N. Y. judge to Wylys: You can’t keep SEC away by declaring bankruptcy

Onetime Texas billionaire Sam Wyly and the estate of his late brother Charles just can’t seem to outsmart the Securities and Exchange Commission. Their latest attempt to evade the consequences of their allegedly fraudulent offshore trust scheme failed Monday, when U.S. District Judge Shira Scheindlin of Manhattan, in a ruling of first impression in the 2nd U.S. Circuit Court of Appeals, said that the SEC is entitled to freeze the Wylys’ assets, even though both Sam and Charles’ estate declared Chapter 11 bankruptcy in late October, after the SEC began to take steps to collect the nearly $200 million (plus interest) Scheindlin awarded the agency in September.

The Wylys were found liable for fraud after a jury trial last May, the culmination of the SEC’s four-year case accusing the brothers of improperly using trusts on the Isle of Man to conceal their trading in companies they served as directors. (The Wylys’ lead lawyer, Steve Susman of Susman Godfrey, has said the defendants will appeal.) The SEC asked for more than $700 million in damages for a scheme that supposedly netted the brothers $550 million. Scheindlin awarded the agency $187.7 million, plus interest that would bring the total bill up to more than $300 million. (As of October, according to the SEC, the total owed by the Wylys, including interest, was $299 million.)

On Oct. 8, SEC lawyer Bridget Fitzpatrick informed the judge that the agency wanted a temporary freeze order to preserve the Wylys’ assets. The SEC was willing to give Sam and Charles’ heirs a reasonable monthly budget for living expenses, Fitzpatrick said, but the agency was concerned that the Wylys might have unjustified ideas about reasonableness. (The SEC suggested that $10,000 per month should be enough.) Fitzpatrick also said that the SEC wanted to be sure that Wyly assets didn’t make their way offshore before the government could nab them. In a subsequent letter to Scheindlin, Fitzpatrick said the SEC hadn’t expected to have trouble collecting from the Wylys, given testimony that they are worth a collective $556 million, but that since the trial, Sam Wyly and the estate of Charles Wyly have been pleading “relative poverty.” They’ve been burning through money at a rate of $3.75 million a month over the past decade, the SEC claimed, and without a temporary freeze, they might spend down their assets until there’s not enough to cover what they owe the SEC.

Susman responded that the SEC’s proposed freeze order was way too broad and that $10,000 a month wasn’t enough money for Sam, an 80-year-old in poor health who has to pay for (among other things) the cost of appealing the SEC’s case. Sam and other Wyly relatives later suggested that perhaps they could get by on $20,000 a month, not counting mortgage and rent payments. As you might expect, the SEC said that was not a reasonable amount.

While the SEC’s freeze motion was before Scheindlin, Wyly firmed up a deal with Christie’s to sell three paintings, without informing the SEC. According to a letter from Fitzpatrick to Judge Scheindlin, a week after the SEC moved for a freeze, Christie’s asked Wyly on Oct. 15 to confirm the reserve prices on the paintings in advance of their scheduled Oct. 27 sale. “Essentially, Sam Wyly tried to liquidate more than $300,000 in art after this court’s Sept. 25 order awarding $128.3 million in disgorgement against him,” Fitzpatrick wrote.

But the art deal was hardly a whisper compared to Sam’s roar of defiance on Oct. 19: He filed for Chapter 11 bankruptcy protection in federal bankruptcy court in Dallas. (Charles’ estate did the same on Oct. 23.) Sam Wyly’s lead bankruptcy lawyer, Josiah Daniel of Vinson & Elkins, told Judge Scheindlin in a letter that because of the automatic stay on proceedings against Chapter 11 debtors, the SEC is not entitled to an order freezing Sam Wyly’s assets. Daniel noted that the bankruptcy code carves out an exception to the stay so the government can continue to pursue enforcement actions against debtors. But there’s an exception to the exception, Daniel said, that bars even the government from enforcing a money judgment or even claiming control over a Chapter 11 debtor’s assets without obtaining relief from the automatic stay.

Daniel cited a 2000 decision by the 2nd Circuit in SEC v. Brennan as precedent. In that case, the appeals court held that the SEC could not enforce an order to recover the offshore assets of the infamous broker-dealer Richard Brennan of First Jersey securities, who declared bankruptcy after the SEC won a $75 million judgment against him in 1995.

In a letter to Judge Scheindlin about Wyly’s bankruptcy filing, however, the SEC said there is a key difference between the Wyly and Brennan cases. In the Brennan case, a judgment had already been entered for the SEC. Here, Judge Scheindlin hasn’t entered judgment, the SEC said, so the SEC can continue to prosecute its case – including the motion for a freeze order.

The SEC had some fun at Wyly’s expense – pointing out that his bankruptcy petition shows he owes a Dallas country club $383.20 and his own lawyers at Bickel & Brewer about $4,500 – but its argument was dead serious. Wyly, it argued, was attempting to use Chapter 11 to “mount a collateral attack” on Scheindlin’s findings and to “shift any efforts to collect this court’s judgment to a different forum.”

In Monday’s opinion, Scheindlin avoided any pronouncements about the Wylys’ motives for seeking bankruptcy protection. She even said it was a “close” call whether the SEC’s requested asset freeze would violate the automatic stay. But she decided that in seeking the freeze, the SEC was acting in its policing and regulatory capacity rather than to enforce a money judgment, so the Brennan precedent does not apply. (Her reasoning: No judgment has yet been entered against the Wylys; and the freeze would only preserve the status quo, not give the SEC control over any Wyly assets.) The judge also said that the SEC can freeze certain assets of Wyly family members, whom it sued last week in connection with the damages award, but not as many as the SEC wanted.

Sam Wyly’s bankruptcy lawyer, Daniel of V&E, declined to comment. Wyly counsel Susman didn’t respond to my phone message.