Tag Archives: SEC v. Wyly

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 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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SEC v. Wyly: Judge Scheindlin Ignores Bankruptcy Stay and 2d Circuit To Keep Wylys in Her Charge

The Wyly saga continues.  With a bare nod (but certainly no bow) to contrary Second Circuit precedent on the impact of the automatic bankruptcy stay on SEC enforcement actions, Judge Scheindlin issued a freeze order against the Wylys for the specific purpose of allowing the SEC to take steps toward collecting an eventual money judgment in its favor.

On November 3, 2014, in an opinion you will find here (SEC v Wyly, 10-cv-5760 (Nov. 3, 2014) (“Freeze Opinion”), Judge Scheindlin acknowledged that the Wyly bankruptcy filings mandated a stay of the SEC proceedings apart from a narrow exception in the bankruptcy  statute for a governmental action to enforce “the police and regulatory power, including the enforcement of a judgment other than a money judgment. . . .”  Id., slip op. at 3.  She also acknowledged Second Circuit precedent applying this provision in SEC v. Brennan, 230 F.3d 65 (2d Cir. 2000).  In Brennan, the court said that for such proceedings “anything beyond the mere entry of a money judgment against a debtor is prohibited by the automatic stay,” and that this included “[s]teps preparatory to money collection.”  Id. at 71-72 (emphases in original).  Then, having quoted the language emphasized in Brennan, Judge Scheindlin went on to ignore it.

She issued the freeze order on the theory that “[t]hough the question is close,” the automatic stay does not apply because “there has been no final judgment” and “Brennan explicitly drew the line at entry of judgment, and explained that all actions taken by the government ‘up to the moment’ when judgment is entered are actions within the government’s police or regulatory capacity.”  Id., slip op. at 6-7.  Therefore, the exception “is only implicated after final judgment has been entered and the government is acting to ‘vindicate its own interest in collecting its judgment.’”  Id., slip op. at 7.  That, plainly and simply, ignores the specific language the Second Circuit emphasized in Brennan: “anything beyond the mere entry of a money judgment” is stayed, including steps “preparatory to money collection.”  The sole purpose of the freeze order, and the discovery the SEC sought into what happened to the Wyly assets, fits plainly within this description.  The notion that Brennan “explicitly drew the line at entry of judgment” is wrong; the appellate court’s reference to “steps preparatory to money collection” did not distinguish between steps before and after final judgment.  Indeed, the Brennan court gave as an example of proceedings that must be stayed under the bankruptcy law government a specific earlier Eighth Circuit EEOC case that involved post-bankruptcy proceedings before the entry of judgment.  See Brennan, 230 F.3d at 72.

Judge Scheindlin also sought to distinguish between efforts supposedly to preserve assets versus those to control assets.  Freeze Opinion, slip op. at 7-8.  But there is nothing in the Brennan language drawing this distinction.  In fact, Brennan invalidated an order to place assets into a court registry to protect them against dissipation, which would seem on its face to involve an effort to preserve, not control, those assets.  No doubt the appellate court recognized that steps “preparatory to money collection” would certainly include limits imposed on the debtor to preserve assets.  Moreover, it is naïve, at best, to view a freeze order, which deprives the debtor of any control at all over the assets, as implicating “preservation” but not “control.”  And Judge Scheindlin is anything but naïve.

Judge Scheindlin’s opinion departs from the reasoning of Brennan as well as its plain language.  She willfully blinds herself to the thrust of the appellate opinion.  The Second Circuit made it clear that the exception to the stay was narrow, and was focused only on permitting governmental proceedings to proceed to the extent needed to accomplish the purpose of deterring wrongful conduct.  See Brennan, 230 F.3d at 73.  That does not include “acts only to vindicate its own interest in collecting its judgment.”  Id.  Moreover, the most fundamental aspect of the Brennan decision was its emphasis on the importance of deferring to the bankruptcy court when trying to assure that a debtor’s assets were properly protected and distributed:

In the final analysis, the policies behind § 362 as a whole weigh strongly in favor of applying the automatic stay in these circumstances.  As noted, the general policy behind the automatic stay is “to grant complete, immediate, albeit temporary relief to the debtor from creditors, and also to prevent dissipation of the debtor’s assets before orderly distribution to creditors can be effected.” . . .  In addition, the automatic stay provision is intended “to allow the bankruptcy court to centralize all disputes concerning property of the debtor’s estate so that reorganization can proceed efficiently, unimpeded by uncoordinated proceedings in other arenas.” . . . .  Section 362(b)(4) carves out a limited exception to these policies . . . in order to prevent a debtor from “frustrating necessary governmental functions by seeking refuge in bankruptcy court.” . . .  Here, however, it is undisputed that the type of relief sought by the SEC is available through the Bankruptcy Court. . . .  Thus, it is hard, if not impossible, to argue that Brennan is “seeking refuge in bankruptcy court.” . . . .

Id. at 75.  The plain mandate of the Second Circuit was to defer to the bankruptcy court by complying with the stay except as necessary to allow a governmental proceeding to achieve its deterrent purpose.  Judge Schendlin did not even address this point in her opinion.

Judge Scheindlin ignored the automatic stay not only to approve a freeze order, but to grant the SEC expedited post-trial discovery that goes far beyond preservation of assets.  She approved continuing, and expensive, “steps” that are plainly “preparatory to money collection,” contrary to the instructions in Brennan.  Her final words in the section addressing this portion of the freeze order were that the automatic stay “does not apply to . . . a temporary asset freeze, expedited discovery, preservation of financial documents, and an accounting.”  Freeze Opinion, slip op. at 8.  And she later asserted that the very purpose of these steps was preparatory to the SEC’s enforcement of a disgorgement order: “I conclude that expedited discovery, preservation of financial documents, and an accounting are necessary to enable the SEC to ascertain the full extent of the Wylys’ assets and determine which of those assets would be subject to disgorgement.”  Id., slip op. at 10.  It would be hard to devise a more clear statement of “steps preparatory to money collection” that the Second Circuit held in Brennan were subject to the statutory bankruptcy stay.  And there can be no doubt that this order affirmatively does not allow, as the Second Circuit mandated, “the bankruptcy court to centralize all disputes concerning property of the debtor’s estate so that reorganization can proceed efficiently, unimpeded by uncoordinated proceedings in other arenas.”  Brennan, 230 F.3d at 75. 

All of the evidence suggests Judge Scheindlin is driven by a desire to maintain control over a case on which she has worked long and hard over the years.  But even a federal judge should accept when she is trumped by statute, and should not ignore appellate precedent to try to keep the deck in her hands.

Straight Arrow

November 4, 2014

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

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

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

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

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

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

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

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

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

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

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

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

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

Straight Arrow

October 23, 2014 (updated October 27, 2014)

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