Issue Preclusion in Bankruptcy Case Where SEC Securities Enforcement Action Aids the IRS in Establishing a $2 Billion Claim

September 18, 2015 by Leave a Comment

I have read a lot of bankruptcy cases but cannot remember one involving individuals where the proof of claim for the IRS was $8,913,614.00 for taxes entitled to priority status and $2,029,481,997.00 for its general unsecured claim. It takes a lot of effort for an individual to owe the IRS over $2 billion and this may be the largest personal bankruptcy case ever, a distinction I previously thought belonged to the Hunt brothers. This post will not focus on how the Wyly brothers came to owe this kind of money to the IRS but you can read about it here and here. This post will focus on an action brought against the Wyly brothers by the SEC and how the decision in that case has impacted the following tax case and the efforts of the Wyly brothers to litigate the underlying merits of the tax liability in bankruptcy.

I should pause to set the parties straight. The case results from Charles and Sam Wyly placing assets, principally securities, which explains the involvement of the SEC, into offshore trusts. Charles passed away in 2011. The current bankruptcy case involves Sam and the probate estate of Charles in which his widow, Caroline D. Wyly, is the named individual.

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The SEC brought a case against Charles and Sam for failing to properly report their ownership interests in filings required by the SEC. The SEC won the case by showing that the Wyly brothers had placed the securities in an offshore trust but maintained control over the property in such a way that required disclosure of their interest to the SEC. As a result of proving the securities violation, the SEC then obtained an order requiring that they disgorge certain assets. In calculating the amount of disgorgement, the SEC turned to the tax code because the motivating force behind the failure to disclose sprang not from a desire to engage in unlawful securities activity but rather from a desire to keep the IRS from assessing taxes. Because much of the SEC case involved proving the same facts that the IRS needs to prove in order to establish the tax liability, the IRS sought to apply the doctrine of issue preclusion, otherwise known as collateral estoppel, in the bankruptcy litigation over the amount of taxes owed by the Wyly brothers. The bankruptcy court goes through a careful analysis of the law concerning issue preclusion and the facts of this case before deciding that the IRS correctly invoked the doctrine.

The tax merits of the Wyly’s liability ends up being litigating in bankruptcy court because B.C. 505(a) permits debtors to litigate the merits of their tax liability while in bankruptcy if the merits have not been previously litigated. Even though the Wyly brothers did not previously litigate the merits of their tax liability, they did litigate about many of the underlying issues during the disgorgement phase of the SEC litigation. The findings of the court in the SEC litigation and how those findings impact the actual tax merits litigation becomes the focus of the tax merits case heard before the bankruptcy court. The SEC suit had two phases, the violation phase and the disgorgement phase. The bankruptcy court here notes that the opinion issued in the disgorgement phase “carefully sets forth the details of the creation and direction the Offshore Trusts based on the jury verdict (the violation phase), the undisputed facts, and the District Court’s own factual findings.”

Between 1992 and 1996 Sam and Charles Wyly caused the establishment of offshore trusts and various subsidiary entities. Some of the trusts were settled for the benefit of their families and some charitable organizations (the Bulldog trusts) and some were nominally settled by a foreign citizen (the Bessie trusts). Between 1992 and 1999, Sam and Charles transferred securities to these trusts. “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.” The trusts and subsidiary companies exercised options and warrants and engaged in other activities regarding the securities between 1995 and 2005. The bankruptcy court, following on the district court opinion, found that the trusts could have lawfully deferred taxation on the income related to the securities if Sam and Charles had given up beneficial ownership of the securities. During this period Sam and Charles never disclosed beneficial ownership of the securities in the offshore trusts to the SEC making their actions toward the IRS and the SEC consistent.

The jury found that, in fact, Sam and Charles controlled the securities throughout this period and beneficially owned the securities. Consequently, the jury found them liable on nine counts of securities fraud. “Disgorgement serves to remedy securities law violations by depriving violators of the fruits of the illegal conduct.” In the disgorgement phase the district court found that Sam and Charles maintained a consistent position with respect to the IRS and the SEC regarding the securities for the purpose of avoiding taxation and that the appropriate measure of damages should look to the income tax not paid as a result of the securities fraud. Because of the link between the securities case and the issues presented in the 505(a) litigation over the amount of the tax liability related to the offshore trusts, the government sought issue preclusion (collateral estoppel) on 64 issues decided during the securities litigation. Because the debtors did not point to any distinctions among the 64 issues, the bankruptcy court treated them as a unit.

