 With court ordered pre-judgment interest, the Wylys’ final total payment will be between $300 million and $400 million.6

Judge Scheindlin’s disgorgement order is the second part of a bifurcated trial in which a jury decided the Wylys’ liability and Judge Scheindlin later determined the remedy. In May 2014, a New York jury found that the Wyly brothers committed securities fraud by failing to disclose their ownership of more than 5% of the stock of companies for which they served as directors.7 The Wylys allegedly used offshore trust accounts to secretly trade these securities, which the SEC claimed yielded $1.4 billion in illicit profits. But on July 29, Judge Scheindlin barred the SEC from seeking the total profits earned by the Wylys, holding that “[i]t defies logic to presume that all of the rise in the value of a company’s stock price over 13 years ... is reasonably tied to two directors’ failure to disclose their trading.”8 The SEC then amended its disgorgement claim to a mere $150 million for profits attributable to the failure to disclose the trades, but argued for an additional $600 million for disgorgement based on unpaid taxes.9

This was a distinct departure from prior SEC arguments regarding the tax ramifications of its cases; previously, the SEC routinely has taken the position that disgorgement of illicit profits should not be reduced by the amount of any taxes paid on the profits, because the defendant taxpayer can separately seek any appropriate adjustment to tax liability that results from payment of disgorgement.10 In effect, the SEC appears to have taken a “heads I win, tails you lose” approach to the tax implications of its cases; no reductions for taxes paid, but extra disgorgement sought for unpaid taxes, even when the IRS has not claimed such taxes are due.

Judge Scheindlin previously ruled that the SEC’s claims for substantial penalties accrued five years prior to the tolling agreement and were time barred.11 Thus, the only monetary relief available to the SEC was disgorgement.12 Combined with the court’s ruling limiting the disgorgement of the Wylys’ profits, the SEC was faced with a victory on liability but an outcome on sanctions that would leave the Wylys with a substantial net gain from their trading. The SEC thus focused on another pretrial ruling by the court, i.e., that the SEC was free to argue that the measure of disgorgement damages should be the amount of unpaid federal taxes that the defendants avoided paying by transferring stock options to offshore corporate accounts and failing to disclose control over the options.13

The court and the SEC acknowledged that there was no statutory basis or precedent in prior case law for allowing the SEC to use unpaid taxes as a basis for disgorgement in a securities fraud action.14 In that same vein, the court stated that the Secretary of the Treasury has the full power to collect taxes, which it has delegated to the IRS.15 Nevertheless, the court held that since the SEC only sought to use the amount of unpaid taxes as a measure for disgorgement, as opposed to levying or attempting to collect taxes, there is nothing in the securities laws or the Tax Code to prohibit the SEC from doing so.16 According to the court, as long as the SEC could show that there was a “causal connection between the securities violations and the tax avoidance,” the amount of unpaid federal taxes is an appropriate level of disgorgement in an SEC action.17

To show a causal connection, the SEC relied heavily on Section 674(a) of the Tax Code, which states that “[t]he grantor shall be treated as the owner of any portion of a trust in respect of which the beneficial enjoyment of the corpus or the income therefrom is subject to a power of disposition, exercisable by the grantor or a nonadverse party, or both, without the approval or consent of any adverse party.”18 According to the SEC, Section 674(a) of the Tax Code substantially overlaps with Rule 13(d)-3a of the Securities Exchange Act, which defines a beneficial owner for filing requirements as “any person who, directly or indirectly ... has or shares (1)[v]oting power ...; and/or (2) investment power which includes the power to dispose, or to direct the disposition of, such security.”19 Furthermore, the SEC argued that there was evidence of the Wylys acknowledging that the fraudulent system was created in part to avoid paying taxes.  The court agreed with the SEC and held that it had sufficiently shown evidence of a causal connection between the Tax Code and the alleged securities violation.20

