Tag Archives: disgorgement

Some SEC Administrative Law Judges Are Thoughtful and Even Judicious

We have now on several occasions bemoaned the fate of Laurie Bebo, former CEO of Assisted Living Concepts, Inc., to be forced to litigate her professional future before SEC Administrative Law Judge Cameron Elliot, whom we believe to be, shall we say, not the brightest star in the firmament.  See SEC ALJ Cameron Elliot Shows Why In re Bebo Should Be in Federal Court; Bebo Case Continues To Show Why SEC Administrative Proceeding Home Advantage Is Unfair; and SEC ALJ in Bebo Case Refuses To Consider Constitutional Challenge and Denies More Time To Prepare Defense.  And we have argued that the SEC’s home administrative law court is not a fair forum for the resolution of career-threatening enforcement actions against non-regulated defendants, notwithstanding that the Dodd Frank Act permits such cases to go forward.  See Challenges to the Constitutionality of SEC Administrative Proceedings in Peixoto and Stilwell May Have Merit; Ceresney Presents Unconvincing Defense of Increased SEC Administrative Prosecutions; and Opposition Growing to SEC’s New “Star Chamber” Administrative Prosecutions.  That might make a reader think we believe that all SEC ALJs lack the ability or temperament to preside over and decide important cases.  So, to set that record straight, allow us to say that, like almost almost any other place, the SEC administrative law courts are administered by appointees with a range of abilities and demeanors.  It is not the lack of judicial ability that makes the SEC’s administrative courts a poor forum for such cases, it is that the forum is bereft of procedural protections that enhance the chance that a respondent will get a fair shake even when the presiding ALJ is one of poor judicial timber.

In federal court, there are also good judges, bad judges, and a range in between.  But the scales of justice have calibrating factors other than the judge.  In a federal court, equal access to potential evidence through liberal discovery; equal opportunity to develop familiarity with the record over a reasonable period of time; evidentiary rules designed to assure that unreliable evidence, and excessively prejudicial evidence, is excluded; and, of course, the fact that a jury sits to consider the evidence, and use their combined common sense to find facts, all combine to make it possible for a defendant to overcome poor judging.  There is a vacuum of such protections in the administrative law court.  That makes the quality, or questionable quality, of the judge/trier of fact, much more important.  When the judge fails to understand, or care, that he or she is essentially the only factor between a fair proceeding and one tilted in favor of the prosecutor, justice suffers.

So, in celebration of the new baseball season, I’d like to throw a change-up today and discuss an SEC administrative law judge who, although appointed only recently, is showing great potential to be worthy of his position.  I’ve not seen SEC ALJ Jason Patil in the courtroom, but I’ve been very impressed with his approach in some recent cases.  He’s shown he can act with independence, thoroughness, attention to detail, and a strong dose of common sense.  So this blog post is to give credit where credit is due.

All the more credit is due because Jason Patil is the proverbial “new kid on the block.”  He was appointed to the SEC’s ALJ bench on September 22, 2014, after receiving a Stanford degree in political science in 1995, a law degree from from the University of Chicago Law School in 1998, and an L.L.M, from Georgetown University Law Center in 2009.  He served at the Department of Justice for 14 years.

Fewer than 3 months after ALJ Patil started at the SEC, the Second Circuit rocked the boat of the DOJ and the SEC with its insider trading decision in United States v. Newman.  ALJ Patil had to consider the impact of that decision in a case before him: In the Matter of Bolan and Ruggieri.  The SEC’s enforcement lawyers made every effort to obtain an early, post-Newman ruling from ALJ Patil in that case that would limit the scope of the Newman opinion through the adoption of a standard that would not apply Newman‘s holding to insider trading cases based on the misappropriation theory, rather than the so-called “classical” insider trading theory on which the Newman and Chiasson prosecution was founded.  ALJ Patil resisted the SEC’s full-court press to make him an early adopter of an approach that essentially ignored key language in the Second Circuit opinion.  He rejected that effort, ruling that, as the Newman court said, the standard for liability was the same under either the classical or misappropriation insider trading theory.  See SEC ALJ in Bolan and Ruggieri Proceeding Rules Misappropriation Theory Mandates Proof of Benefit to Tipper.

That showed intelligence, independence, and, to be frank, guts, for a newly-appointed ALJ.  But it was a later decision that showed me that ALJ Patil seems to have the stuff of a good judge.  In the Matter of Delaney and Yancey, File No. 3-15873, was not a high profile insider trading case, but it was apparent from the Initial Decision he wrote that he was able and willing to evaluate cases fairly and decisively.  His decision in that case is available here: ALJ Initial Decision in the Matter of Delaney and Yancey.  In that case, he wrote a careful opinion, weighing the evidence, distinguishing between the roles and conduct of the respondents, weighing expert testimony, considering (and often rejecting) varying SEC legal theories, and applying a strong dose of common sense.

The case was a technical one, involving charges against two individuals, the President and CEO of a broker-dealer that was a major clearing firm for stock trades (Mr. Yancey), and that firm’s Chief Compliance Officer (Mr. Delaney).  The SEC alleged many violations by the firm of SEC regulations governing the settlement of trades.  Mr. Delaney was charged with aiding and abetting, and causing, numerous violations of SEC regulations by virtue of his conduct as the Chief Compliance Officer.  Mr. Yancey was charged with failing adequately to supervise Mr. Delaney and another firm employee, allowing the violations to occur.  ALJ Patil exhaustively reviewed the evidence to reach reasoned decisions, with cogent explanations supporting his views.  In doing so, he was not shy about chiding the SEC for fanciful theories and woefully unsupported proposed inferences.