Looking to United States v. Shanbaum, the bankruptcy court found that four elements must be met for issue preclusion:

First, the issue under consideration in a subsequent action must be identical to the issue litigated in the prior action. Second, the issue must have been fully and vigorously litigated in the prior action. Third, the issue must have been necessary to support the judgment in the prior case. Fourth, there must be no special circumstance that would render preclusion inappropriate or unfair.

Identity of Issues

The bankruptcy court found that issue preclusion in tax matter is narrowly applied and limited “to situations where the matter raised in the second suit is identical in all respects with that decided in the first proceeding and where the controlling facts and applicable rules remain unchanged.” The most common use of issue preclusion in tax cases occurs when the civil case trails a criminal case. Even where the criminal conviction does not contest the underlying liability or the application of the fraud penalty, the elements proven in the criminal case can bind the taxpayer in the subsequent civil matter. The bankruptcy court found that “the District Court determined a variety of facts adversely to Sam and the Probate Estate in the Disgorgement Opinion, all of which support an adverse determination on a key issue raised in the IRS proofs of claim here: whether the Offshore Trusts should be treated as a grantor trusts for federal tax purposes.” The taxpayers argued that the amount of the disgorgement should not control in the tax case to set their liability and the bankruptcy court agreed. In doing so it pointed out that the IRS did not seek issue preclusion on the amount of the liability but only the issues that would allow it to compute the liability. The bankruptcy court pointed to the oral arguments in the disgorgement case to support its conclusion that all of the parties knew they were fighting about the tax consequences in fixing the measure of damages. It concluded that whether the trusts were grantor trusts was specifically litigated during the disgorgement phase and was identical to the issue raised in the 505(a) proceeding.

Fully and Vigorously Litigated

The taxpayers argued that the prior decision was incorrect; however the bankruptcy court stated that “the correctness of the prior determination is irrelevant to issue preclusion, and judgments retain preclusive effect despite pending appeals…. What matters is whether the grantor trust question was raised, was submitted for determination, and actually was determined by the District Court.” Here the answer was yes to all of those questions and the fight over these issues in the district court was one in which the taxpayers were well represented by highly competent counsel – “one of the finest litigation firms in the country.” They had the opportunity to be heard on the very issue for which the IRS sought issue preclusion and fully fought the issue.

The wife of Charles, the primary beneficiary of the estate, raised the issue that it was not a party to the SEC proceeding. The bankruptcy court looked at the effect of issue preclusion on non-parties in this context. For issue preclusion to apply, the current party must have “sufficient privity with the parties to a prior suit.” The bankruptcy court found that she had essentially the same interest as the estate and pointed out that she sought permission from the bankruptcy court to use funds belonging to her bankruptcy estate to pay the fees of the Probate Estate’s counsel and expert witnesses.

Necessary to Support the Prior Judgment

The matter sought for issue preclusion must have been “essential to the judgment” and “ranks as necessary or essential only when the final outcome hinges on it.” Sam argued the federal tax status of the offshore trusts was not essential to the outcome of the SEC case. He makes this argument in the narrow sense that the disgorgement decision did not hinge on this and more broadly in that the disgorgement opinion was not necessary to the final judgment. The bankruptcy court disagreed and found that the grantor trust determination was essential to the calculation of the precise amount of money owed by Charles and Sam during the disgorgement phase. The court further held that “the Disgorgement Opinion generally, and the grantor trust determination specifically, cannot be said to be ‘incidental, collateral, or immaterial to that judgment.’”

Sam pointed to a criminal restitution case where the holding in the restitution phase did not create issue preclusion, but the bankruptcy court distinguished the case pointing out that the IRS did not seek preclusion based on the amount of the disgorgement order but only the basis for calculating the amount. Here, the determination regarding the federal tax status of the trusts was necessary for the final judgment in the SEC case and satisfies the necessary element for issue preclusion.

