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

Posted on Sep. 18, 2015

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.

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.


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.


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.

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