In the recent case of SEC v. Wyly (SDNY, no. 1:10-cv-05760, 2014 BL 267268), the US Securities and Exchange Commission (SEC) successfully obtained a disgorgement order against Samuel Wyly and the estate of Charles Wyly. The Wylys committed securities fraud by trading the securities of corporations on whose boards they sat and failing to disclose to the SEC their beneficial ownership of the securities. This is the first time that the SEC has sought and received a disgorgement remedy for a securities fraud based mainly on taxes that would have been clearly owed if the Wylys had disclosed the trades. (The IRS had not pursued the Wylys for those taxes.)
The disgorgement remedy is equitable and therefore is not subject to the statute of limitations; a government seeking to enforce explicit statutory provisions can avail itself of this remedy. "[T]he primary purpose of disgorgement is not to compensate investors. Unlike damages, it is a method of forcing a defendant to give up the amount by which he was unjustly enriched." The SEC action was not "a civil action for the collection or recovery of taxes . . . [but] is a civil action for securities law violations, the remedy for which is measured by the amount of taxes avoided as a result of the defendants' securities violations. . . . Measuring unjust enrichment by approximating avoided taxes does not transform an order of disgorgement into an assessment of tax liability."
In the event that the IRS sought collection, "any amounts disgorged . . . should be credited towards any subsequent tax liability determined in an IRS civil proceeding."
Between 1992 and 1996, the Wylys created a number of trusts in the Isle of Man; each trust owned several subsidiary companies. The Wylys were directors of Michaels Stores, Sterling Software, Sterling Commerce, and Scottish Annuity and Life Holdings. As part of their compensation, the Wylys received stock options and warrants, which they then sold or transferred to the Isle of Man trusts in exchange for private annuities. The Wylys simultaneously disclaimed beneficial ownership of the securities in public filings with the SEC. Between 1995 and 2005, the Isle of Man trusts exercised the options and warrants and separately acquired options and sold those and other shares in all four companies without filing SEC disclosures. The filings, Sam Wyly said, "could trigger tax problems."
The trusts were found to be grantor trusts. A grantor trust is created when the contributor of cash or property retains an interest in the property: the contributor is treated as the trust's owner unless the transfer is made at FMV. The Wylys were found to have maintained their beneficial ownership in the securities at all times even though the trusts were administered by professional asset management companies located in the Isle of Man. The protectors were deemed to be the Wylys' agents because they received lucrative work from the Wylys. On several occasions, the protectors and Sam Wyly bypassed the trustees and directly placed sell orders.
The court cited Gould (139 TC 418, at 437 (2012)). In that case, the Tax Court concluded that "[i]n determining the settlors of a trust, [a court] look[s] beyond the named grantors to the economic realities." The court in Wyly also cited Gudmundsson (634 F. 3d 212, at 221 (2d Cir. 2011)): "[I]n general, the term 'fair market value' is understood to mean 'the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge or relevant facts.'"
The court also applied the substance-over-form doctrine established in Helvering v. Gregory (69 F. 2d 809, at 810 (2d Cir. 1934)), whereby the courts look to a transaction's objective economic realities rather than to the particular form employed by the parties. The court cited Close (107 TCM (CCH) 1124; 2014 WL 521039), which said that the following facts were critical in determining whether a trust had economic substance:
(1) whether the taxpayer's relationship to the transferred property differed materially before and after the trust's creation; (2) whether the trust had an independent trustee; (3) whether an economic interest passed to other trust beneficiaries; and (4) whether the taxpayer respected restrictions imposed on the trust's operation as set forth in the trust documents or by the law of the trusts.
The court ordered the Wylys to pay $187,718,702.70 plus prejudgment interest for the entire period of fraud to December 1, 2014. That amount mainly represents taxes avoided by the Wylys relating to the exercise of options and the sale of stock in the four companies in which they were influential insiders.
Previously published in Canadian Tax Highlights - Volume 23, Number 3, March 2015
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