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Securities and Exchange Commission v. Wyly

March 31, 2011

SECURITIES AND EXCHANGE COMMISSION, PLAINTIFF,
v.
SAMUEL WYLY, CHARLES J. WYLY, JR., MICHAEL C. FRENCH, AND LOUIS J. SCHAUFELE III, DEFENDANTS



The opinion of the court was delivered by: Shira A. Scheindlin, U.S.D.J.

OPINION AND ORDER

I. INTRODUCTION

On July 29, 2010, following a six-year investigation into matters spanning almost two decades, the Securities and Exchange Commission ("SEC") filed this suit alleging thirteen Claims for securities violations by billionaire brothers Samuel Wyly and Charles J. Wyly (together, the "Wylys"), their attorney Michael C. French ("French"), and their stockbroker Louis J. Schaufele III ("Schaufele"). The gist of the fraud alleged is that, from 1992 through at least 2005, the Wylys hid their ownership of and trading activity in the shares of four public companies*fn1 on whose boards of directors they sat*fn2 by creating a labyrinth of offshore trusts and subsidiary entities in the Isle of Man and the Cayman Islands (the "Offshore System"); transferring hundreds of millions of shares of the Issuers' stock to those entities; and installing surrogates to carry out their wishes regarding the disposition of the stock -- all while preserving their anonymity and evading federal securities laws governing trading by corporate insiders and significant shareholders.*fn3 Attorney French and stockbroker Schaufele were allegedly essential to the success of this scheme, which also included a singular instance of insider trading by the Wylys and Schaufele in 1999. The SEC seeks penalties, injunctive relief, and disgorgement of roughly $550 million in gains and prejudgment interest.

Defendants now move to dismiss Claims One through Four of the Complaint, which allege that, through the use of the Offshore System, the Wylys and French committed primary violations of section 10(b) of the Exchange Act (Claim One) and section 17(a) of the Securities Act of 1933 (the "Securities Act") (Claim Four); that French and Schaufele aided and abetted the fraud alleged in Claim One under section 10(b) (Claim Three); and that the Wylys and Schauefe engaged in insider trading, also in violation of section 10(b) of the Exchange Act (Claim Two). The most interesting and complicated questions raised by the defendants' motions, however, have nothing to do with the substance of the federal securities laws' antifraud provisions; rather, they concern the applicability and interpretation of various limitations periods purportedly governing the SEC's claims for monetary penalties for both their fraud claims (Claims One through Four) and their non-fraud claims (Claims Five through Thirteen). I first address these threshold questions before turning to the defendants' more substantive arguments.

II. BACKGROUND*fn4

A. False Filings

The Complaint identifies dozens of false securities filings which serve as the foundation for the defendants' alleged fraudulent scheme.*fn5 Those filings fall broadly into three groups: (1) filings of one or both of the Wylys personally (such as Schedule 13Ds, Schedule 13Gs, or Form 4s (described below)) that understate their shareholdings and stock trading; (2) corporate filings by the Issuers (such as Form 10-Ks, proxies, or registration statements) that also understate the Wylys' (and/or French's) shareholdings in the particular Issuer making the filing; and (3) filings by "Offshore Trustees" (see below) falsely claiming they have sole dispositive power over their shares.*fn6

Schedule 13D is a disclosure report required under section 13(d) of the Exchange Act to be filed by any person who "is directly or indirectly the beneficial owner of more than five percent" of the stock of any class of a public company's outstanding stock.*fn7 A person beneficially owns a security if such person directly or indirectly, through any contract, arrangement, understanding, relationship or otherwise, has or shares (i) voting power, which includes the power to vote, or to direct the voting of, such security; and/or (ii) investment power, which includes the power to dispose, or to direct the disposition of, such security.*fn8

Form 4 is a disclosure report required under Exchange Act section 16(a) to be filed by every public company officer, director and greater-than-ten-percent shareholder reporting any changes to their beneficial ownership of their company's securities.*fn9