The opinion is long, detailed, and more in the weeds than many of us like to get.  The aiding and abetting charge against Mr. Delaney required proof that he assisted the violations through either knowing or extremely reckless conduct (i.e., scienter).  The SEC enforcement staff is quick to accuse people of knowing or reckless misconduct, and is often willing to draw that inference with little in the way of supporting evidence.  ALJ Patil’s review of the evidence presented in support of the scienter element was precise and thorough.  He dissected the evidence piece-by-piece, in impressive detail.  Here is some of what he said:

The Division has failed to show that Delaney acted with the requisite scienter, and
therefore its aiding and abetting claim against Delaney fails.  As an initial matter, I note that the Division is unable to articulate or substantiate a plausible theory as to why Delaney would want to aid and abet [his firm’s violations].  While the Division correctly argues that motive is not a mandatory element of an aiding and abetting claim, numerous courts have noted its absence when finding that scienter has not been proven. . . .    The Division also failed to establish that Delaney had anything to gain from the alleged misconduct.  The Division’s original theory was a wildly exaggerated belief that [the] . . . violations resulted in millions of dollars of additional profits. . . .  The Division was forced to abandon that theory, and in the end agreed that the “only specifically quantified benefit” to [the firm] . . . was a meager $59,000.  I do not find that sum would have given Delaney any motive to aid and abet the . . . violation. . . .  Although the Division also argues that there would have been “substantial costs to [the firm] . . . that . . . could expose the firm to significant losses,” the Division produced no evidence to quantify the costs or losses, and the testimony to which the Division points is general and speculative. . . .  As the Division did not provide any evidence quantifying the purported costs or losses, I am unable to determine whether there were any.

One of the SEC’s major points was the contention that Mr. Delaney’s knowing misconduct was apparent because he was shown to be a liar by misstatements in the Wells Submission submitted to the SEC on his behalf by his lawyers.  ALJ Patil forcefully torpedoed this theory:

I disagree with the Division’s conclusion that “Delaney has not been honest or
truthful” and “[i]nstead . . . has been evasive and inconsistent.”. . .  The Division’s
primary evidence for this alleged dishonesty are statements made in Delaney’s Wells
submission.  The Division argues, “either the statements Delaney approved about his knowledge and actions were lies to the Commission in his Wells submission or his repudiation of those statements are lies to the Court now.”. . .  Based on my careful review of that document, I conclude that it is primarily comprised of argument by counsel and grounded in incomplete information. . . .  It is based not just on Delaney’s understanding at that time, but on his counsel’s characterization of other evidence selectively provided to Delaney by the Division. . . . .  In contrast to that argumentative submission, Delaney testified five times under oath, including at the hearing. . . .  I find that Delaney’s testimony was overwhelmingly consistent, and the handful of inconsistencies alleged by the Division in such testimony either do not exist or are easily explained by the circumstances. . . .  In this case, where Delaney testified multiple times under oath at the Division’s request, as did other witnesses, I have decided to base my decision on that testimony and other documents in the record, which I find more probative than past characterizations made by Delaney’s counsel. . . .  I do not accept the Division’s insistence that everything in the [Wells Submission], particularly the statements in the legal argument section, should be taken, in essence, as testimony of Delaney.

Perhaps most telling was ALJ Patil’s careful review of supposed inconsistencies in testimony by Mr. Delaney.  His evaluation of that testimony reflected thoughtful consideration of the facts and circumstances both when the events at issue occurred, and when the testimony was given.  The decision took the SEC lawyers to task for arguing that testimony was inconsistent when the supposed inconsistencies were more plausibly explained by poor questioning by the SEC staff during their numerous examinations of him:

To the extent that Delaney’s testimony could be at all be characterized as “evasive” or
“inconsistent” . . . , it may be because he lacks a completely clear recollection of what
took place years ago regarding his alleged conduct.  Delaney credibly and convincingly
explained that his initial testimony was given with virtually no preparation or opportunity to
review documents, thus preventing him from having a full and fair recollection of the events he was asked about. . . .  While his conduct with respect to [the Rule at issue] is especially
important in the present action, at the time of such conduct, Delaney was in the business of
putting out “fires,” . . . and [the Rule], though undeniably important, was most assuredly not the top priority for the compliance department. . . .  [T]he Division argues that “Delaney quibbled about whether he had seen the release [for the Rule] in the same exact format as that in the exhibit used at the hearing and during his testimony.” . . .  Several exhibits copy or link to the text of the releases . . . with the appearance and formatting of each differing dramatically from the way the text of such releases is ultimately arranged in the printed version of the Federal Register, the document Delaney was shown at the hearing. . . .  When someone is testifying about a document that may not look anything like the version he had read, it is not “quibbling” to explain that one has never seen something that looks like the exhibit.  I in fact thought that the Federal Register version of the releases looked considerably different from the other copies and would have been hesitant to say I had read the exhibit without first looking it over. . . .  Despite his exasperation at the Division’s repeated insinuations that he was lying, I found Delaney a credible and convincing witness. My perception, that his hours of testimony were sincere and truthful, is consistent with the attestation of all the hearing witnesses regarding Delaney’s honesty and integrity.

Finally, the Division asserts that Delaney contradicted himself because, on the one hand,
in August 2012 he did not recall being concerned about the contents of [a FINRA letter] and, on the other hand, in July 2013 he testified that a disclosure in that letter would be a big deal for [his firm]. . . .  However, because Delaney was asked somewhat different questions on the two different occasions (as opposed to being asked the same question on both occasions), his answers were consistent.  In August 2012, Delaney was asked whether he was concerned about the letter, not the conduct at issue. . . .  When asked about the purported contradiction at the hearing, Delaney reasonably explained that he was not concerned about the letter disclosing the conduct, which was accurate as he understood it, but at the same time was concerned about the underlying rule violations. . . .  It is telling that the Division, who has had Delaney testify so often, seizes on such minor supposed contradictions.  I find all of the purported inconsistencies identified by the Division are
either immaterial or have been adequately explained by Delaney.  I found, on the whole,
Delaney’s testimony to be credible, with the exception, noted previously, that he may not recall comparatively minor events and discussions that took place up to six years before the hearing.

Having found no evidence of knowledge, ALJ Patil went on to reject the SEC staff’s suggestions that Mr. Delaney’s conduct was nevertheless “reckless.”  He carefully distinguished between evidence of negligence and “extreme recklessness.”  He then dissected individual emails presented by the staff as “red flags” to show, one-by-one, that they were no such thing.

