Tag Archives: Judge Shira Scheindlin

Why the SEC’s Proposed Changes to Its Rules of Practice Are Woefully Inadequate — Part III

This is the third in a series of posts addressing the SEC’s proposals for revising the Rules of Practice in its administrative court.  These proposals purport to modernize antiquated procedures in that forum.  Our first two posts addressed two blatant inadequacies in the SEC’s proposals: (1) requiring that respondents plead in their answers certain defense theories that are not “affirmative defenses” required to be pled in response to complaints filed by the SEC in the federal courts; and (2) providing for a discovery process limited to a maximum of 5 depositions, requiring that those be shared among multiple respondents, allowing the Division of Enforcement an equal number of depositions (in addition many investigative depositions taken before the case was filed), and limiting the scope of witnesses that respondents could depose within the tiny allotment provided.  You can review these comments here (Part I), and here (Part II), respectively.

Before we turn to the third respect in which the SEC’s proposals continue and expand the unfairness of the SEC’s administrative forum, we pause to report that SEC Chair Mary Jo White publicly embarrassed herself by insisting that the current forum is perfectly fair and needs only to be “modernized,” whatever that actually means.  As reported in the Wall Street Journal, here is what she said about the new proposals:

The SEC chief said that the commission recently proposed rules to modernize the administrative law proceedings and submitted a draft for public comment.  The proposal came amid calls for overhauling the system, which critics say is biased toward the agency and provides few protections to defendants.  The proposed change, she noted, includes allowing for additional time and discovery depositions before the trials.

Ms. White described the administrative law judge system as “very fair proceedings” that offer even more due-process rights to defendants than district court.  The 2010 Dodd-Frank financial overhaul law allowed the SEC to handle a broader range of cases in the in-house court.  Still, she acknowledged that the agency needs to critically examine the system for the sake of both fairness and appearance because “the rules haven’t been modernized for almost 10 years.”

SEC’s White Defends In-House Courts, but Sees Need to Modernize.

As an experienced defense counsel, Ms. White certainly knows that what she is saying is false.  There is no conceivable way that one could describe the SEC’s current administrative litigation process as offering “even more due-process rights to defendants than district court.” Similar statements in disclosures by public companies would be prosecuted as section 10(b) frauds by the SEC itself, if they were material.  Perhaps she could beat the fraud charge on the theory that her misstatements were “mere puffery” (a defense the SEC staff itself rarely accepts).  It is sad, indeed, that such an eminent lawyer in private practice has fallen into lock-step acceptance of the SEC mantra that it is gloriously clothed and everything is really fine, when the outside world knows the opposite is true: the SEC enforcement process is clothed in rags and the administrative enforcement forum is badly in need of reform.

Now we turn to the third respect in which the SEC’s regulatory proposal for its court is grossly inadequate: The new proposals do nothing to cure the extreme unfairness of the current Rules of Practice regarding the issuance of subpoenas to the SEC and third parties.

Remember the starting point for the respective parties when a case is commenced.  The SEC staff starts after having conducted years of investigation, in which it is able to obtain virtually limitless information from any person it chooses to subpoena, or ask for a “voluntary” production of materials.  The defense, on the other hand, typically has no access to information from third parties, and may only have had at best limited access to information from co-respondents, including other respondents who settled rather than litigate the charges against them (e.g., in many cases, the company they work for).  Thus, at the start of the case, the SEC itself is in possession, custody, or control of many potentially relevant materials, and the respondent typically has very little access to most of the materials the SEC has.

In cases filed in federal court, this imbalance between the parties can be remedied by means of aggressive use of the document production and subpoena powers available under the Federal Rules of Civil Procedure.

First, because the SEC is a party, it is subject to discovery as a civil litigant, including requests for documents in its possession, custody, or control.  Although the SEC struggles mightily in these cases to avoid discovery that typically occurs against other civil litigants, and it succeeds before some pro-government judges, the general rule is that once it files its case, it is a civil litigant under the federal rules just like any other civil litigant, and therefore subject to the same discovery rules as other plaintiffs.  In a well-publicized discovery decision by Judge Shira Scheindlin in SEC v. Collins & Aikman Corp., the judge noted tersely that “[w]hen a government agency initiates litigation, it must be prepared to follow the same discovery rules that govern private parties.”  See Case Study: SEC v. Collins & Aikman Corp. (Law 360).

