In SEC v. Wyly, the Securities and Exchange Commission (“SEC”) sought disgorgement for unpaid federal income taxes against Charles Wyly and Samuel Wyly (“Wylys”), two of the four defendants in the case. No. 10 Civ. 5760 (SAS), 2013 BL 158497 (S.D.N.Y. June 13, 2013). The court held that if the Wylys were found liable for the fraud claims relating to the alleged misrepresentation of ownership and control of their trust entities, then the SEC would have the opportunity to make a case for disgorgement at that time.
According to the allegations, the Wylys set up overseas trusts that had the appearance of non-grantor trusts. Non-grantor trusts have a tax rate on capital gains of essentially zero, while grantor trusts are taxed at the rate of the beneficial owner.
The SEC asserted that the trusts were structured more like grantor trusts due to the continued exercise of dominion and control over the assets by the Wylys. The SEC further asserted that the Wylys had misrepresented the status of the trusts, thereby achieving an unjust tax benefit. As a result, the SEC sought disgorgement of the federal income tax that the Wylys would have paid if they had properly disclosed the beneficial ownership of the trusts. The Wylys argued, however, that the SEC could not seek disgorgement of the amount because the Secretary of the Treasury had “exclusive authority to assess and collect taxes.”
A district court has “broad power to fashion equitable remedies” for violations of the securities laws. SEC v. First Jersey Secs., Inc., 101 F.3d 1450, 1474 (2d Cir. 1996). The purpose of disgorgement is to “deprive violators of their ill-gotten gains.” Any risk in the uncertainty of calculating the disgorgement “should fall on the wrongdoer whose illegal conduct created that uncertainty.” Concurrently, Congress has granted the Secretary of the Treasury the exclusive authority to assess and collect taxes. The Tax Code states there is “no civil action for the collection or recovery of taxes.” 26 U.S.C. § 7401.
The Wylys argued that the SEC was foreclosed from seeking disgorgement in the form of taxes because the authority to collect taxes rests solely with the Secretary of the Treasury. In effect, they argued that the SEC action was “the equivalent of a tax collection action”. The court first found that the claim did not arise in a civil action seeking the recovery of taxes, but in a civil action for securities law violations.
Second, the court found that there was no prohibition on using tax benefits as a measure of unjust enrichment under the Tax Code or the Exchange Act. Finally, the court found that there was no “express limitation on the SEC’s authority to calculate and disgorge any reasonable approximation of profits causally connected to the violation.” As a matter of law, the court found that the SEC was not foreclosed from seeking disgorgement measured as a tax benefit.
The court also determined that the SEC had sufficiently plead a causal connection between the alleged tax benefit and the alleged securities violations. The SEC had provided sufficient evidence from the Wylys’ records and meeting minutes that the overseas trusts were created partly for tax advantages and that the IRS might look at SEC filings to search for inconsistencies.
The court also addressed the issue of double recovery of the alleged tax benefit by the SEC and by the IRS. The SEC pointed out that the IRS investigated the overseas trusts and decided not to pursue tax liability against the Wylys. The court determined that the SEC should not be precluded on the premise that the IRS might change its previous decision.
The court held that the SEC could make a case for disgorgement, as measured by tax benefits, should the Wylys be found liable for any fraud claims.
The primary materials for this case may be found on the DU Corporate Governance website.