ALJ Patil nevertheless found Mr. Delaney liable for “causing” some of the firm’s violations, based on his conclusion that Mr. Delaney acted negligently.  He found violations “because the evidence supports that Delaney contributed to [the firm’s] violations and should have known he was doing so.”  He did so on the basis of testimony “that according to SEC guidance, in situations ‘where
misconduct may have occurred’– as opposed to ‘conduct that raises red flags’ – compliance
officers should follow up to facilitate a proper response.”  He provided a lengthy and lucid explanation of why he reached the conclusion that Mr. Delaney faced such a situation and failed to act prudently.

The case against Mr. Yancey failed entirely.  ALJ Patil found that Mr. Yancey, as CEO, was Mr. Delaney’s supervisor, but the evidence did not show intentional conduct by Mr. Delaney, and a supervisory violation can occur only when “[t]he supervised person must have ‘willfully aided, abetted, counseled, commanded, induced, or procured’ the securities law violation.”  But even if Mr. Delaney had willfully aided an abetted the firm’s rules violations, “the Division has failed to show that Yancey did not reasonably supervise Delaney . . . because “[a] firm’s president is not automatically at fault when other individuals in the firm engage in misconduct of which he has no reason to be aware.”  He concluded: “Yancey had no reason to believe that any ‘red flags’ or ‘irregularities’ were occurring at [the firm] that were not already the subject of prompt remediation.  Given the absence of such evidence, I find that the Division did not prove that Yancey failed reasonably to supervise Delaney, even were such a claim viable here.”

As for the supervisory charge regarding the second firm employee, who was a registered representative who did act willfully, Yancey “persuasively dispute[d]” that the employee was not subject to the CEO’s “direct supervision.”  “[A]s an initial matter, a president of a firm ‘is responsible for the firm’s compliance with all applicable requirements unless and until he or she reasonably delegates a particular function to another person in the firm, and neither knows nor has reason to know that such person is not properly performing his or her duties.’ . . .   I find that Yancey is not liable for [the employee’s] intentional misconduct because the record supports that Yancey reasonably delegated supervisory responsibility over [him] . . . and then followed up reasonably.”  ALJ Patil rejected several theories of the SEC staff why Mr. Yancey should nevertheless be considered a supervisor.  He ultimately found no liability for Mr. Yancey.

On the issue of sanctions, ALJ Patil did not rubber stamp SEC staff requests.  He gave a reasoned explanation for issuing a cease and desist order against Mr. Delaney, found he could not issue a bar order against him because he did not act willfully, and imposed what seem to be reasonable civil penalties, totaling $20,000, for the conduct involved.  His order on the SEC’s disgorgement request was, perhaps unintentionally, amusingly tongue-in-cheek: “I have opted not to order disgorgement in this case, because the amount at issue is negligible. The Division contends, in effect, that Delaney must pay back the portion of his $40,000 in bonuses during the relevant time period that arose from the Rule 204T/204 violations.  The quantified benefit of the violations, $59,000, is approximately 0.008 percent of [the firm’s] revenue during that period. . . .  Even if all of Delaney’s bonuses were based on [the firm’s] performance (which, they are not, since the parties seem to be in general agreement that such performance was only one of three factors in bonuses), based on the preceding figures, the percentage of Delaney’s bonuses tied directly to the quantifiable benefit . . . is three dollars and twenty cents.  Even accounting for prejudgment interest, a disgorgement order is unwarranted.”

Kudos to ALJ Patil for what appears to be a fine job of adjudicating a tiresome case.  In a careful ruling, he handed the SEC a substantial defeat and a partial victory.  If he keeps this up in his tenure as an SEC ALJ, we should see some high-quality, thoughtful, and independent decisions penned by him.

Straight Arrow

April 14, 2015

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Final Disgorgement Order in SEC v. Wyly Is Far from “Final” Because of Unnecessary Pre-Judgment of Pending Tax Issues

On February 26, 2015, Judge Shira Scheindlin issued a final disgorgement order in SEC v. Wyly, implementing her previous opinions in September and December 2014.  We previously discussed those opinions here (Wyly Brothers Hit with More than $300 Million Securities Law Disgorgement Order for Unpaid Taxes) and here (SEC v. Wyly: New Scheindlin Disgorgement Opinion Shows How SEC Remedy Has Gone Awry).  The newest opinion can be read here: Final Disgorgement Opinion and Order in SEC v. Wyly, and the final judgment in the case can be found here: Final Judgment in SEC v. Wyly.

The new decision does not depart from the earlier opinions, it merely resolves disputes about how to implement them.  As a result, the parties are left with a set of varying rulings contingent on what may happen (1) on appeal, and (2) in an ongoing Internal Revenue Service audit.

In September, the judge decided that the SEC was entitled to a “disgorgement” remedy that included payment of federal taxes that she found were avoided in the Wylys’ offshore trust transactions.  Even though the transactions themselves violated no securities laws, and the Wylys’ tax returns violated no securities laws, she decided that because the Wylys’ nondisclosure of beneficial ownership in those trusts under section 13(d) of the Securities Act of 1934 may have caused the IRS to miscalculate taxes that were due, the taxes avoided were “causally related” to the securities violations.

In December, the judge considered SEC contentions on securities profits gained because of the nondisclosure, which was based on expert analysis founded on no generally accepted underlying theory or economic literature, but she nevertheless was inclined to accept that analysis as sufficient to satisfy the Second Circuit’s low threshold for ordering a disgorgement.  But she decided that a disgorgement ordered on that basis would yield an inequitable result, and declined to issue that order.  Obviously not keen on getting the case back on remand, she said that in the event the Second Circuit disagreed that she had the discretion to act as she did, she was ruling in favor of the SEC on the theory it presented.  See SEC v. Wyly: New Scheindlin Disgorgement Opinion Shows How SEC Remedy Has Gone Awry.

In the February 2015 opinion, Judge Scheindlin addresses specific proposed orders to implement the earlier decisions.  The end result is a “final judgment” that is far from “final” – it includes multiple possibilities depending on what the court of appeals decides, and what taxes the Wylys may yet be required to pay to the IRS.  You need a flow chart to get it all straight.  But the contingent order-writing to take account of future tax determinations was unnecessary — and, in my view, wholly inappropriate – in a disgorgement order for securities law violations.  That is because whatever happens in the future as to taxes owed, those determinations should fully and adequately assure that the Wylys retain no “ill gotten gains” in the form of taxes unlawfully avoided.

