Sam Wyly is shocked, etc.

Billionaire Brothers Avoided Taxes by Hiding Stock

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
Read More.
a | A

Back in the eighties and nineties, the Wyly brothers ran, and owned huge stakes in, a weird bunch of public companies, including some craft stores, some software companies, and a reinsurer. These companies were good and made the Wyly brothers a lot of money. An odd biological fact is that a big enough pile of money will spontaneously generate tax advisers, and so some tax advisers duly crawled out of the Wylys' pile of money and told them how to avoid paying taxes.

The gist was that if the Wylys put the shares in offshore trusts that they didn't control, then they could avoid taxes. Or, if they put the shares in offshore trusts that they did control, but pretended they didn't, then that might also work. That caused problems. Not just the obvious one (try not to do any pretending on your tax returns!), but also a securities law problem. Here is a stylized version of the conversations that they had with their advisers:

Adviser: You could avoid taxes by hiding all of your assets in offshore trusts.

Wylys: Cool, let's do that thing.

[later]

Wylys: I think we have to make some securities filings about all this stock we own?

Adviser: Nonono, if you do that, then the IRS will know that you own it, and you'll have to pay taxes.

Wylys: Oh, well, we don't want that.

Adviser: No.

Wylys: It's a pickle.

Adviser: Just one of those things I guess.

So, yeah. They didn't do a great job with the securities filings. And eventually -- like, over a decade later -- the government came after them. But the strange thing is that "the government" was not the Internal Revenue Service, which is in charge of going after people who don't pay their taxes. It was the Securities and Exchange Commission, which is in charge of going after people who don't do a great job with their securities filings.

The SEC sued, and won its civil enforcement action, because the Wylys really do seem to have done a pretty bad job of disclosing their positions for years and years. But the weird question is how they should be punished for that. The thing is, no one was really hurt by the securities violations. The hidden offshore accounts weren't used to pump up fraudulent companies, or to nefariously steal control of companies, or to conceal insider trading (mostly! ). The companies were fine. The harm was that the Wylys sometimes sold stock in companies they controlled without a registration statement disclosing that they were the ones selling, and I guess at the margin if you knew that the directors of the company were selling you'd want to pay a somewhat lower price. But it's a bit of a stretch to say that you were defrauded.

I mean, no one was hurt but the Internal Revenue Service, obviously. The point of the securities violations was not to commit securities fraud. It was to avoid taxes. The IRS missed out on something like $170 million in taxes because the Wylys' trading profits were in offshore trusts.

So the SEC came to court asking for $619 million from the Wylys, on two theories. First of all, the SEC said, well, any time you sell stock without a registration statement that you should have sold with a registration statement, you have to give back all of the money you made selling the stock. Which is kind of the law! But terrible. Like, these were big public companies and not otherwise fraudulent; no one who bought the stock was really harmed. So it seems harsh to make them give the SEC all the money they made.

On the other hand, the SEC also said: Well, the Wylys avoided taxes by doing all of this securities fraud, so they should have to pay us the taxes they avoided, as a penalty for the securities violations. Which is much, much weirder. Like, why is the SEC enforcing the tax law? (The IRS has not yet sued the Wylys, though they are currently being audited.) On the other hand, like, fair enough, right? The purpose of the Wylys securities violations really was to avoid taxes. The person harmed by the violations was the IRS. Why shouldn't the SEC recover on the IRS's behalf?

Yesterday the judge in the case issued an opinion on all of this that I thought was pretty cool. She more or less nixed the SEC's first theory -- which, though reasonably straightforward securities law, was terrible -- and agreed with the second, which, though pretty weird, actually makes a lot of sense. So the Wylys will have to pay the SEC $168 million in, basically, back taxes. Plus tons and tons of interest. The Wyly side is very unhappy about this, and you would be too if you had to write the SEC a check for $300 million you didn't have. But this strikes me as fair and smart and the reasonable resolution to this.

Still, it is strange that these guys avoided paying taxes and were caught by the SEC for their securities law violations. This is a tax case disguised as a securities case. Why not just bring a tax case? There are probably some social and historical reasons, but don't underestimate the legal ones. It's often much easier to prove a securities violation covering up some naughtiness than it is to prove the underlying naughtiness. Whether or not the underlying naughtiness was actually naughty, lying about it in filings is a violation. Saying something that's not true in a registration statement, or not filing a registration statement when you're supposed to, is a pretty automatic way to get in trouble. There is less questioning of intent than there is in many other kinds of cases.

Going after people for securities fraud is often like going after Al Capone for tax evasion. It's hard to prove that Capone's money was ill-gotten, but easy to prove that he didn't pay taxes on it. Ironically, here the underlying crime was tax evasion, but still. It turns out to be hard to prove that the Wylys evaded taxes, but easier to prove that they violated securities law in doing so.

