Judge Shira Scheindlin ordered that Sam Wyly and the Estate of Charles Wyly disgorge $187.7 million for their previously adjudicated securities law violations (discussed here in several previous posts). The opinion is availiable here: SEC v Wyly Disgorgement Opinion. Together with prejudgment interest, the total amount awarded is more than $300 million. The source of the “profits” ordered to be disgorged is federal tax allegedly avoided when the Wylys used offshore trusts for securities transactions and failed to disclose those transactions as required under the securities laws. With participation of counsel (also prosecuted by the SEC), they treated those transactions as not under their control. A jury found otherwise and the resulting violations.
There is a major question whether it is proper for a judge to order disgorgement for securities law violations based on a failure to pay taxes that the Internal Revenue Service, fully knowledgeable of the allegations, never found to be due. That issue will no doubt go to the Second Circuit Court of Appeals. In our view, Judge Scheindlin overstepped the proper bounds of “disgorgement” relief by rendering a tax decision without the government agency responsible for making tax determinations even involved in the case. It is not even clear that the IRS cannot still seek relief for failure to pay those taxes, which would result in duplicate payments (including multiple interest payments) and would, in our view, be plainly improper.
The opinion tries to address these issues, but does so poorly. It states that the disgorgement ordered “should be credited towards any subsequent tax liability determined in an IRS civil
proceeding as a matter of equity” (slip op. at 62), but whether and how that order is applied is far from clear, given that the IRS is not a party to the SEC case. And if this event comes to pass, what is the purpose of Judge Scheindlin pre-judging it in the context of a securities enforcement action, knowing that the IRS knows about, and is considering, the issue? The judge also takes a poor stab at how to handle a determination by tax authorities that the amount of tax Judge Scheindlin finds was avoided was not, in fact, required to be paid. The opinion allows for a motion to vacate the judgment “[i]n the event there is a judicial determination that contravenes the legal conclusions of this Opinion and Order – that is, if another court determines that the IOM Trusts are in fact, tax-exempt non-grantor trusts,” but excludes such relief “if the IRS, in exercising its discretion, chooses not to proceed with an administrative or civil action against the Wylys.” (Slip op. at 62 n.205.) This is plainly inadequate because the determination that no unlawful tax avoidance occurred could properly be made by the IRS itself, without any judicial determination. There is no reason for Judge Scheindlin to intervene in, and potentially negate, that process in the context of a securities enforcement action. An IRS determination that the transactions were not taxable totally undermines any finding by Judge Scheindlin that the Wylys unlawfully evaded that tax, nullifying the basis for disgorgement.
As a result, whichever way the tax process goes, it is wrong for the judge to jump the gun and order a tax-based disgorgement before the IRS acts. If the IRS agrees with the judge, the tax will be paid, and no disgorgement is appropriate because there will be no undue tax benefits remaining. If the IRS or a tax court disagree with the judge, no tax will have been unlawfully avoided, and there is no benefit to disgorge. Either way, Judge Scheindlin should limit a disgorgement order to unlawful proceeds derived from the securities violations found, not supposed tax avoidance based on underlying transactions that did not themselves violate the law (only the nondisclosure of stock ownership violated the law).
In short, the SEC and Judge Scheindlin should leave the IRS to do its work, and limit disgorgements to profits improperly earned as a result of securities violations, not tax collections.
September 26, 2014
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