Second, Fed. R. Civ. P. 45 allows defendants to issue subpoenas directly to third parties for relevant evidence, or for other information likely to lead to the discovery of admissible evidence.  There is no “gateway” procedure for these subpoenas – the party need not convince the judge to issue a subpoena; it can do so itself.  The burden then falls on the subpoenaed party to figure out how to respond, knowing that the courts usually take the view that discovery should be permitted unless it plainly imposes an undue burden or obviously seeks information not calculated to lead potentially useful evidence.  What happens following the issuance of these subpoenas is predictable.  In some, but few, cases, the third party will simply comply.  In some, but also few, cases, the third party will seek to quash the subpoena in its entirety.  In the vast majority of cases, the party issuing the subpoena and the third party will enter into discussions during which they reach some agreement about what material will be provided in response to the subpoena and which requests will be withdrawn.  The end result is that the defendant can gather what he or she considers important information from third parties without having to defend that view before a judge, but also typically agrees to accept less than he or she might get if the issue were fully litigated before a judge.

In contrast, in an SEC administrative proceeding, the respondents have no subpoena power.  That is so even though their opponent – the SEC staff – was accorded essentially unlimited subpoena power during the investigative stage, and typically uses that power to gather information that would support a potential charge, not defend against one.  (That is why production of the “investigative file” is often far from sufficient for adequate trial preparation by the respondent.)  The Rules do provide for the possible issuance of subpoenas, to third parties and the SEC itself, but only by application to the administrative law judge, who decides whether the subpoena will be issued.  The ALJ places the burden on the respondent to show that the subpoena is warranted, often asking for supporting information about the materials sought in the subpoena that is not, and cannot, be known by the respondent.  The ALJ also typically sets a higher bar for discovery than the standard in federal court.  The SEC staff almost always objects to the issuance of these subpoenas because they are focused on winning, not on seeking the truth.

SEC Rule of Practice 232 governs this process.  It says:

[A] party may request the issuance of subpoenas requiring . . . the production of documentary or other tangible evidence. . . .

Standards for Issuance.  Where it appears to the person asked to issue the subpoena that the subpoena sought may be unreasonable, oppressive, excessive in scope, or unduly burdensome, he or she may, in his or her discretion, as a condition precedent to the issuance of the subpoena, require the person seeking the subpoena to show the general relevance and reasonable scope of the testimony or other evidence sought.  If after consideration of all the circumstances, the person requested to issue the subpoena determines that the subpoena or any of its terms is unreasonable, oppressive, excessive in scope, or unduly burdensome, he or she may refuse to issue the subpoena, or issue it only upon such conditions as fairness requires. . . .

. . . Any person to whom a subpoena is directed, or who is an owner, creator or the subject of the documents that are to be produced pursuant to a subpoena, or any party may . . . request that the subpoena be quashed or modified. . . .

If compliance with the subpoena would be unreasonable, oppressive or unduly burdensome, the hearing officer or the Commission shall quash or modify the subpoena, or may order return of the subpoena only upon specified conditions. . . .

This sets up the ALJ as a gatekeeper for all subpoenas.  And history shows that the ALJs are, at the prodding of the SEC staff prosecuting the case, stingy gatekeepers indeed. The end result is the inverse of the environment for document discovery in the federal courts.  Instead of giving the party the authority to commence the process to obtain documents, which gives the opposing party, or the third party recipient, the burden of having to negotiate a resolution or appear in court to defend its intransigence, the respondent must plead for the issuance of a subpoena and bear the initial burden of convincing the ALJ to do so.  Even if that happens and the subpoena is issued, the recipient (or other persons) still can move to quash the subpoena.

As a result of this highly restrictive set of rules governing subpoenas by respondents – compared to almost no restrictions for subpoenas issued by the SEC staff during the investigative process – very modest document discovery is possible in SEC administrative proceedings.