On the other hand, this can be a little unsatisfying. Are the Wylys tax evaders? The judge in their securities-law case seems to think so. But no one's really decided that question. They're being punished for tax evasion without ever exactly being found guilty of tax evasion.

Eric Holder announced his resignation yesterday, and lots of people are mad that he didn't put more bankers in prison. One thing that I tend to think about that is that the thing that bankers could be put in prison for is mostly securities fraud. Generically, you don't get in trouble for making bad mortgage loans, or for taking huge risks at your bank, or for doing the stuff that brings down the economy. You get in trouble for failing to disclose that stuff properly to investors. (Or, I mean, you don't, as the case may be.) It's not the crime, it's the cover-up, as it were, because the securities stuff is the easy stuff to prove. Even though it's often the less important stuff.

  1. All of this is drawn mostly from the district court opinion yesterday. In particular, pages 26-27 contain findings of a conversation that is really not that different from my stylized version:

    The Wylys pursued the offshore program primarily for its tax advantages. However, because Tedder suggested transferring stock options in publicly traded companies -- Sterling Software and Michaels Stores -- any such transaction would implicate the securities laws. French testified that he raised concerns about whether the Wylys would continue to have filing obligations as directors of Sterling Software and Michaels Stores, even after the transfers. Tedder responded that making SEC filings could threaten the Wylys’ tax benefits, because “disclosure of the offshore trusts in SEC filings may lead the IRS to discover and investigate the tax issue, and . . . the IRS might use the Wylys’ SEC filings against them if the tax issue was ever litigated.” ... Sam Wyly corroborated French’s account by testifying that Tedder told him that SEC filings “could trigger tax problems if you had these things on file and [were] reporting the trust shares on [Schedule] 13Ds.”

    Michael French was the Wyly family lawyer; David Tedder was a "lawyer and trust promoter" who built the tax trusts.

  2. "Statute of limitations?," you ask, in that ungrammatical way you have of asking questions. I guess that the fact that the trusts were hidden probably tolls it?

  3. Except that the judge dismissed a claim of insider trading, which we've talked about before.

  4. Last time I wrote about this, I said that some of this is some serious nitpicking, and I stand by that. The Wylys would say things like "The Selling Stockholder named in the table is an irrevocable trust established by Sam Wyly and of which Sam Wyly and his family are included as beneficiaries," which you'd think would be enough to disclose the relationship. But the question is whether they adequately disclosed their control of their shares, I guess. Plus sometimes they would sell shares from offshore trusts without any disclosure at all, on the theory that they didn't control the shares so they had no insider-disclosure obligations. All in all: Definitely a bad job of disclosing. Even the Wylys never really denied that; they just said that the obligations were confusing and their failure to obey them was in good faith.

  5. Again, see footnote 3. Insider-ish trading, maybe. But that's only one out of the many trades, and not illegal.

  6. That number comes from footnote 218 on page 67 of the opinion. The SEC asked for a higher number, some $194 million; see footnote 2 on page 2.

  7. See page 72 of the opinion:

    Because section 5 is a strict liability offense, the typical measure of disgorgement is all profits made on the sale of unregistered securities, minus the direct transaction costs of acquiring the shares. In many section 5 cases, this is an appropriate disgorgement amount because the sale of unregistered securities is commonly accompanied by misrepresentations about the investment, a lack of publicly available information about the company, and valueless shares.
  8. I exaggerate. Actually she made the Wylys disgorge 25 percent of their profits on the unregistered sales, because they got the unregistered shares at a discount and then re-sold them as though they were registered shares. Which seems fair enough! The point is, she rejected the SEC's theory that all profits on those shares should be disgorged.

  9. Or, one of them, and the other's estate. This case has been going on for a long time.

  10. Incidentally, if the IRS ever finishes its audit and comes after the Wylys, they'll get to credit this against their back taxes. Probably. See pages 61-62 and footnote 205 of the opinion.

  11. Like, the SEC seems to have thought it had an insider trading case at the start, so it wanted to pursue it, and it only later morphed into a tax case. Also I guess the IRS moves really slowly?

  12. Consider the case of ChinaCast Education Corporation, which was plundered by its executives. U.S. regulators couldn't charge the executives with stealing stuff, since the stealing happened in China, but they could charge them with securities fraud, because they failed to tell their U.S. investors that they'd been stealing the stuff in China. Or just the other day, another executive pled guilty in U.S. court to securities fraud for basically plundering a company in China (fine!) and not disclosing it to U.S. investors (trouble!).

  13. Obviously, if the disclosure failings are what brought down the economy then there you go. There is ... a literature on that question. But remember that senior bank executives sign off on things like annual reports to shareholders, not mortgage-backed securities offering documents.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Matthew S Levine at mlevine51@bloomberg.net

To contact the editor on this story:
Toby Harshaw at tharshaw@bloomberg.net