Fairness

The bankruptcy court looked to whether it would be fair to apply issue preclusion taking into account all of the circumstances. Issue preclusion can occur in situations in which one party did not participate in the prior suit. Here, Caroline did not participate in the SEC suit. The IRS did not participate though its status as a federal agency creates some mutuality. The IRS argued here that because the section 505(a) suit was filed by the Wyly family as a part of their bankruptcy cases, the use of issue preclusion here is defense. Courts have generally given wider latitude to raising issue preclusion in a defensive posture. The Wyly family argues that the IRS proof of claim in the bankruptcy started the cases making the IRS, in effect the plaintiff in the action and the use of issue preclusion offensive rather than defensive.

The bankruptcy court concludes that in this situation the distinction between offensive and defensive issue preclusion does not matter. Because of the broad remedy sought by the SEC the Wyly family defended vigorously, had the opportunity for full discovery and really had no impediment to fully litigating the issues on which the IRS now seeks to bind them. In reaching this conclusion, the bankruptcy court looked carefully at the Supreme Court’s decision in Parklane Hosiery. It found many similarities and stated that “the parties can point to no facts that make issue preclusion in this case any less foreseeable or less fair than issue preclusion in Parklane.” It concludes that because the Wyly family had a fair shot at the issue in the SEC case, the application of issue preclusion here does not offend the doctrine of fairness.

Conclusion

The lawyers at the SEC deserve much credit and recognition from the IRS. Their approach to the case laid the foundation for a significant victory by the IRS in the bankruptcy case and, depending on the amount of money in the bankruptcy estate, a significant recovery for the Treasury. Where taxpayers seek to hide their actions from taxation and simultaneously fail to meet their reporting obligations at the SEC, this case serves warning that the SEC will look to remedies that could affect the sought after tax benefits. The case adds another tool to the Government’s toolkit for combatting tax loses when persons move their assets offshore.

Whether the partnership between the SEC and the IRS was planned or fortuitous, it worked well here. Some similarities exist in the way it ultimately worked out between this and the restitution cases where the proof in a criminal tax case can now lead to immediate assessment. It also has similarities to whistleblower cases where a third party finds the unpaid tax although the SEC goes far beyond what third parties must do to recover a reward. At the least the IRS should have some ceremony recognizing and thanking the SEC lawyers and trying to institutionalize the process. The more of these type arrangements the IRS can create, the better for it as it continues to try to overcome the actions of a Congress that does not want to promote tax collection by allocating money to the IRS. Creating partnerships with other agencies less subjected to the scrutiny the IRS receives may become a valuable strategy to combat its fiscal woes.

Filed Under: Bankruptcy, Issue Preclusion

Insider Trading and Forfeiture of Millions in Stock Gains Runs into Section 1341 and Issue Preclusion

March 17, 2014 by 2 Comments

People may remember Joseph Nacchio, who once ran Qwest Communications at the height of the telecom boom and into the bust. While CEO, in 2001 Nacchio sold shares and reported over $44 million in net gain from these stock and paid just under $18 million in taxes on the gain. The stock tanked just after the sale. The SEC and Department of Justice came down hard on him. He was convicted on 19 counts of insider trading, and eventually ordered to pay a $19 million fine and to forfeit the $44 million in net profit from the sale of the shares.

After spending over four years in low-security federal prison, he was released last September. After his release, the WSJ ran a great story on Nacchio, replete with tales of prison life, including Nacchio’s prison buddies Spoonie and Juice playing practical jokes on new inmates, Nacchio paying fellow inmates cans of tuna to do chores, and pictures of a tanned and buff Nacchio emerging from prison combative and convinced that the fed investigation of him stemmed from his refusal to turn over phone records to NSA rather than any violations of securities laws.

Well, how does this relate to tax procedure? When he forfeited the close to $44 million net gain from the stock sake in 2007, he filed a refund claim that relied on Section 1341 to allow him to be treated as if he never had the stock gain to begin with. IRS denied the claim, triggering a refund suit in the Court of Federal Claims and cross motions for summary judgment. Last week, the Court of Federal Claims issued an order denying the government’s motion and granting Nacchio’s motion in part.

Below, I will briefly explain the substantive issue in the case and how Section 1341 can apply to unwind the effects of income inclusion when income earned in an earlier year is returned in a later year. The added procedural wrinkle in this case is whether Nacchio’s criminal conviction in an insider trading case can serve to bar a taxpayer’s use of Section 1341. The government argued that under the doctrine of issue preclusion (or collateral estoppel) Nacchio’s conviction precluded the taxpayer’s use of Section 1341; the court found that issue preclusion did not apply but declined to issue a final opinion on the claim’s merits.