Recent cases show that an ALJ will issue a subpoena to the SEC, but only a narrow one and only in rare circumstances.  In In the Matter of Charles L. Hill, Jr., the respondent sought discovery relevant to his defense that the administrative process was biased and the administrative prosecution violated his constitutional rights.  Mr. Hill asked for a subpoena to the SEC for ten categories of materials.  ALJ James Grimes issued a subpoena for two of those categories – materials on administrative prosecutions of similar cases and reflecting allegations by a former ALJ of internal communications encouraging favoring the SEC staff in these cases.  See SEC ALJ James Grimes Issues Important Discovery Order Against SEC.  But he refused to allow other aspects of the subpoena, which included materials sought to support contentions of equal protection and due process infringements.  That order turned on a detailed judgment that the materials sought could not assist those defenses based on a merits analysis, which is a far more demanding standard than the discovery standard in federal court – whether the material could possibly lead to admissible evidence.  See Order Denying in Part Subpoena Request in In the Matter of Charles L. Hill, Jr..

In In the Matter of Ironridge Global Partners, LLC, ALJ Grimes refused to issue a subpoena for materials bearing on the respondents’ defenses of bias and constitutional infringements (see Decision by SEC ALJ James Grimes on Motion for Issuance of Subpoenas in In the Matter of Ironridge Global Partners).  He also refused to permit a subpoena of the notes of SEC staff witness interviews “to the extent those portions relate to the facts and circumstances of this case, [and] the portions do not reflect attorney-opinion work product.”  He rejected this request — which seeks factual material that has often been ordered produced in federal courts — because he found the respondents had not sufficiently shown the need to obtain those materials, including because they were unable to show specifically how portions of the materials they had never seen could be useful in defending the case.  That is a standard far beyond what would apply in federal court.  In a federal court, at the worst, on a motion to compel production, the court would perform an in camera review of the materials and typically mandate production of the factual portions of those materials.  More likely, the court would try to force the parties to negotiate a compromise.  Amazingly, ALJ Grimes ruled that the respondents’ argument that it was important that they learn what fact witnesses told the SEC about the very practices at issue in the case was not a sufficient showing of need because “Respondents necessarily already know how they conducted their business. . . .  They therefore already possess information about the facts addressed in the Division’s interview notes.”  See Third Order on Subpoenas in In re Ironridge Partners, LLC.  The notion that the need to learn about actual evidence to be presented in the case fails to satisfy the burden for supporting a subpoena shows the unreasonably narrow scope used by SEC ALJs in ordering discovery against the SEC.

The current Rules of Practice support and encourage the ALJs’ niggardly approach to granting subpoenas.  They also fundamentally alter the balance of discovery in these cases as compared to those filed in federal court.  Discovery against the SEC in the administrative forum is very difficult and always very limited.  The ALJs believe that the limited scope of materials specifically made available to respondents under Rule 230 (which is limited to the so-called “investigative file”) operates against discovery from the SEC of other sorts of materials.  The federal courts do not generally hold the same view — they note that the federal rules of discovery apply equally to all parties.  And in federal court, the ability of a defendant to cause a third party to negotiate document production by issuing a subpoena directly to that party provides access to a much wider range of material than could possibly be available by seeking approval from ALJs, who apply discovery standards far more stringent than those used in federal court, and focus excessively on adhering to the Commission-set schedule (since that is what the Commission requires them to do).

The SEC’s proposed changes to the Rules of Practice do nothing to cure this fundamental, and deeply consequential, bias allowing the SEC staff far greater access to evidence or potential evidence than respondents.  In fact, there is no discussion at all of how well or poorly Rule 232 has operated, nor any discussion of whether some changes to that rule might enhance fairness or efficiency in the administrative court.

The only material change proposed for Rule 232 is to add another reason to quash a subpoena.  No effort is made to try to equalize access to evidence or potential evidence, or to try to equalize subpoena rights between federal court and the administrative court.  But for some reason the SEC found it necessary to grant ALJs additional grounds for quashing subpoenas previously approved, adding as a new reason for quashing a subpoena whether it “would unduly delay the hearing.”  As a result, even if the ALJ found the subpoena appropriate when first sought, and it is not oppressive or excessive, he or she must (“shall”) quash the subpoena if it will “unduly delay the hearing.”  This is yet another respect in which the Commission views compliance with its (arbitrary and artificial) schedule to be more important than giving respondents a fair and just proceeding.

The document discovery process in SEC administrative proceedings is unfair, unjust, and a major reason why targets of SEC prosecutions do better in federal courts than in the administrative forum.  Since the SEC seems not to care much about any of those things, no reforms were proposed.  That is our third reason why the proposed rule changes are woefully inadequate and should be rejected as arbitrary and capricious.

Straight Arrow

November 18, 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: 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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