In re Wyly

IN RE: SAMUEL E. WYLY, et al. DEBTOR.

CASE NO. 14-35043-BJH

UNITED STATES BANKRUPTCY COURT FOR THE NORTHERN DISTRICT OF TEXAS DALLAS DIVISION

Entered: August 25, 2015

August 24, 2015

(Chapter 11)

(Jointly Administered)

RELATED TO DKT. NO. 611

MEMORANDUM OPINION AND ORDER

This dispute arises in the jointly administered bankruptcy cases of Samuel E. Wyly ("Sam") and his sister-in-law, Caroline D. Wyly ("Dee") (collectively, the "Debtors"). Dee was married to Sam's brother Charles J. Wyly, Jr. ("Charles") before he died in 2011. These bankruptcy cases were filed after the U.S. District Court for the Southern District of New York (the "District Court") entered an opinion and order granting equitable remedies against Sam and Charles' probate estate (the "Probate Estate") in an SEC civil enforcement action for securities fraud (the "SEC Action"). SEC v. Wyly, 56 F. Supp. 3d 394 (S.D.N.Y. 2014) (referred to in textand citations as the "Disgorgement Opinion"). The Disgorgement Opinion explained that the amount to be disgorged was calculated based on the amount of federal income taxes avoided by Sam and Charles on securities held in certain trusts in the Isle of Man (the "Offshore Trusts").

On October 19, 2014, Sam filed a voluntary petition under chapter 11 of title 11 of the U.S. Code (title 11 will be referred to as the "Bankruptcy Code"). Dee filed her own bankruptcy case on October 23, 2014. The two cases are jointly administered as case number 14-35043, with Sam's bankruptcy case as the lead case.¹

Both Sam and Dee have filed motions seeking an adjudication of their federal income tax liability by this Court pursuant to 11 U.S.C. § 505(a),² arguing that they have correctly reported and paid their taxes every year (the "505 Motions").³ Sam's Mot. Bankr. Code § 505 to Determine Tax Liability, ECF No. 4; Dee's Amended Mot. Bankr. Code § 505 to Determine Tax Liability, ECF No. 516. The IRS filed proofs of claims in both bankruptcy cases seeking payment of tax and penalties based in part on the federal tax treatment of the Offshore Trusts as determined by the District Court in the Disgorgement Opinion. 14-35043 Proof of Claim 18-1 (asserting priority unsecured claims totaling $8,913,614.00 and general unsecured claims totaling $2,029,481,997.00against Sam's bankruptcy estate); 14-35074 Proof of Claim 11-1 (asserting priority unsecured claims totaling $50,063,484.00 and general unsecured claims of $1,189,602,317.00).

On May 29, 2015, the IRS filed this motion for partial summary judgment and supporting brief seeking to bind Sam and Dee to specific factual findings made by the District Court in the Disgorgement Opinion. United States' Mot. Partial Summ. J., ECF No. 611 (the "IRS Motion"); United States' Br. Supp. Mot. Partial Summ. J., ECF No. 612 (the "IRS Brief"). The IRS Motion is opposed by Sam, Dee, and the committee of unsecured creditors appointed in Sam's case (the "Committee"). Debtor's Resp. Mot. Partial Summ. J., ECF No. 672; Debtor's Br. Supp. Resp. Mot. Partial Summ. J., ECF No. 673 (collectively, "Sam's Response");⁴ Debtor Caroline D. Wyly's Resp. Mot. Partial Summ. J., ECF No. 670 ("Dee's Response"); Official Committee Objection Mot. Partial Summ. J., ECF No. 669 (the "Committee Response"). The SEC filed a statement providing context and clarification about the Disgorgement Opinion. SEC's Statement Regarding Final J., ECF No. 689 ("SEC Statement"). The IRS filed a reply to the various responses. United States Reply, ECF No. 691 (the "IRS Reply"). The Court heard argument on the IRS Motion at a hearing held on July 24, 2015 (the "Hearing").

Because the Court concludes that the IRS has satisfied the elements of issue preclusion as explained more fully below, the IRS Motion will be granted.

I. BACKGROUND

In 2010, the SEC brought a civil enforcement action against Sam and Charles, among others, for violations of securities laws in connection with their transactions with the Offshore Trusts involving specific securities. When Charles died in 2011, Donald Miller, Jr., executor of the Probate Estate, was substituted as a defendant in the SEC Action over his objection. TheDistrict Court bifurcated the SEC Action into a liability phase and a remedies phase. A jury trial was held in the liability phase from March 31 to May 7, 2014. On May 12, 2014, the jury returned a verdict for the SEC on nine counts of securities fraud.

