A win-win for the SEC: In an extraordinary securities case involving the billionaire Wyly brothers, the SEC established liability for multiple violations and was able to persuade the court to adopt its disgorgement calculations based on two different theories—one of which was novel and unsupported. The defendants were required to pay approximately $200 million to the court, not counting prejudgment interest.
Flying under the radar: The SEC’s civil enforcement action centered on a 13-year-long tax deferral scheme carried out by the defendants, Sam and Charles Wyly. They created a number of offshore trusts and subsidiary companies on the Isle of Man that they used to trade shares in four public companies (issuers) on whose boards they sat, without properly disclosing their beneficial ownership of the stock. By transferring valuable options and warrants to the trusts, exercising the options and trading in secret, and reinvesting the proceeds in other ventures, the Wylys were able to accumulate tremendous tax-free wealth, the agency alleged.
A jury agreed and found the Wylys liable for nine violations, including fraud under section 10(b) of the Securities Exchange Act and failure to make various disclosures. Subsequently, the federal district court held a bench trial to determine remedies. The SEC initially asked the court to order disgorgement based on unpaid taxes related to profits made from the options and stock transactions of the four companies in which the defendants were “influential insiders.”
The Wylys argued that the Tax Code prohibited disgorgement measured by unpaid taxes. They also pointed to the risk of double recovery and conflicting orders since there was an IRS audit underway covering some of the same years of securities fraud.
The court disagreed, noting that “[m]easuring unjust enrichment by approximating avoided taxes does not transform an order of disgorgement into an assessment of tax liability.” Further, the risk of duplication or conflict was avoidable by crediting amounts disgorged in the SEC case toward any subsequent tax liability the IRS may determine. “Disgorgement is a remedy that gives courts flexibility to determine the appropriate remedy ‘to fit the wrongful conduct,’” said the court, and ordered Sam Wyly to disgorge approximately $123.8 million and Charles Wyly to disgorge approximately $63.4 million.
Alternative disgorgement measure: Anticipating an appeal and wanting to ensure a resolution of “this already aged matter,” the court recently approved the SEC’s alternative way of calculating disgorgement based on trading profits.
The SEC’s expert developed a novel approach that tried to measure the benefit to the Wylys resulting from a lack of disclosure. She pointed out that “because of this invisibility, the Wylys appeared more like a buy-and-hold investor than what they really are.” Comparing their actual trading to a buy-and-hold benchmark was a way to measure the difference between what the Wylys actually earned and what they would have earned if they had been buy-and-hold investors.
The Wylys’ expert said there was no authority supporting the SEC expert’s methodology. The analysis should have focused on whether there were abnormal returns after the Wylys sold securities from the offshore system. This standard approach would have shown that “the defendants received, in the aggregate, no improper gains.”
The court sided with the SEC. “This case is highly unusual—if not sui generis,” it said. Violations went on for 13 years, and the volume of offshore and undisclosed transactions was large. Also, the Wylys were not “garden-variety insiders.” Looking to standard insider trading cases and using the typical approach, i.e., performing an event study for each trade, was not helpful. The SEC‘s expert came up with a method that could reasonably approximate the profits “causally connected to the Wylys’ violations,” the court concluded. But it ordered the SEC to recalculate the disgorgement amount by taking out 38% of gain related to securities the Wylys never actually sold.
Takeaway: As the court hinted, its orders may not be the last word in this protracted litigation. Nevertheless, the court said it was “confident” that the tax-based disgorgement calculation was the best measure of the Wylys’ ill-gotten gains. Parallel bankruptcy and IRS proceedings are also underway. Stay tuned.
Find a discussion of SEC v. Wyly, 2014 U.S. Dist. LEXIS 175940 (Dec. 19, 2014) and SEC v. Wyly, 2014 U.S. Dist. LEXIS 135671 (Sept. 25, 2014) in the April edition of Business Valuation Update; the court opinions will be available soon at BVLaw.