Judge Scheindlin’s stubborn insistence on making the tax issues part and parcel of the securities relief accomplishes nothing other than creating potential future headaches and possible injustices.  As we previously wrote, what is the purpose of pre-judging the tax issues in the context of a securities enforcement action, knowing that the IRS is addressing them?  The IRS is not obligated to, and may not, accept her ruling. Indeed, Judge Scheindlin acknowledges that the IRS is not bound by her view about how the disgorgement should be treated by tax authorities (“the IRS may take notice of this Court’s conclusion that there should be an offset for amounts paid to the SEC, even though the IRS is not a party here. Should the IRS disregard that language, the Wylys may return to this Court and move to vacate the final judgment….”  Slip op. at 6-7.).  That’s a future time bomb.

The prospect of disagreement goes both ways: she is not prepared to defer to a possible IRS decision that her analysis was wrong and taxes were not unlawfully avoided.  She only allows the Wylys to “pursue all available remedies should another court determine that the IOM Trusts are tax-exempt.”  Id. at 7 (emphasis added).  In other words, if a tax court rules the taxes were not owed, the Wylys may (or may not) get their money back by seeking relief from Judge Scheindlin’s judgment, but they are not permitted to ask for that relief if the IRS decides no taxes were owed, and the issue never gets to court.  The latter result seems blatantly unfair.  It is inconsistent with the concept of “disgorgement” because it mandates that they “return” proceeds that were not unlawfully obtained.  It could also be an improper judicial refusal to defer to an agency judgment in its own area of expertise.  All of this nonsense could be avoided if the court did not take up live tax disputes as part of a securities enforcement proceeding.

 What we wrote in our earlier post still seems correct:

[W]hichever 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).

(One of the pleasures of blogging is that you get to quote yourself with impunity.)  🙂

As we discussed earlier this week (see Let’s Get Real: When SEC “Disgorgement” Remedy Is Used as Punishment It Should Be Treated that Way), the legal standards governing the disgorgement remedy badly need serious thought and judicial leadership.  The SEC will try to “shoot the moon” in almost every case, and courts need to exercise reasoned discretion over how far they are prepared to go with this “equitable remedy” which more and more often is used to try to get defendants to pay far more than a realistic and well-conceived return of their own “ill-gotten gains.”  That is all that “disgorgement” should be.  To her credit, Judge Scheindlin resisted the SEC’s “shoot the moon” efforts a couple of times in the Wyly case.  But she lost her bearings on the tax-based disgorgement theory, leaving more than a little bit of a mess in the end.

Straight Arrow

March 6, 2015

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Let’s Get Real: When SEC “Disgorgement” Remedy Is Used as Punishment It Should Be Treated that Way

Virtually every SEC enforcement proceeding includes a request for so-called “disgorgement” relief.  Once upon a time, “disgorgement” meant that a wrongdoer should be denied benefits he or she gained from misconduct.  As a matter of justice or fairness, that seemed hard to argue about.  There seems no good reason why someone found liable for misconduct should be entitled to retain the benefits of that misconduct.  And there would seem to be good reasons why that shouldn’t happen: otherwise one could argue we leave in place an economic incentive to commit wrongdoing, if the proceeds of misconduct exceed penalties imposed once liability is found (plus other costs of the proceeding).

But where the rubber meets the road, things get more complex.  How exactly should we figure out what the “ill-gotten gains” really are?  How do we take into account potential ongoing civil liabilities for that conduct?  Is it really “disgorgement” of ill-gotten gains if victims of the misconduct can recover those amounts in civil actions, perhaps benefited by application of collateral estoppel against the wrongdoer on the issue of liability?  Is it “disgorgement” to cause multiple liabilities for the same “ill gotten gains”?  What about other possible governmental liability for the “ill-gotten gains”?  If another governmental entity has a claim to recover some or all of those amounts, how many times should the government get to recover the gains, plus impose “penalties”?  What if there are parallel criminal and civil government enforcement actions?  Is it “piling on” to impose a “disgorgement” on top of a  criminal fine, possible criminal forfeiture, and civil penalties, which together are much larger than any possible “ill-gotten gains”?

It gets even more complex.  What rights does an accused have when he faces government actions for “disgorgement,” on top of civil penalties and other possible forms of relief?  An accused has a right to a jury trial in any criminal action, but also has a Seventh Amendment right to a jury in many civil actions.  As a relic of history, there is no Seventh Amendment right to a jury in a civil action that would, in former days, have been tried in courts of “equity.”  Should disgorgement be treated as an “equitable” remedy for which there is no right to jury trial?  Does that seem right (might one say “equitable”?) if the “disgorgement” calculation proposed by the government could result in a liability that vastly exceeds any possible civil penalty that is permitted by statute?  Indeed, does it ever really make sense to allow a “disgorgement” theory that results in findings of liability that dwarf the statutory limits on penalties that can be awarded in a case?  And what about time limits on seeking disgorgement relief?  There are statutes of limitation for criminal and civil actions, but, again as a vestige of judicial history, those statutory time limits don’t apply to actions for so-called “equitable relief.”  If actions for civil penalties are time-barred, should it really be possible to pursue stale liability claims solely for “disgorgement”?  How about if the stale claims for “disgorgement” seek amounts that vastly exceed the possible penalties that are time-barred?

These are complicated and nuanced questions, which have multiple layers of issues of fairness and public policy.  Unfortunately, the SEC has little patience for any such considerations.  It not only takes a knee-jerk position that what it calls “disgorgement” should be pursued in every case, but it opposes any meaningful restriction on how it should calculate such “disgorgement,” and opposes allowing an accused procedural rights to fight disgorgement like other civil liabilities.  Not only that, the SEC has also decided that “disgorgement” doesn’t really mean that a wrongdoer must give up his or her ill-gotten gains; to the SEC, it means that the wrongdoer must also pay amounts gained and retained by other persons as a result of the misconduct.  (As an example, just look at the SEC’s most recent effort in SEC v. McGee to get an insider trader to be responsible for “disgorgement” that includes not only the $292,000 he earned in alleged illegal profits, but also more than $1 million in alleged profits earned not by him, but by the “downstream” tippees who traded.)  And as to the calculation of “ill-gotten gains,” let’s just say that the only principle the SEC accepts in doing such calculations is that “more is better.”

