SEC Suit for Disgorgement of Federal Income Tax Related to Securities Fraud (6/16/13)

In SEC v. Wyly, 2013 U.S. Dist. LEXIS 83897 (SD NY 6/13/13), here, the SEC sued the Wyly brothers (Wikipedia entries for the two here and here) for certain securities violations related to holdings in offshore trusts designed to avoid / evade federal income tax and the securities laws.  Their offshore trust holdings were investigated by the Senate Finance Permanent Subcommittee on Investigations and a report issued titled Tax Haven Abuses:  The Enablers, the Tools and Secrecy, which can be downloaded here. (See the end of this blog for a newspaper summary of the Report's discussion of the Wylys.)

Among the relief sought by the SEC was disgorgement of income tax avoided / evaded by certain offshore shenanigans, apparently within scope of the Senate Report, that were at the center of the alleged securities violations.  The question presented in the opinion I discuss here is whether the SEC can sue for disgorgement of their tax savings.

The first issue is one of disgorgement as a remedy at all.  The district court had previously held that the SEC's penalty claims were time-barred.  See a Reuter's article on the previous holding, here.  However, that holding was not dispositive of the issue of disgorgement which, although not a penalty, is a remedy that is available to the SEC if it can prove fraud.  The Court said (footnote omitted):

In an Opinion and Order dated June 6, 2013 ("June 6 Opinion"), I held, among other things, that the Securities and Exchange Commission's ("SEC") penalty claims against defendants in this case were time barred insofar as they accrued more than five years before tolling agreements with the SEC took effect. Therefore, for those claims against the Wylys that accrued prior to February 1, 2001, the only monetary relief available is disgorgement. For the Wylys' alleged failure to disclose their beneficial ownership of certain securities in SEC filings, the SEC contends that the measure of disgorgement is the amount of federal income taxes that the Wylys allegedly avoided by transferring stock options to the Offshore Corporations1 and failing to disclose their control over the options. The sole issue addressed in this Opinion is whether the SEC has the authority to seek disgorgement measured as the amount of federal income taxes it claims the Wylys would have been required to pay if they had disclosed their beneficial ownership of the securities in question, or whether such relief impermissibly impinges upon the Secretary of the Treasury's ("Secretary") exclusive authority to assess and collect taxes.

The Court described the applicable law as follows (most quotation marks and all footnotes omitted for better readability):

The securities law violations at issue arise from the Section 13(d) requirement that any person who acquires "beneficial ownership" of more than five percent of a class of registered securities must file a statement disclosing such ownership with the SEC. It is well-established that once the district court has found federal securities law violations, it has broad equitable power to fashion appropriate remedies, including ordering that culpable defendants disgorge their profits. The primary purpose of disgorgement is to deprive violators of their ill-gotten gains, thereby effectuating the deterrence objectives of those laws. The authority to order disgorgement includes the authority to calculate the amount to be disgorged, and that calculation need only be a reasonable approximation of profits causally connected to the violation. District courts are given wide latitude in approximating the losses avoided by defendants that are causally connected to the securities fraud violations. Moreover, any risk of uncertainty in calculating disgorgement should fall on the wrongdoer whose illegal conduct created that uncertainty. 

At the same time, Congress has granted exclusive authority to assess and collect taxes to the Secretary and mandates compliance with specific procedures in exercising this authority. Assessment of taxes must be done by recording the liability of the taxpayer in the office of the Secretary in accordance with the rules or regulations prescribed by the Secretary. The Secretary also has exclusive authority to "collect the taxes imposed by the internal revenue laws." The Internal Revenue Code ("Tax Code") states that no civil action for the collection or recovery of taxes, or of any fine, penalty or forfeiture, shall be commenced unless the Secretary authorizes or sanctions the proceedings and the Attorney General or his delegates directs that the action be commenced.

This frames the issue which the court described (footnotes omitted):

Whether the SEC has the authority to seek disgorgement in the form of unpaid federal income taxes is truly an issue of first impression —  no court has ever addressed the question, indeed the SEC acknowledges that it has never before sought unassessed federal taxes as a measure of disgorgement. 

As a formal matter, this is not a "civil action for the collection or recovery of taxes," which would clearly fall within the exclusive authority of the IRS under Section 7401 of the Tax Code. Rather, this is a civil action for securities law violations, the remedy for which is measured by the amount of taxes avoided. There is no explicit prohibition, either in the Tax Code or in the Exchange Act, on using tax benefits as a measure of unjust enrichment in other contexts. Nor is there any express limitation on the SEC's authority to calculate and disgorge any reasonable approximation of profits causally connected to the violation. The cases on which Defendants rely to argue that this remedy is barred are therefore inapposite.

