The SEC v. Wyly case is a gift that keeps on giving for securities law buffs. Our third post on this case is prompted by Judge Shira Scheindlin’s thoughtful decision (which can be found here: SEC v Wyly Disgorgement Opinion), in which Judge Scheindlin granted a motion to preclude a new SEC “disgorgement” theory in the remedies stage for the violations found by the jury on May 12, 2014.
Our first post on SEC v. Wyly discussed the jury’s determination that the Wyly brothers violated a number of federal securities laws, including section 10(b), when they used offshore trusts to trade the stock of public companies they controlled without disclosing those trades. The Wylys’ theory that the offshore trusts acted independently, negating any disclosure requirement, was rejected by the jury. See here.
Our second post on the case discussed Judge Scheindlin’s rejection of the SEC’s overreaching theory that the Wylys engaged in insider trading when they purchased stock in companies they controlled after having allegedly formed an intention in their minds to sell those companies at some later point. See here.
In June, the SEC notified the Wylys of a new remedy theory it intended to pursue for the violations found by the jury. In a previous interrogatory response, the SEC declined to specify its theory for a “disgorgement” remedy for those violations, but noted two possible theories based on taxes avoided by the offshore transactions and profits related to the sale of unregistered securities. The June 4, 2014 amended interrogatory response laid out a new approach to supposed “disgorgement”: all of the profits earned by the Wylys in all of the offshore transactions, which would be roughly $488 million. The Wylys moved to preclude disgorgement on that theory. Judge Scheindlin agreed that the SEC’s newly-minted disgorgement theory was untenable.
Some background on disgorgement would be helpful. Although disgorgement remedies were not mentioned in the securities statutes, the SEC for many years has sought and obtained equitable orders in enforcement cases requiring the return of “ill-gotten gains,” that is, profits derived from violations of the securities laws. Over the years, the SEC’s theory of what constitutes “ill-gotten gains” has become more and more aggressive. Some effort was made in earlier cases to try to associate the amount sought with profits from the actual violation that occurred. But in more recent years, the SEC has pursued disgorgement theories akin to a “but for” theory – that any profits gained that would not have occurred if there were no violation should be subject to disgorgement, whether or not there is proximate causation between the violation and the profits.
The problem with this approach is that it ignores the law. The courts have made it clear that disgorgement is an equitable remedy that must be tailored to the objective of depriving the violator of gains improperly obtained through the violation. They repeatedly explain that disgorgement must be remedial; it cannot be punitive. They repeatedly insist that for profits to be disgorged, they must have been caused in some meaningful way by the violation of law. And it remains the SEC’s burden to prove this is the case. That being said, the courts naturally accord themselves broad discretion to decide an appropriate disgorgement, they do not insist on exact calculations (a “reasonable approximation” is sufficient).
The SEC has benefited from some questionable leniency accorded to it by the courts on the issue of burden of proof. Although it is quite clear that the SEC has the burden of proving that the remedies it seeks are supported by the facts and law, the courts have taken a “squishy” approach to satisfying this burden that comes close to reversing it. The result is this somewhat bizarre explanation of burden, which Judge Scheindlin faithfully records in her opinion: “‘Once the SEC has met the burden of establishing a reasonable approximation of the profits causally related to the fraud, the burden shifts to the defendant to show that his gains ‘were unaffected by his offenses.’’ Defendants are ‘entitled to prove that the  measure is inaccurate,’ but the ‘risk of uncertainty in calculating disgorgement should fall upon the wrongdoer whose illegal conduct created that uncertainty.’” SEC v. Wyly, slip op. at 6 (quoting SEC v. Contorinis, 743 F.3d 296, 305 (2d Cir. 2014), which in turn was quoting SEC v. First Jersey Sec. Inc., 101 F.3d 1450, 1475 (2d Cir. 1996)).