Unfortunately, courts have been much too willing to accept aggressive SEC theories of “disgorgement,” which naturally has led to increasingly more outrageous SEC disgorgement calculations on the “more is always better” theory of law enforcement public policy.  The law in this area is now so prolix it is impossible to follow.  Somehow, we have reached the stage where, contrary to every sense of fairness and due process, a defendant is required by some courts to bear the burden of proving that a proposed SEC disgorgement calculation is incorrect, as long as the SEC proposal is deemed by the court to be plausible.  This judicial recognition of the concept “close enough for government work” as the rule of law in an enforcement proceeding is a mockery of due process, especially when what is at issue often may be amounts of supposed “disgorgement” that make the defendant bankrupt or destitute.  And, in a bizarre rejection of jurisprudence on the issue of causation, although the courts agree that for disgorgement not to be a form of punishment, it must be “causally connected” to the wrongdoing, some courts now accept that the proceeds of misconduct can be determined by mere “but for” causation, notwithstanding what may be, at best, strained proximity between the wrongdoing and the ultimate proceeds.  These are not just district court decisions, but influential appellate decisions in the Second and Third Circuits as well.  See SEC v. Contorinis, 743 F.3d 296 (2d Cir. 2014); SEC v. Teo, 746 F.3d 90 (3d Cir. 2014).  The SEC often takes the position that a company employee who commits or assists in a violation should “disgorge” all or portions of his or her salary, apparently on the bizarre (and, of course, unproven) theory that they were paid for the violations and not to perform actual duties as employees.  Some courts actually accept this nonsense.

In short, a combination of SEC over-exuberance, to be kind, and judicial acceptance, has resulted in bringing the securities “disgorgement” remedy far from its origins as a means of divesting a wrongdoer of his or her ill-gotten gains.  This departure raises serious questions about whether what is now labeled a “disgorgement” remedy is, in fact, a traditional form of equitable relief.  See The Equity Façade of SEC Disgorgement, and Thinking about SEC Disgorgement.  There is no doubt that Supreme Court consideration will ultimately be required.

The issue of disgorgement relief is so significant and complex, it is impossible to address in a single blog post.  On several previous occasions, we have discussed the issue in specific enforcement contexts.  The SEC v. Wyly enforcement action provided several opportunities to examine the issue.  In that case, Judge Scheindlin issued one decision describing the current state of the law of disgorgement in the Second Circuit, and then refusing to follow it because the result was so plainly inequitable.  See SEC v. Wyly: New Scheindlin Disgorgement Opinion Shows How SEC Remedy Has Gone Awry.  Judge Scheindlin also rejected some of the SEC’s more far-fetched theories of unlawful proceeds — including the notion that all of the increased value of stock the Wylys over a 13-year period should be disgorged when the only violation found was that they failed to disclose those holdings in section 13(d) disclosure filings, which certainly did not drive the increasing value of the stock.  See SEC v. Wyly III: SEC’s Overreach on Disgorgement Remedy Shot Down.  On the other hand, Judge Scheindlin ultimately awarded as a “disgorgement” for securities law violations a supposed unlawful tax avoidance that, if it truly was an unlawful tax avoidance, could be recovered by the IRS — and was actively being investigated by the IRS.  As a result, the defendants will be required to “disgorge” as supposed tax benefits either amounts the IRS do not allow them to retain (meaning there are no real “ill-gotten gains” to disgorge), or amounts the tax authorities determine were not, in fact and law, unlawful tax avoidances, in which case there also is no ill-gotten gain.  (Judge Scheindlin’s disgorgement order tried to address this issue by allowing disgorged amounts to be “credited towards any subsequent tax liability determined in an IRS civil proceeding as a matter of equity,” but the effect of that determination is far from clear, since the IRS is not a party to the SEC case.  She also tried to account for the possibility that tax was not really avoided by allowing a motion to vacate the judgment if another court rules that no taxes were owed — but not if the IRS itself determines not to assert any unlawful tax avoidance — which on its face is a half-baked approach to the issue, since much tax policy is determined without a court determination.)  This is “Alice in Wonderland” jurisprudence.  See Wyly Brothers Hit with More than $300 Million Securities Law Disgorgement Order for Unpaid Taxes.  As a result of the huge “disgorgement” imposed by Judge Scheindlin, Sam Wyly, once one of the wealthiest men in America as a result of growing a huge retail and securities empire with his now-deceased brother, is in bankruptcy.

Another example of disgorgement without bounds discussed in earlier posts is the SEC’s outrageous calculation of a $2 billion disgorgement in SEC v. Life Partners Holdings, Inc., which we discussed here: SEC Again Runs Amok, Seeking $2 Billion in Texas Case.  Fortunately, the district court rejected this absurd contention: see SEC Gets Reasonable Relief in Life Partners Case — but only 2.5% of $2 Billion Request.  The combined penalties and disgorgement issued in that case still forced the company into bankruptcy.  One wonders how “equitable” that felt to the company’s shareholders, whom the SEC presumably was trying to protect.

Which brings us to the disgorgement dispute du jour: whether the SEC’s effort to obtain “disgorgement” in SEC v. Graham should be permitted because, unlike the civil remedies found time-barred in that case, the five year statutory statute of limitations under 28 U.S.C. § 2462 does not apply to the portion of an enforcement action seeking disgorgement.  Section 2462 bars government civil claims for fines, penalties, or forfeitures, “pecuniary or otherwise” if they are not commenced “within five years from the date when the claim first accrued.”  For years, the SEC argued for a restrictive reading of section 2462 which would allow it to pursue claims for five years after they were “discovered,” rather than five years from when they accrued.  That position was finally put to rest by the Supreme Court in Gabelli v. SEC, 133 S. Ct. 1216 (2013).  Since then, the SEC has been searching for other ways to pursue enforcement actions after the five-year period expires.

