SEC and Sam Wyly Butt Heads On the Impact of Wyly’s Bankruptcy Filing

The SEC’s battle with the Wyly brothers took new and entertaining turns in the past week.  With “Homeland” getting less and less engaging by the episode, Showtime should look into buying the rights to SEC v. Wyly.

On September 25, 2014, Judge Shira Scheindlin of the U.S. District Court for the Southern District of New York, who is presiding over SEC v. Wyly, issued an Order (SEC v Wyly Disgorgement Opinion) that the Wylys must disgorge to the SEC taxes they avoided by not treating offshore trusts funded with Wyly-owned stock options as if they were owned by the Wylys themselves.  Why the court was addressing tax issues in a case focused on a breach of disclosure obligations under section 13(d) of the Securities Exchange Act of 1934 remains the source of some consternation which is likely to be addressed on appeal.  A previous Straight Arrow post adverted to this issue: Wyly Brothers Hit with More than $300 Million Securities Law Disgorgement Order for Unpaid Taxes.  Nevertheless, based on this decision, Sam Wyly faces a future judgment of roughly $200 million.

On October 8, 2014, the SEC asked Judge Scheindlin to impose an asset freeze on Sam Wyly, the estate of Charles Wyly, and assorted other persons, including the offshore trusts that were the subjects of the litigation.  The SEC had no evidence of any effort or threat by the defendants to dissipate their assets, which could justify such an order.  But through this relief, the SEC could conveniently impede the defendants from funding a staunch continuing defense against the SEC claims (or a defense of the ongoing IRS tax audits).  It is a common practice for the SEC to obtain asset freeze orders that hamstring defendants from defending themselves, although, to be fair, on occasion this relief is warranted by a true threat that assets could be dissipated or moved to a judgment-proof location.  That is not the case here.

On October 19, 2014, Sam Wyly filed a voluntary petition for a Chapter 11 bankruptcy in federal bankruptcy court in Dallas, Texas.  That would permit Wyly, under the guidance of the bankruptcy court, to plan and execute an orderly liquidation of assets, as necessary, to satisfy creditors.  Under the terms of the bankruptcy statute, it also automatically stayed litigation that could interfere with that process.  The chief creditors are the SEC, by virtue of the New York federal court’s huge disgorgement award, and the IRS, which is pursuing tax audits that could result (or might not) in claims of tax due from the Wylys on the same theory.  Some orderly approach to the payment of this liability seems to make sense.  The SEC disgorgement award for the most part consists of taxes the court found were avoided by the Wylys’ offshore trust arrangement, and presumably the IRS claims would cover the same territory.  In addition, Judge Scheindlin acknowledged in her Order that the disgorgement and true tax liability are connected when she wrote that a future adjudication of no tax liability would entitle the Wylys to seek to vacate a disgorgement judgment in the SEC action, which was founded on an estimate of the tax liability they supposedly avoided.  (See Judge Scheindlin’s disgorgement order at footnote 205.)  It is hard to imagine anyone arguing that the Wylys should pay the Government the same tax twice.

Also on October 19, Wyly filed a motion in the bankruptcy court to allow him to function as a debtor in possession and, under court supervision and with transparency to creditors, move toward a full payment of all creditors, including the SEC, in an orderly way.  A copy of that motion can be read here: Wyly Bankruptcy Court Motion.

The impact of the bankruptcy filing on the SEC case is not totally clear.  Wyly’s lawyers say it has the effect of automatically staying SEC efforts to freeze Sam Wyly’s assets.  The SEC, however, argued in a letter to Judge Scheindlin that this is not correct because under a statutory exception to the automatic stay, the SEC, as a governmental unit, can continue its case to a “judgment other than a monetary judgment.”  See the SEC letter here: SEC Letter to Judge Scheindlin re Wyly Bankruptcy.  Since the entire purpose of the asset freeze would be to enforce solely the monetary aspect of any final judgment, it is not entirely apparent to this non-bankruptcy lawyer whether the SEC’s argument holds water (or is just all wet).  No doubt much tree pulp will be wasted arguing that issue in multiple courts.  The SEC’s motivation, however, is plain.  They want to control the process of grabbing the money they will be awarded in a judgment, and not leave that to a process left in control of Wyly, as the debtor in possession of the bankruptcy estate.

And some of you out there thought Jarndyce v. Jarndyce was fiction!

Update on the Danger of Challenging the Power of a Presiding Judge: At  a hearing on October 23, 2014, Judge Scheindlin granted the SEC’s motion to freeze Sam Wyly’s assets despite the bankruptcy filing.  Apparently, she acknowledged that this order could violate the automatic stay under the bankruptcy law, but argued on her own behalf that the freeze was okay because it only maintained the status quo.  See the article about the hearing here.  That, of course, is the bankruptcy court’s job.  Observors at the hearing noted that the judge was piqued by what she viewed as an end run around her by means of the bankruptcy filing.  Those who know Judge Scheindlin are not surprised that she would react negatively to perceived maneuvers to wrest control of the case from her.

The stated rationale for the order was that the “assets that might be depleted or dissipated before entry of the final order,” but it is doubtful that the SEC presented evidence of any realistic threat of dissipation of assets.  She said: “They may be property of the bankruptcy estate, but no one is protecting them from being depleted,” but that is obviously wrong.  There is now a court in Dallas tasked with assuring that the assets are used only as permitted by that court.  Apparently the judge at least acknowledged there is a process in the bankruptcy court for reviewing expenditures and agreed that her freeze order should exempt expenditures approved in that process.

Most likely, Judge Scheindlin just did not like the idea that someone other than she would be in control of Wyly’s assets going forward.  Her annoyance also seems apparent from the fact that she agreed that the SEC could conduct third party discovery to try to determine why the Wylys’ assets had dropped to “only” $500 million since the early 2000s.  That process plainly should occur under the auspices of the bankruptcy court, which oversees statutory protections against an improper dimunition of assets that may have harmed creditors.

One thing litigators know is that judges are the unquestioned Kings and Queens of their courtrooms, and they rarely take kindly to efforts to usurp their (to be sure, localized) royalty.  If the freeze award is appealed (if, indeed, it is subject to immediate appeal), perhaps there will be a begrudging appellate recognition of the limits of royalty in the courtroom (but don’t hold your breath).

Second Update on the Audacity of the SEC: On October 27, 2014, the SEC and parties impacted by a an SEC proposed freeze order commenced battles over the scope and terms of the freeze order endorsed by Judge Scheindlin.  The SEC’s audacity is breathtaking; hopefully the judge, who is audacious enough herself to contest the applicability of bankruptcy laws to her court, will call balls and strikes fairly here.  The SEC chose to ignore what the judge said about the freeze order and proposed one that left out carefully discussed limits focusing on issues of comity between the New York court and the Dallas bankruptcy court.  The SEC also decided it needs to have a broad, open-ended ability to freeze assets of innocent bystanders — uncharged members of the Wyly extended family — without an iota of evidence that they are in possession of Sam or Charles Wyly’s assets.  For a flavor of what is going on, take a look at these letters to the court by the affected parties: Wyly Family Counsel Letter to ScheindlinWyly Counsel Letter to Scheindlin re Freeze Order.  Perhaps Judge Scheindlin will see the foolishness of her ill-considered decision that her court should be the overseer of these disputes rather than the Dallas bankruptcy court, which lacks the manifold Article III duties facing Judge Scheindlin every day.

Straight Arrow

October 23, 2014 (updated October 27, 2014)

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