The problems with this difficult-to-parse burden-shifting approach are apparent from a recent Third Circuit decision. In SEC v. Teo, 746 F.3d 90 (3d Cir. 2014), the Third Circuit recently accepted an extremely aggressive SEC disgorgement theory that on its face seems in conflict with the SEC’s burden to establish causation. In Teo, the disgorgement order deprived the defendant of all stock profits he gained when stock he accumulated without satisfying section 13(d) disclosure requirements burgeoned in value because of a third-party tender offer. Even though the tender offer was not part of the defendant’s violation, he was required to “disgorge” the benefit he gained from that offer as part of the remedy for the 13(d) nondisclosure. Although the vast bulk of the defendant’s profits were plainly caused by a third party action that was independent of the defendant’s violation, the court rejected the argument that it was the SEC’s burden to show that other intervening events, like the tender offer, were not responsible for the defendant’s gains. Instead, the court held it was the defendant’s burden to challenge the SEC’s calculation of profits, which he failed adequately to do when he merely relied on the apparently obvious independent intervening event being responsible for a large portion of the defendant’s gains.
The SEC’s current view appears to be that it satisfies its burden by showing a mere “but for” connection between the violation and profits earned by the violator, leaving it the defendant’s burden to prove a negative – that the profits “were unaffected by” the offenses. If accepted, this result provides the SEC with huge powers to impose debilitating penalties on defendants under the rubric of supposed “disgorgement.” This is especially troubling because it remains unclear whether these supposed “disgorgement” remedies are subject to the five-year statute of limitations on the SEC seeking civil penalties for the same conduct. If the “disgorgement” remedy is truly a “remedial” and not “punitive” form of equitable relief – which is doubtful in some cases – that statute of limitations would not apply.
In the Wyly case, it is quite apparent that the SEC’s newly-minted “disgorgement” theory was designed to penalize the Wylys, whom the SEC staff plainly does not view kindly. The notion that the undisclosed trust transactions should occasion a payment of almost half a billion dollars, representing essentially all of the increased value of stock lawfully owned by the Wylys over a period of 13 years, boggles the mind. It is not conceivably fair and equitable relief for the violations found. The mere fact that the SEC staff chose to pursue it reflects how far they will try to extend their essentially unfettered discretion to pursue disfavored defendants.
Fortunately, Judge Scheindlin saw through this charade and said so in no uncertain terms. She noted that “It is the SEC’s burden to establish both a reasonable approximation of profits and the causal connection between the approximation and the vioilations.” Slip op. at 14 (emphasis in original). She dismissed the SEC’s reliance on cases in which the disgorgement of all profits from transactions was approved because the transactions themselves yielded the profit because of the illegality. The chief example of these cases is insider trading violations, where the profit is realized by virtue of the violation itself. Similar cases involve section 13(d) disclosure violations where the failure to disclose transactions itself permitted the violator to obtain additional securities at prices kept artificially low by the undisclosed information.
In contrast, Judge Scheindlin noted that in this case, the SEC had not presented any evidence that the Wylys’ profits were enhanced in any respect by the failure to disclose that they were the beneficial owners of stock sold by their trusts. She concluded: “[T]here is no evidence here that the defendants’ unlawful conduct – that is, the scheme to hide beneficial ownership by failing to disclose transactions – resulted in any market distortion, price impact, or profit tied to the violation. Nor is there evidence that the scheme was motivated by the expectation of such profits.” Slip op. at 16-17. She explained that if the SEC’s theory were accepted, the court would effectively be adopting “a per se rule requiring disgorgement of all profits made by those who fail to properly disclose their beneficial ownership of securities – regardless of whether that failure resulted in unlawful trading, market manipulation, or distortion,” which would eliminate the burden of showing a causal connection. Id. at 17 (emphasis in original). She also forcefully rejected the SEC’s loose characterization of the Wylys’ trades as “unlawful” merely because they occurred as part of “a fraudulent scheme,” noting that the jury found the nondisclosure of beneficial ownership unlawful, but “did not find that the trading itself was unlawful and could not have reasonably done so.” Id. at 18.
Finally, Judge Scheindlin bridled at the SEC’s notion that the entire rise in value of the Wylys’ stock should be the measure of disgorgement: “It defies logic to presume that all of the rise in the value of a company’s stock price over thirteen years – in the highly charged market of the 90s tech bubble, no less – is reasonably attributable to two directors’ failure to disclose their trading.”
Judge Scheindlin’s well-conceived “push back” at the SEC’s aggressive disgorgement theory comes at an important time in the development of law in this area. A petition for certiorari has been filed in Teo, and that may provide an opportunity for the Supreme Court to weigh in on the apparently limitless use of the “disgorgement” remedy as the SEC staff’s newly-favored “nuclear” option in enforcement actions.
July 30, 2014
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