In Graham, the SEC alleged a classic Ponzi scheme, in which the alleged perpetrators promised wealth-creating returns to purchasers of condominium units that were to be renovated and rolled into a large, nationwide resort.  As alleged, the returns paid to investors were funded by later purchases of new investors.  Because the last condominium sale occurred in 2007, however, and the SEC didn’t commence any action until 2013, the district court held that section 2462’s five-year statute of limitations barred all of the SEC’s claims.  District Judge King rejected the SEC’s argument that its claims should continue for the requested relief of disgorgement and an injunction because those were equitable claims and therefore not subject to any statute of limitations.  On the issue of disgorgement, Judge King wrote: the “disgorgement of ill-gotten gains . . . can truly be regarded as nothing other than a forfeiture (both pecuniary and otherwise),” which is expressly covered by section 2462.  “To hold otherwise would be to open the door to Government plaintiffs’ ingenuity in creating new terms for the precise forms of relief expressly covered by the statute in order to avoid its application.”  See his opinion here: SEC v. Graham.

In our discussion of this case at the time (see SEC v. Graham: SEC’s Delay in Filing Causes Ponzi Scheme Claims To Be Dismissed) we said: “This last ruling is dagger for the SEC.  Its litigation position is always that the non-penalty relief involves equities, not penalties, which relieves the SEC of unpleasant litigation burdens (including taking those issues away from a jury).  To be fair, most courts have historically agreed with that view, although the analysis is typically thin.  But in recent years the courts have tended to take a much more critical view of the relief the SEC always seeks because it often is highly punitive, even though the SEC portrays it as otherwise.  But that is an issue for another day.”  That other day has now arrived.  The SEC’s appeal is now before the Court of Appeals for the Eleventh Circuit in SEC v. Graham, No. 14-13562-E.

Will the Eleventh Circuit look past SEC’s label of “disgorgement” and recognize that so-called “disgorgement” relief has, in reality, become a harsher form of penalty than the civil “penalties” the SEC is permitted to obtain by statute?  Will the court accept the SEC argument that the “disgorgement” remedy is no more than long-standing ancillary equitable relief forcing divestiture of ill-gotten gains, and therefore not a penalty or forfeiture and not covered by section 2462?  Or will the court take note of the myriad ways that the SEC has caused the disgorgement concept to mutate in one the most severe forms of punishment in its arsenal of punitive weapons?

The Securities Industry and Financial Markets Association (SIFMA) is hoping it can convince the Eleventh Circuit court to see things as they are, not as they are labeled.  It filed an amicus brief in support of affirming the decision below, which seeks to explain why the SEC’s actions for these so-called “equitable” remedies are government enforcement actions that are, and should be, within section 2462’s actions for “civil fine, penalty, or forfeiture, pecuniary or otherwise.”  SIFMA’s brief is available here: SIFMA Amicus Brief in SEC v. Graham.

Whichever way the Eleventh Circuit goes on this, the many disgorgement issues mentioned above will remain, and will have to be resolved over time.  Let’s hope the courts will more consistently look at “disgorgement” on a case-by-case basis, and treat it in all respects for what it really is in each case, rather than allowing the SEC to label punishment as “disgorgement,” like a wolf in sheep’s clothing.

Straight Arrow

March 3, 2015

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SEC v. Wyly: New Scheindlin Disgorgement Opinion Shows How SEC Remedy Has Gone Awry

On December 19, 2014, Judge Shira Scheindlin issued yet another opinion in SEC v. Wyly, addressing yet another SEC theory of disgorgement against the Wyly brothers.  The opinion is available here: SEC v Wyly Opinion on New SEC Disgorgement Theory.  It is unusual because it covers many pages ruling that a new disgorgement calculation proposed by the SEC is, for the most part, consistent with Second Circuit law, but then decides to disregard that approach because she believes her previous disgorgement calculation is more appropriate. The earlier disgorgement opinion can be seen here: SEC v Wyly September 25 Disgorgement Order.

The previous disgorgement analysis led to an order that the Wylys pay just short of $200 million plus prejudgment interest for the securities law violations found by the jury.  It was based on benefits directly flowing from the Wylys’ use of offshore trusts for their trading in securities of companies they controlled, those benefits being the avoidance of taxes they should have paid (according to the court) if they Wylys owned up to the fact that they controlled those offshore trusts for taxation purposes.  In an earlier post, I questioned the propriety of using a securities disgorgement award to cause the payment of taxes, especially when there is ongoing IRS consideration of that very same issue.  See here: Wyly Brothers Hit with More than $300 Million Securities Law Disgorgement Order for Unpaid Taxes.  The SEC’s new disgorgement theory called for an additional disgorgement (beyond the taxes avoided) of about $200 million plus prejudgment interest.

The newest opinion lays out an extensive review of the status of the law of the so-called disgorgement remedy.  The effective end point of this review is that courts have great discretion to decide what amounts to “disgorgement of ill gotten gains,” largely unencumbered by traditional considerations of causation.  Once Judge Scheindlin establishes that the only standard guiding this process is that there must be a “reasonable” basis to find “but for” causation of a benefit, the sky is essentially the limit.

Based on this standard, the judge examines a new disgorgement calculation proposed by an SEC expert.  She conducted an extended hearing on this proposal, including testimony from the SEC expert and a defense expert.  In essence, the new approach put forward by the SEC was to calculate purported profits the Wyly brothers obtained from undisclosed stock trading activity greater than the profits that would have been realized by a hypothetical uninformed “buy and hold” investor.  The Wylys’ trading was never found to be unlawful, however. The violation of law that occurred was the failure to comply with disclosure requirements under SEC Rule 13D by not filing Schedules 13D for securities held by offshore trusts that the jury found they controlled.  The SEC’s theory was that the 13D violations enabled the Wylys to do their trades secretly, which allowed them to garner more profits than the hypothetical “buy and hold” investor.  This, the SEC argued, was sufficient to satisfy the meager “but for” causation requirement render the gains “ill gotten,” and justify a disgorgement of those profits, which would not have been obtained “but for” the 13D violations.