The Court then analyzed the scant authority even remotely in point and found no limitation on the SEC's ability to seek disgorgement even if it is disgorgement of unassessed taxes.

Finally, the Court analyzed the evidence and (footnote omitted):

I find that the SEC has produced sufficient evidence of a causal connection between the taxes allegedly avoided and the alleged securities violations. Therefore, if the SEC is successful on its fraud claims, the parties will have the opportunity to litigate to the Court whether there is a sufficient causal connection between the securities violations and the tax avoidance.

The Court concluded by addressing the threat of the defendants having to pay taxes twice.

This Opinion would be incomplete if it did not address the potential for double enforcement by both the IRS and the SEC. As the SEC points out, the IRS was investigating these Offshore Trusts as early as 2003, and ultimately declined to pursue tax liability against the Wylys on the basis of these trusts. Neither the SEC nor Defendants could answer definitively whether the IRS would be foreclosed by the governing statute of limitations from pursuing an action against the Wylys now. I would welcome the Secretary's input on the question. However, the specter of the IRS reversing its previous decision not to pursue tax liability against the Wylys does not warrant precluding the SEC from pursuing its own mission of deterring securities fraud.

I am surprised that the parties could not provide some information on the statute of limitations for the IRS to collect the taxes that the SEC now seeks to disgorge.  The Court says that they could not answer the question definitively, but not many issues can be answered definitively until a court rules on the issues (the issue being here whether the tax assessment statute of limitations is still open).  There has to be a huge back story there, but I don't know what it is.

One question that comes to mind is whether, in order to obtain disgorgement, the SEC will have to prove that the Wylys committed civil tax fraud so that the civil tax statute of limitations is still open and the IRS could, if it chose, assess the tax.  In this regard, the tax statutes of limitations in Section 6501, here, seem to require a timely assessment, with, seemingly, a denial of the IRS's right to collect or retain tax if the assessment is not timely made. (I will look at this issue in more detail later when I have time.)  But, assuming that is the case, even if the SEC were to obtain disgorgement, when it was turned over to the IRS, then would the IRS would have to return it the Wylys because it could not apply it to a properly assessed tax.  So, one way or another, there will have to be a determination of civil tax fraud to obtain an open statute of limitations.  And, if so, then the Wylys would also be subject to the 75% civil fraud penalty (and interest).  I admit, I have not traced all this through and am speculating a bit.  Isn't this fun?

Enjoy!

Addendum on 6/17/13 1:30pm:  

I have just posted a discussion / speculation about some of the civil tax procedure issues presented by this case: Tax Procedure Aspects of SEC Disgorgements For Taxes Underpaid (Federal Tax Procedure Blog 6/17/13), here.

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The following are excerpts from David Cay Johnston, Tax Cheats Called Out of Control (NYT 8/1/06), here.

So many superrich Americans evade taxes using offshore accounts that law enforcement cannot control the growing misconduct, according to a Senate report that provides the most detailed look ever at high-level tax schemes. 

* * * * 

The Wyly brothers told the committee that they would invoke their Fifth Amendment right against self-incrimination and thus were not called to testify. The report characterizes them as active participants in tax schemes. 

* * * * 

The report also dissects deals by the Wyly brothers of Texas, showing how they made at least $190 million through stock option exercises offshore but had yet to pay taxes on most of the money. They then borrowed against their offshore accounts to buy jewelry, pay for portraits of family members, buy homes and operate properties named Rosemary’s Circle R Ranch, LL Ranch, Stargate Horse Farm, Cottonwood Galleries and 36 Malibu Colony.

Senator Levin said he might propose limiting or barring the transferring of executive stock options to others, as well as more disclosure when they are exercised. 

The report says that Credit Suisse First Boston, Lehman Brothers and Bank of America “all knew that the offshore entities” for which they made trades were associated with the Wylys, but ignored rules requiring disclosure of these transactions and helped them hide the true ownership of the assets. Only when Robert M. Morgenthau, the New York District attorney, issued subpoenas in 2004 did Bank of America close the Wyly accounts. 

William Brewer, a Dallas lawyer for the Wylys, said that while the Senate report “intends to present a balanced view, the committee report is reflective of a number of misunderstandings.”
“The Wylys believe they have paid all taxes due,” he added. “And in any event, as the report makes clear, the Wylys were counseled by an armada of lawyers, brokers, financial professionals and offshore service providers to ensure that they were at all times fully meeting their obligations.”