A brief summary and discussion follows.

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Section 1341-Introduction

The effects of the annual system of tax accounting are somewhat mitigated by Section 1341. As Nacchio v US described, that provision is triggered in the following circumstances:

The taxpayer must have subjectively believed he had an unrestricted right to the money in the year it was received based on all the facts available that year; and

The taxpayer must be entitled “to a deduction (in excess of $3,000) under another section of the Internal Revenue Code for the loss resulting from” repaying the money.

If the taxpayer meets the requirements of Section 1341, then the taxpayer is entitled to either the equivalent of a refund for income tax paid in the earlier year, or a deduction from income in the year of repayment, whichever is more beneficial to the taxpayer.

So in the refund suit that Nacchio brought, he had to establish that he had a claim of right to gain originally included in the 2001 joint return he filed with his wife, and that they were entitled to deduct the $44 million forfeited under some section of the Internal Revenue Code. The benefit he sought under Section 1341 was the equivalent of the refund of income taxes he paid in 2001, because that was more beneficial than taking a deduction in 2007—the year that Nacchio actually forfeited the net gains from the stock sales.

Is Nacchio Entitled to a Loss Deduction?

The first part of the opinion discussed whether Nacchio is entitled to deduct as a loss under Section 165(c)(2) for the forfeiture payment. Caselaw generally establishes that forfeiture is a loss for purposes of Section 165. The government argued nonetheless that Nacchio was not entitled to deduct that loss because it “would contravene public policy by ‘reducing the sting’ of the forfeiture penalty.”  Courts and IRS have applied the public policy doctrine to preclude deductions under Section 165 when allowance of the deduction would “immediately and severely frustrate sharply defined policies” (in this case relating to proscribing insider trading) or if the deduction would “directly and substantially dilute the punishment imposed.” (citing to the Supreme Court case of Tellier v US)

Those standards are hardly the stuff of clarity but in this case the Court of Federal Claims came down hard on the government.

Mr. Nacchio’s forfeiture is a loss. The proceeds from Mr. Nacchio’s insider trading evaporated — they were disgorged. Yet, the Government seeks to tax these proceeds not on the ground that they are income, but on an amorphous notion that the public policy against securities fraud must prevent the deductibility of monies that were received due to insider trading even though the monies were disgorged….

Indeed, because Plaintiffs paid over $17.9 million in taxes on a $44.6 million gain they did not retain, disallowing Plaintiffs’ loss deduction would impose a punitive tax consequence uncalled for by criminal statute, the Internal Revenue Code, or precedent. See Tellier, 383 U.S. at 694-95 (“We decline to distort the income tax laws to serve a purpose for which they were neither intended nor designed by Congress.”). Disallowing the deduction would result in a “double sting” by requiring the taxpayers to both make restitution and pay taxes on income they did not retain. In sum, the public policy against insider trading does not prevent the deduction of the amount forfeited here as a loss under § 165.

The government also argued that Section 162(f) applied, which disallows trade or business expense deductions for “any fine or similar penalty paid to a government for the violation of any law.”  The government argued that the forfeiture was a fine or similar penalty for these purposes. The court disagreed with the government. Recall that Nacchio did not attempt to justify the deduction as a trade or business expense, but sought a deduction under Section 165(c)(2) for losses related to a profitseeking transaction. Regulations under Section 162 and Section 165 essentially incorporate the 162(f) standard into Section 165. Courts have sidestepped the issue as to whether the regulations under Section 165 are valid; after all Congress in codifying Section 162 did not similarly amend Section 165.

The Court of Federal Claims cited a Second Circuit case Stephens v US that provides the justification for incorporating 162(f) into a Section 165 analysis:

Though Congress, in amending Section 162, did not explicitly amend Section 165, we believe that the public policy considerations embodied in Section 162(f) are highly relevant in determining whether the payment to Raytheon was deductible under Section 165. Congress can hardly be considered to have intended to create a scheme where a payment would not pass muster under Section 162(f), but would still qualify for deduction under Section 165. (citation omitted)

Recall that 162(f) precludes deduction for a “fine, or similar penalty.” So the issue that Court of Federal Claims considered was whether the forfeiture was not just a penalty but a penalty that is similar to a fine. Here the court discussed how Nacchio was ordered to pay both a $19 million fine that was paid to a state general crime victims fund and $44 million or so in forfeited profit to a separate fund to compensate victims of the Qwest securities fraud. That distinction was key to the court, as the forfeiture payment’s compensatory purpose severed it from being a “similar” penalty for purposes of Section 162(f) and 165.

