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From Securities Regulation Daily, June 17, 2013

SEC Has Authority to Seek Disgorgement Measured As Amount of Unpaid Federal Income Taxes

By Rodney F. Tonkovic, J.D.

The District Court for the Southern District of New York found as a matter of first impression that the SEC has the authority to seek disgorgement measured as the amount of unpaid federal income taxes that two brothers allegedly avoided by failing to disclose their control over stock options. At issue was whether this relief would impinge upon the Secretary of the Treasury’s exclusive authority to assess and collect taxes. An earlier opinion detailing the factual background of the case and addressing the Commission's motions for summary judgment was published in Securities Regulation Daily on June 7, 2013 (SEC v. Wyly, June 13, 2013, Scheindlin, S.).

According to the SEC, from 1992 until 2005, two brothers, Samuel Wyly and the late Charles Wyly, hid their beneficial ownership of, and trading activity in, the shares of four companies on whose boards they sat. To do this, they created offshore trusts and subsidiary entities, transferred shares to those entities, and installed surrogates to carry out their wishes regarding the disposition of the stock. This conduct was carried out anonymously and while evading federal securities laws governing trading by corporate insiders and the insider-transaction reporting provisions.

The trusts were set up to create the appearance of "non-grantor" trusts, making them separate taxable entities and allowing the trusts' capital gains to be taxed at the favorable Isle of Man rates. The trusts were, in reality, grantor trusts, due to the Wyly's control over them, and should have been taxed at the applicable U.S. capital gains rate. The Wylys had discussed a potential settlement of issues regarding tax treatment of the offshore trusts with the IRS in 2003.

SEC may seek disgorgement. The court first concluded that the SEC is not foreclosed as a matter of law from seeking disgorgement measured as a tax benefit. The Wylys argued that the disgorgement sought by the SEC was the equivalent of a tax collection action. The Tax Code delegates the exclusive authority to collect taxes to the Secretary of the Treasury.

According to the court, this action was not for the collection or recovery of taxes, which would fall within the exclusive authority of the IRS under Section 7401 of the Tax Code. Rather, the action is "a civil action for securities law violations, the remedy for which is measured by the amount of taxes avoided." There is no prohibition in either the tax or securities laws, the court continued, on using tax benefits as a measure of unjust enrichment, and the SEC can request disgorgement of the profits that it calculates are causally connected to the violation.

Causal connection. The Wylys argued that, even if the Commission can seek disgorgement, there was no causal link between the alleged securities violations and any unjust tax benefits. The SEC asserted that the tax benefits were "a direct and primary measure" of the ill-gotten gains. As evidence for its position, the SEC noted that the Wylys acknowledged that the offshore trusts were created, at least in part, for tax advantages. The Commission also pointed to minutes from the 2003 meeting with the IRS which showed that the participants recognized the risk that the offshore trusts were actually grantor trusts.

The court concluded that the SEC produced sufficient evidence of a causal connection between the taxes allegedly avoided and the alleged securities violations. If the Commission is successful on its fraud claims, the court held, it can then make its case for disgorgement.

The case is No. 10 Civ. 5760 (SAS).

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