You can read the opinion to see how Judge Scheindlin handles this novel theory.  It was novel both as a disgorgement theory and as a matter of expert testimony – it was acknowledged by the SEC’s expert that her calculation had never been accepted in the field of economics or econometrics.  It was unsupported by any generally-accepted form of economic or statistical analysis for determining excess stock profits. The judge nevertheless found that what the expert did was “reasonable” and, therefore, under Second Circuit law, agreed it could form the basis for a disgorgement calculation under a “but for” causation theory.  She rejected a portion of the analysis, but otherwise accepted the approach as a valid disgorgement calculation under Second Circuit law.

Judge Scheindlin then took an unusual step: she decided not to issue an order following that approach, saying she was “confident that the remedy already imposed” in her earlier September 25, 2014 disgorgement order (see here) was “the best measure of the Wylys’ ill-gotten gains.”  Slip op. at 56.  She accepted the alternative calculation “only in the event that a higher court disagrees with the measure of disgorgement calculated in the September 25 Order.”  Id.  In other words, she appears to be saying to the Second Circuit: “accept this if you want to under the law you have laid out in other cases, but I don’t think it really think it is a just and fair result as an order of disgorgement in this case.”

Judge Scheindlin was right to reject the proposal as an inappropriate “disgorgement” of ill-gotten gains by the Wylys.  Without saying so, she seems to have — properly in my view – balked at the application of the “but for” concept to deprive a violator of profits with only an attenuated relationship to the violations of law found by the jury.

“But for” causation is essentially a meaningless concept in the context of awarding a remedy because it is almost infinitely flexible, making it a standardless standard.  One need not have attended law school and studied the concept of proximate causation to understand that “but for” arguments can launch absurd chains of causation that are purposeless other than for metaphysical ruminations.  Without some directness requirement, one can spin a “reasonable” theory of “but for” causation that borders on the absurd.  If someone intentionally breaks the speed limit to get to a Seven-Eleven before the deadline for buying a lottery ticket, and buys a ticket that wins a $500 million prize, is the $500 million an “ill-gotten gain,” making disgorgement of the $500 million for speeding an appropriate remedy?  Of course not (even if the violator intentionally violated the speed limit with this purpose in mind).  There is no real nexus between winning the lottery — a random event — and the speeding violation, even though there plainly is “but for” causation.

For disgorgement to serve as a reasonable form of “remedial” relief in law enforcement actions, there must be a limiting theory on the concept of “ill gotten gain” beyond the non-standard of “but for” causation.  Without some form of directness analysis – some way of tying the profits obtained to the substance of the violation found – the disgorgement remedy is so amorphous that it will, in many cases, swamp the formal remedies prescribed for these violations (i.e., schedules of penalties adopted by Congress), yielding equitable relief that truly shocks the conscience, as I believe it did for Judge Scheindlin.

Straight Arrow

December 25, 2014

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SEC Gets Reasonable Relief in Life Partners Case — but only 2.5% of $2 Billion Request

On August 22, 2014, we discussed the SEC’s outrageous request for a $2 billion award of disgorgement and penalties in SEC v. Life Partners Holdings, even after getting no fraud judgment.  See SEC Again Runs Amok, Seeking $2 Billion in Texas Case.  The final judgment is now in, and Judge James Nowlin gave a thoughtful and well-reasoned package of relief of just below $50 million, only $1,950,000,000 less than the SEC argued was the proper result.  So the SEC can be 2.5% right and still cause a lot of pain.  You can read the court’s Final Judgment here: Judgment in SEC v Life Partners Holdings.

Fraud violations of section 17(a)(1) of the Securities Act of 1933 were found by the jury, but the judge set aside that portion of the verdict because the SEC’s only evidence of securities fraud involved a time period not charged in the complaint.  Judgment was issued only on the jury’s findings of reporting violations of section 13(a) of the Securities Exchange Act of 1934 and SEC Rules thereunder, but it was plain from the opinion that the judge found serious culpability at least for the individual who controlled and guided the company’s conduct.

Brian D. Pardo

R. Scott Peden


Individual defendants Brian Pardo and R. Scott Peden




Judge Nowlin gave short shrift to the testimony of the SEC’s putative “expert,” Larry Rubin, who testified that there should be a “disgorgement” remedy of $500 million, on the theory that “retail investors would have paid $500 million less than they actually did” if Life Partners used accurate life expectancy information in its disclosures.  (Life Partners is in the “life settlement” business, acquiring and reselling life insurance policies that generate payments when the insured person dies; longer life expectancies result in delays in revenue or lower resale values.)  The court wrote that it “is not satisfied that Larry Rubin’s testimony supports the SECs proposition that $500 million is a reasonable estimate of [Life Partners’] illicit gains….  [T]he task of discerning the good money from the bad — as the law requires — is exceptionally complicated in this case, and the SEC offers a meat cleaver when a scalpel is required.  Such an approach is not a reasonable means of calculating how much [Life Partners] should have to pay back.”  Slip op. at 9-10.

Judge Nowlin was forced to resort to his own analysis in an effort to do rough justice where the SEC failed to even attempt to do so.  He excoriated the defendants’ bad faith in issuing a series of false disclosures, and made an effort to distinguish between gains obtained as a result of misleading Life Partners investors, which was the subject matter of the allegations, and benefits derived from overpricing resales of policies by Life Partners, which were not securities violations.  That analysis showed that an order to disgorge $500 million would be “neither justified nor just.”  Id. at 11.

Without the benefit of any useful expert analysis, the judge came up with a disgorgement number he felt comfortable with — $15 million.  He found this was “sufficiently large — it is more than half the current market capitalization of [Life Partners] — to deter future wrongdoers,” yet he was “confident that it does not overstate the ext[e]nt of [Life Partners’ ill gotten gains.”  Id. n.5.

The judge also went through a reasonable analysis of the other forms of relief awarded.  He granted the SEC’s request for an injunction against future violations — which the SEC seeks in every case — but not before explaining in detail why injunctive relief was warranted.  Here, he explained, the key defendant who controlled the company was a recidivist with a previous injunction against him, who presided over a company that made no efforts to remedy past violations and operated with an ill-informed and inactive Board of Directors.  The judge dwelled on how grossly uninformed one the directors was.  This was not an example of rote issuance of an injunction merely because a violation was found.  See slip op. at 3-7.