In court filings arguing for a reduction of the damages claimed by the SEC, the Wyly brothers continued to argue that tax-based disgorgement sought by the SEC is unavailable as a matter of law, in part because it is unclear whether the “power of disposition” discussed in Section 674(a) includes the power to make investment decisions, discussed in Rule 13(d).21 Thus, according to the Wyly brothers, the court’s ruling that there was a substantial overlap between the tax and securities regulations was flawed as a matter of law.22 Additionally, the Wyly brothers argued that the SEC’s calculations of unpaid taxes were erroneous because the SEC calculated the total amount of unpaid taxes as unpaid ordinary income tax, although some of the unpaid taxes were for unregistered securities; the SEC did not take into account deductions the Wyly brothers would have claimed; and the SEC failed to reduce its disgorgement claim by amounts already paid by the Wyly brothers.23

Judge Scheindlin’s ruling that the Wylys are liable for the disgorgement of unpaid taxes in connection with securities fraud violations has set an important precedent in determining the monetary remedies the SEC may seek in actions for securities fraud and other violations. In addition, because the court held that the Wylys would be entitled to a credit for the disgorgement if the IRS were to pursue them for unpaid taxes, the court has effectively eliminated any incentive or likelihood that the IRS will also seek a judgment against the Wylys.24 Time will tell whether the SEC will continue to succeed in its time-honored argument that tax consequences should be ignored when the result would be lower disgorgement amounts for the SEC.

1 S.E.C. v. Wyly, 1:10-cv-05760-SAS, ECF 476 at 67  n.218 (S.D.N.Y. Sept. 25, 2014).

2 Id. at 74.

3 Id.

4 Id.

5 Id. at 74 n.231.

6 Stewart Bishop, Wyly Bros. Ordered to Pay At Least $187M For Tax Fraud, Law360 (Sept. 25, 2014, 3:38 PM ET), http://www.law360.com/securities/articles/581162?nl_pk=8bd62c54-c1b6-40b4-9ba6-62d16d2d2e56&utm_source=newsletter&utm_medium=email&utm_campaign=securities.

7 The claims against the brothers stemmed from Section 13(d) of the Securities Exchange Act, which requires any person who acquires a beneficial ownership of more than 5% of a class of registered securities to file a disclosure statement with the SEC. 

8 S.E.C. v. Wyly, 2014 WL 3739415 at *7 (S.D.N.Y. Jul. 29, 2014).

9 Patricia Hurtado, SEC Cuts Wylys’ Damages Demand by Half to $750 Million, Bloomberg news (Aug. 5, 2014, 4:45 PM ET), http://www.bloomberg.com/news/2014-08-04/wylys-used-offshore-trusts-to-hide-trades-jury-finds.html.

10 See, e.g., U.S. Securities and Exchange Commission, Litigation Release No. 18146, Court Imposes $534,408 of Disgorgement, Prejudgment Interest, and Civil Penalty against Former UCLA Student and Relatives in Internet Stock Manipulation Case (May 19, 2003), available at http://www.sec.gov/litigation/litreleases/lr18146.htm; S.E.C. v. Razmilovic, 738 F.3d 14, 35 (2nd Cir. 2013) (affirming district court’s disgorgement order and rejecting defendant’s argument that taxes paid should be included in a disgorgement calculation). 

11 See S.E.C. v. Wyly, 950 F. Supp. 2d 547, 558 (S.D.N.Y. 2013).

12 S.E.C. v. Wyly, 2013 WL 2951960 at *1.

13 See S.E.C. v. Wyly, No. 10 Civ. 5760(SAS), 2013 WL 2951960 (S.D.N.Y. June 13, 2013).

14 Id. at *3.

15 Id. at *2.

16 Id. at *3.

17 Id. at *5.

18 26 U.S.C. § 674(a).

19 17 C.F.R. § 240.13d-3(a).

20 S.E.C. v. Wyly, 2013 WL 2951960 at *4.

21 Def.’s Remedies Hearing Proposed Findings of Fact and Conclusions of Law at 8, July 28, 2014, ECF No. 434.

22 See id.

23 See id. at 10-12.

24 See Wyly, 1:10-cv-05760-SAS at 61-62.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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