B. The Offshore System Scheme

The Complaint alleges that between March 1992 and January 1996, in the Isle of Man, a self-governing British crown dependency located between Scotland and Northern Ireland in the Irish Sea, the Wylys established seventeen trusts, the beneficiaries of which were Sam or Charles Wyly, their respective family members, or both.*fn10 Initially, they selected a single Isle of Man-based trust management company to serve as their Offshore Trusts' trustee, but between 1992 and 2004 selected numerous additional "Offshore Trustees."*fn11 Employees of the various Offshore Trustees served as directors of more than thirty Isle of Man-based shell companies that were wholly-owned by the various respective Offshore Trusts ("Offshore Companies").*fn12 The Offshore Companies, along with the Offshore Trusts, together comprised the Wylys' "Offshore System."*fn13

The trust agreements governing the Wylys' Offshore Trusts purported to confer upon the Offshore Trustees broad and exclusive authority to manage trust assets, but in practice the Offshore Trusts were controlled by trust "Protectors,"*fn14

Wyly-appointed loyalists who did the Wylys' bidding.*fn15 Thus, the offshore trusts were paper facades used by the Wylys to hide their beneficial ownership of and trading in the Issuers' shares they held in their Offshore System and to evade the federal securities laws' insider-transaction reporting provisions, beneficial-ownership reporting provisions, or both.*fn16 At various times during the course of their thirteen-year scheme, the Wylys allegedly controlled more than twice as many shares in certain of the Issuers as they disclosed publicly,*fn17 which included directing the voting and disposition of shares in the four Issuers held in the offshore trusts.*fn18 Through their conduct, the Wylys -- with awareness of its unlawfulness*fn19 -- allegedly deprived the markets and investors of information reflective of potential shifts or changes in corporate outlook important to investment decisions.*fn20 These unlawful nondisclosures also enabled the Wylys freely to sell millions of shares of the Issuers' stock while avoiding the adverse market reaction and decrease in value often attending the required public disclosure of such trading by insiders.*fn21

1. French

French, who acted as the Wylys' lawyer, also served on the boards of three of the Issuers and as a trust Protector of the Offshore System.*fn22 French provided cover to the Wylys' scheme that was essential both to its concealment and its continuation.*fn23 In his role as a trust Protector, he coordinated with the trusts to communicate the Wylys' investment and voting instructions, which without exception were carried out by the Offshore Trustees.*fn24 Despite having intimate knowledge of the Wylys' control over their Offshore System, French repeatedly (and falsely) told the Issuers and their counsel that the Offshore System was "independent of the Wylys."*fn25 While participating in the Wylys' fraud, French also established offshore entities of his own, which he, like the Wylys, used to control and trade Issuer securities without disclosing that ownership or trading.*fn26

French received an annual salary of 1.5 million dollars over the course of eight years and a sixteen million dollar share in a hedge fund established by the Wylys.*fn27

2. Schaufele

Schaufele served for over fifteen years as the registered representative for various accounts established by the Wylys, including those of the Wylys' offshore entities,*fn28 and helped carry out the Wylys' "protocol" for effecting certain transactions in the Offshore System: conveying instructions to the trust Protectors who in turn conveyed the instructions to the appropriate Offshore Trustee, who then faxed the necessary trading instructions to Schaufele or his assistants.*fn29

Schaufele made misrepresentations to his brokerage firm superiors and in-house attorneys about the Wylys' relationship to and control over the offshore entities (of which he had full knowledge), which were allegedly vital to the scheme's operation and continuation.*fn30

C. 1999 Insider Trading Violations

Around June 1999, Sam Wyly personally decided that both Sterling Software and Sterling Commerce should be sold.*fn31 He obtained Charles Wyly's concurrence, and the two agreed that the sale of Sterling Commerce should proceed first.*fn32 At that time, the Wylys comprised two-thirds of Sterling Software's executive committee and, along with other family members and French, comprised half of Sterling Software's Board of Directors.*fn33

In late September 1999 -- when the plan to sell both Sterling entities was "already underway"*fn34 and when Goldman Sachs had already been retained by Sterling Commerce as an advisor (and had compiled a list of potential acquirors)*fn35

-- Sam Wyly instructed the Wyly Family CFO to determine the cost of purchasing from Lehman Brothers up to four million Sterling Software call options at the company's current trading price, with expiration dates of between twelve and twenty-four months in the future.*fn36

On September 28, 1999, Schaufele provided the Wyly Family CFO with the requested pricing information, but recommended that the Wylys consider a swap agreement*fn37 as an alternative because it would be easier to unwind than call options.*fn38 Sam Wyly concurred and, between September 30 and October 6, 1999, he directed his son Evan -- at the time a fellow board member of three of the Issuers, including Sterling Software -- to negotiate the terms of the transaction with Schaufele.*fn39 Charles Wyly agreed to participate for one-third of the transaction.*fn40