Issue Preclusion, Section 1341 and Subjective Belief

The government still had more arrows in its quiver. It argued that under the doctrine of issue preclusion, Nacchio should be barred from litigating whether “he had a claim of right to the gain he forfeited because a jury convicted him of engaging in insider trading willfully, knowingly and with the intent to defraud.”

As the Court of Federal Claims correctly summarized, issue preclusion requires that the party seeking to invoke the doctrine must establish that the action “presents an issue identical to that previously adjudicated in the criminal case.” The problem with the government’s argument was that according to the Court of Federal Claims whether Nacchio subjectively believed he had an unrestricted right to the income is key for purposes of Section 1341, not whether as a matter of law he had a right to the funds.

Nacchio did not testify at the criminal trial, having invoked the Fifth Amendment. The court felt that the criminal conviction did not directly bear on Nacchio’s subjective beliefs:

The precise issue of whether Mr. Nacchio himself subjectively believed he had an unrestricted right to the funds he received from trading in 2001 was not adjudicated in the criminal proceeding. Mr. Nacchio did not plead guilty to insider trading — an admission which could result in a finding that he had subjectively believed he was not entitled to the gain.” See Culley, 222 F.3d at 1335-36 (holding that taxpayer who pled guilty to mail fraud could not have subjectively believed that he had an unrestricted right to the fraudulently obtained proceeds); Kraft v. United States, 991 F.2d 292, 297-99 (6th Cir. 1993); Wang v. Comm’r, 76 T.C.M. (CCH) at *8 (finding that a taxpayer who plead guilty to insider trading was not entitled to § 1341 relief because he knowingly received illegally obtained income).

Although the jury in the criminal trial believed Mr. Nacchio was guilty of willfully engaging in insider trading, this does not equate to a finding of what Mr. Nacchio himself believed. Mr. Nacchio professed his innocence, and nothing in this Court’s record from the criminal proceeding sheds any light on the bona fides of Mr. Nacchio’s belief. Indeed, Mr. Nacchio did not testify in his criminal trial, invoking his Fifth Amendment privilege against self-incrimination. Mr. Nacchio’s subjective belief as to his claim of right to the forfeited gain was not adjudicated in his criminal trial, and Plaintiffs are not barred from litigating his belief under the doctrine of issue preclusion. So too, Mr. Nacchio’s subjective belief as to his entitlement to the trading gains in 2001 is a question of material fact that cannot be resolved on summary judgment.

Conclusion

I do not know much about Nacchio other than the little I have read in the opinion and some articles I read before writing this post. He seems like a very combative individual, and if the case goes to trial, I suspect the government will have its hands full in trying to show that Nacchio himself believed he had no right to the gains.  The denial of the deduction here seems doubly punitive in light of the fact that it essentially requires the payment of taxes on income that was not retained. That does not seem like a fair result.

On the other hand, if the benefit of Section 1341 when it comes to forfeited funds turns on whether a defendant pleads guilty it does potentially change the dynamics for those facing insider trading charges.  This will increase the costs of pleading guilty and at a minimum create another issue defendants must consider when facing those charges. While I have not done extensive research on the cases that the Nacchio opinion cites for the proposition that a guilty plea could result in a finding of no entitlement to qualify for Section 1341, it is not readily apparent to me that a guilty plea should equate to a finding that a taxpayer did not subjectively believe he had a right to the income in the first place.

I know the IRS has fought hard when taxpayers have attempted to use Section 1341, especially in cases where taxpayers have less than clean hands. Perhaps in a later post we will explore the contours of illegally gained funds and the applicability of Section 1341. We will keep our eyes on this case as it presents a chance to consider when taxpayers may have the appearance of the right to funds even when their criminal activity generated the gains that were eventually forfeited.

UPDATE3.20

Janet Novack, Forbes Washington D.C. bureau chief,  who writes insightful pieces on tax (among other areas) ran a nice story last week that also discussed the Nacchio case.  It has some more detail on Qwest and Nacchio, including his criminal trial and a quote from his attorney on the tax case.

 

 

 

Filed Under: Claim of Right, Issue Preclusion