The judge also made a reasonable effort to calculate civil penalties, choosing an amount below the maximum ($2 million) for a defendant with lower culpability, and hitting the repeat offender who made the company’s decisions with penalties several times higher ($6 million).  Penalties against the company were assessed at $23.7 million.  Given the size and economic wherewithal of the company, this is a huge award.  The judge justified it based on his review of the evidence showing blatant violations of law that were at least reckless, even though the violations adjudicated against the defendants were non-fraud reporting violations of Section 13(a).

In the end, the SEC obtained major relief against the defendants, but showed truly bad form in doing so.  It’s proposed disgorgement and penalties were a joke, and hence were not taken seriously by the judge.  Another judge might have reacted more harshly to this combination of puerile gamesmanship and spectacularly poor judgment.  But Judge Nowlin did his job notwithstanding the SEC’s overreaching, and it looks like rough justice was done.

Straight Arrow

December 3, 2104

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SEC v. Wyly: Judge Scheindlin Steps Back and Allows Bankruptcy Court To Function

In a brief Order issued December 2, 2014, Judge Shira Scheindlin dialed down her assertion of power in the Wyly case by allowing the Texas bankruptcy court to perform its statutory role in the bankruptcy of Charles Wyly’s widow, Caroline Wyly.  The SEC pressed its position that it was entitled to pursue the assets of Mrs. Wyly as a “relief defendant” even though she filed for bankruptcy before being added as a defendant.  Judge Scheindlin rejected that position, and also emphasized the limits of her freeze order in relation to the functions of the bankruptcy court.  A copy of her order is available here: SEC v Wyly Ruling on Motion by Caroline Wyly.

Mrs. Wyly argued that the applicability of the automatic bankruptcy stay to her was pending before the bankruptcy court, which was the appropriate venue, and that after filing her schedule of assets with that court, “the asset freeze no longer applies to the property of her bankruptcy estate.”  Judge Scheindlin agreed, over SEC objections, stating that “The Bankruptcy Court is the appropriate venue to adjudicate this question.”  She reasoned that “the asset freeze most likely no longer applies to any of Mrs. Wyly’s property, as her schedules of assets have been filed in Bankruptcy Court” and therefore “all her property is now under the Bankruptcy Court’s supervision.”

This willingness to allow the bankruptcy court to perform its statutory function is a welcome relief from earlier decisions in which Judge Scheindlin decided some of those functions should be kept within her jurisdiction.  See our earlier post here: SEC v. Wyly: Judge Scheindlin Ignores Bankruptcy Stay and 2d Circuit To Keep Wylys in Her Charge.  The rule of law survives.

Straight Arrow

December 3, 2014

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Wyly Family Members Seek Expedited Review of Asset Freeze Order

Readers of the Securities Diary are by now familiar with the newest Bleak House wannabe, SEC v. Wyly.  You can search for our earlier posts on the Wyly case.  As we previously reported here, Judge Shira Scheindlin issued an ill-considered order against Sam Wyly, the Estate of Charles Wyly, and numerous Wyly family members added to the case as purported “relief defendants,” freezing their assets, with some exceptions.  The purpose of the order was supposedly to avoid the dissipation of Wyly brother assets that are subject to a so-called “disgorgement” order.  But those assets were already protected from dissipation because of a pending bankruptcy proceeding in Texas.  For reasons discussed in our earlier post, the freeze order flies in the face of Second Circuit precedent almost directly on point, which holds that the automatic bankruptcy stay prevents a court from taking steps to assist the SEC in efforts to assure it can collect monetary relief in an enforcement action. 

The SEC, exhibiting its usual “bull in a china shop” approach to litigation, sought to freeze not only the assets of the Wyly brothers, but also 15 family members whom the SEC wanted to subject to their power.  As is typical, the SEC assumed it was entitled to such relief and barely tried to support the request with a showing of need.  It asserted that these family members must have received “ill-gotten gains” from the Wyly brothers because they received distributions from overseas trusts created by the Wylys, but provided no basis for such a finding, and never tried to identify any such assets.  Judge Scheindlin, normally not a pushover for such an SEC “bull rush,” blithely accepted its arguments, probably because she was so miffed that the Wylys had removed assets from her control by filing for bankruptcy.  She issued a freeze order against the family members because the “trusts have made distributions to the Family Members” and therefore “the Family Members are likely in possession of ill-gotten funds.”

The family members (other than one who filed for bankruptcy) are appealing Judge Scheindlin’s order against them.  On November 14, 2014, they sought expedited treatment of their appeal from the Second Circuit, in a filing you can see here: Wyly Family Motion for Expedited Appeal.  The submission provides a brief outline of flaws in Judge Scheindlin’s freeze order.

Particularly appealing (no pun intended) is the discussion of how the freeze order against the family members is completely inconsistent with Judge Scheindlin’s own previous treatment of the SEC’s numerous novel, but plainly invalid, “disgorgement” theories.  The judge rejected some of these theories, but finally accepted the SEC theory that it was entitled to disgorgement by the Wylys of federal taxes allegedly avoided by not treating offshore trusts as being beneficially owned by the Wylys in SEC filings about their stock ownership.  So the only “ill gotten gain” ordered returned by the court was taxes the Wylys did not pay.  (How a tax avoidance could possibly be an “ill-gotten gain” derived from an inaccurate SEC filing is an issue for a later appeal.)  The family members point out, however, that no portion of the trust distributions to family members, which are the only potential “ill-gotten funds” cited by Judge Scheindlin, could possibly be taxes avoided by the Wylys, since those tax benefits were personal to the Wylys and did not inure to the benefit of the offshore trusts.

The blunderbuss approach of both the SEC and Judge Scheindlin in asserting power over innocent persons and circumventing the bankruptcy laws may yet force an appeals court to impose a rule of law on this case.  Although the Wylys are not exactly poster child victims, their family members, who have been accused of no wrongdoing whatsoever, and have yet to see an iota of evidence that they possess “ill-gotten funds,” deserve judicial intervention to protect them from what is essentially a temporary taking of their assets by the district court.

Straight Arrow

November 19, 2014

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