As the SEC sought the equitable remedies of disgorgement and permanent injunction, the District Court held a bench trial for the remedies phase. The District Court issued opinions on multiple points of dispute in connection with the remedies phase, chief among which was the Disgorgement Opinion issued on September 25, 2014 that contains findings and conclusions related to the District Court's primary measure of the amount of disgorgement. A final judgment was entered by the District Court on February 26, 2015, ordering Sam to disgorge $198,118,825.16, ordering the Probate Estate to disgorge $101,238,418.53, providing an alternate measure of the amount of disgorgement in the event the primary measure is overturned on appeal, and granting injunctions against future violations of securities laws. IRS Br. Exh. 5 (the "Final Judgment"). The District Court denied a motion for judgment as a matter of law and for a new trial and closed the SEC Action on July 7, 2015. SEC v. Wyly, No. 10-CV-5760, 2015 WL 4103636 (S.D.N.Y. July 7, 2015).

The Disgorgement Opinion carefully sets forth the details of the creation and direction of the Offshore Trusts based on the jury verdict, undisputed facts, and the District Court's own factual findings. Disgorgement Opinion, 56 F. Supp. 3d at 410-24. A brief sketch of the system of trusts set up by Sam and Charles offshore is helpful to understand the SEC Action and the IRS's claims against these bankruptcy estates. Because some of these details are the very points to which the IRS seeks to apply issue preclusion, the Court will note when these details were found by the jury or the District Court rather than stipulated or admitted by Sam, Charles, and/or the Probate Estate.

Sam and Charles caused the Offshore Trusts and various subsidiary entities to be established between 1992 and 1996. Id. at 410. In the SEC Action and in these bankruptcy cases, the Offshore Trusts are typically divided into two categories: the "Bulldog Trusts"⁵ and the "Bessie Trusts."⁶ Sam and Charles settled all but one⁷ of the Bulldog Trusts in 1992 for the benefit of their families and certain charitable organizations. Id. at 413-14. Nominally, each of the four Bessie Trusts were settled in 1994 and 1995 by a foreign citizen who made a gratuitous $25,000 contribution. Id. at 415. Sam and Charles transferred securities to the Offshore Trusts from 1992 to 1999 in exchange for annuities. Id. at 411. These securities were in the form of options and warrants in public companies for which Sam and Charles served as directors during part or all of the relevant time period. Id. The Offshore Trusts and subsidiary companies engaged in various transactions involving these securities, including exercising the options and warrants, between 1995 and 2005. Id.

In theory, these structures could be used to lawfully defer taxation on income related to these securities if Sam and Charles had given up control and beneficial ownership of the securities in exchange for annuities. Id. at 411-12. Using trusts in this way, even foreign trusts, is not inherently impermissible if the applicable rules are followed. The Disgorgement Opinion examines the applicable tax and securities statutes and regulations in detail. Sections 671 to 679 of Title 26 of the U.S. Code (the "Tax Code") and associated regulations set forth rules by which property held in a trust, including a foreign trust, must be treated as property of the grantor for tax purposes. Furthermore, Sam and Charles were obligated to comply with applicable securities lawsand regulations. In filings with the SEC made throughout this period, Sam and Charles never disclosed beneficial ownership of the securities owned directly or indirectly by the Offshore Trusts. Sam and Charles maintained consistent positions with the IRS and the SEC with respect to their lack of ownership or control of securities held by the Offshore Trusts, and throughout the SEC Action continued to maintain that these positions were correct.

The jury in the SEC Action disagreed, at least as to the correctness of disclosures to the SEC. Throughout the relevant time period, Sam and Charles had been making investment recommendations to the trustees of the Offshore Trusts for the securities at issue. Id. at 410. "All of the [Offshore Trusts'] trustees' securities transactions were based on the Wylys' recommendations and the [Offshore Trusts'] trustees never declined to follow a Wyly recommendation." Id. The jury in the SEC Action concluded from this and other evidence at trial⁸ that Sam and Charles beneficially owned the securities. Id. The jury found sufficient additional facts to establish Sam and Charles' liability for all elements of nine counts of securities fraud. See id. at 401 & n.1.

For her part, the District Court found the establishment of the Bessie Trusts particularly problematic. Statements in the four trust deeds that they were settled with $25,000 contributions from a foreign citizen were "admittedly false." Id. at 415. Two of the Bessie Trusts were each settled with the contribution of a "factual dollar bill" and a debt of $24,999 that was immediately cancelled, and the District Court doubted whether even the dollar bills were actually contributed. Id. The other two Bessie Trusts were settled with a $100 contribution by an individual whosemanagement company was hired to serve as trustee for some of the Offshore Trusts shortly thereafter. Id.

"Disgorgement serves to remedy securities law violations by depriving violators of the fruits of their illegal conduct." SEC v. Contorinis, 743 F.3d...