In order to minimize the borrowing costs imposed by Lehman's credit department, the Wylys followed Schaufele's advice and agreed to limit the initial size of the transaction to 1.5 million shares with an eighteen-month term, and to later seek to increase its size.*fn41 The transaction documents called for the Wyly offshore entities participating in the transaction to pay a fee of six cents per share (for a total of $120,000) based on Lehman's hedging purchases of Sterling Software common stock.*fn42

On October 1, 1999, days after learning of Sam Wyly's trading intentions, Schaufele purchased four thousand shares of Sterling Software at $20.359 per share, for a total investment of more than $80,000.*fn43 He divided the purchases among four different brokerage accounts all held in his wife's name.*fn44

On October 18, 1999, eleven days before Lehman's trading to hedge the transaction and establish its notional price was complete, Morgan Stanley furnished Sam Wyly with an analysis entitled "Operation Windfall" specifically identifying Computer Associates as a potential acquiror for Sterling Software; and on October 22, 1999, five days before Lehman's trading to hedge the transaction and establish its notional price was complete, Sterling Software amended its employment agreements to provide for enhanced payouts to the Wylys in the event of a change in control.*fn45

Following the swap's execution, from November 15 to 17, 1999, Sterling Software's senior managers met and formally agreed to pursue the sale of the company.*fn46 In late November, Sam Wyly summoned several Morgan Stanley investment bankers to his Dallas office to indicate his interest in selling Sterling Software, after which Morgan Stanley notified Computer Associates, whose then-president and Chief Operating Officer made an "overture" to Sam Wyly.*fn47 The two met on January 18, 2000, in Sam Wyly's Dallas home to discuss the acquisition,*fn48 and on February 14, 2000, Computer Associates announced that it had reached an agreement to acquire Sterling Software in a stock swap valued at approximately four billion dollars.*fn49 Based on that day's closing price of Sterling Software, the Wylys' imputed profits from their two-million-share swap transaction exceeded $31.77 million,*fn50 and Schaufele's imputed profits totaled $63,564.*fn51 In March of 2000, both Sterling Software and Sterling Commerce were formally acquired.*fn52

C. The Commission's Investigation

On November 16, 2004, Bank of America reported to the Commission's Enforcement staff that the Wylys' offshore accounts at that institution -- where Schaufele had moved from Lehman Brothers along with the Wylys' accounts in 2002*fn53 -- had been terminated for failure to disclose information regarding their relationship to a web of offshore entities.*fn54 In response, the Commission commenced an investigation, during the course of which the Wylys executed a tolling agreement that remained in place from February 1, 2006, through July 2010.*fn55 French and Schaufele signed tolling agreements dated August 1, 2009, and October 29, 2009, respectively, both of which continued through July 2010.*fn56 The Complaint was filed against Defendants on July 29, 2010.

III. LEGAL STANDARDS

A. Motion to Dismiss

On a motion to dismiss under Federal Rule of Civil Procedure 12(b)(6), the court must "accept as true all of the factual allegations contained in the complaint"*fn57 and "draw all reasonable inferences in [the] plaintiff[s'] favor."*fn58 However, the court need not accord "[l]egal conclusions, deductions or opinions couched as factual allegations . . . a presumption of truthfulness."*fn59 To survive a Rule 12(b)(6) motion to dismiss, the allegations in the complaint must meet a standard of "plausibility."*fn60 A claim is facially plausible "when the plaintiff pleads factual content that allows the court to draw the reasonable inference that the defendant is liable for the misconduct alleged."*fn61

B. Federal Rule of Civil Procedure 9(b)

Federal Rule of Civil Procedure 9(b) provides that "the circumstances constituting fraud . . . shall be stated with particularity." To satisfy the particularity requirement, a complaint must: "'(1) specify the statements that the plaintiff contends were fraudulent, (2) identify the speaker, (3) state where and when the statements were made, and (4) explain why the statements were fraudulent.'"*fn62

However, "intent, knowledge, and other conditions of mind may be averred generally."*fn63

IV. THE SEC'S CLAIMS FOR CIVIL MONETARY PENALTIES*fn64

A. Applicable Law

1. Section 21(d)(3) of the ...


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