Client update: Supreme Court holds SEC may obtain disgorgement but places limitations on the remedy
Deciding a question left open after the U.S. Supreme Court’s 2017 decision in Kokesh v. SEC, the Court held on Monday in Charles Liu v. SEC, 591 U. S. ____ , 2020 U.S. LEXIS 3374 (June 22, 2020)(slip op.) that the U.S. Securities and Exchange Commission (SEC) may continue to seek disgorgement in court proceedings, but it must limit the remedy to actual net profits resulting from a securities law violation, avoid joint and several liability upon non-partner co-defendants, and must actually return disgorged assets to affected investors.
For years, parties before the SEC have argued that the regulator does not have authorization to seek disgorgement in court. Indeed, the authorizing statute does not mention disgorgement at all, but instead references a court’s power to grant equitable relief: “In any action or proceeding brought or instituted by the Commission under any provision of the securities laws, the Commission may seek, and any Federal court may grant, any equitable relief that may be appropriate or necessary for the benefit of investors.” 15 U.S.C. § 78u(d)(5). Footnote 3 in Kokesh invited review of the issue: “Nothing in this opinion should be interpreted as an opinion on whether courts possess authority to order disgorgement in SEC enforcement proceedings or on whether courts have properly applied disgorgement principles in this context.” Kokesh, 137 S. Ct. at 1642 n.3.
What Is Disgorgement?
Disgorgement has long been used as an equitable remedy by the SEC, whereby “an individual found liable for fraudulently trading federal securities may be properly ordered to disgorge any ill-gotten profits.” S.E.C. v. Ridenour, 913 F.2d 515, 517 (8th Cir. 1990). As one court stated, “In a securities enforcement action, as in other contexts, ‘disgorgement’ is not available primarily to compensate victims. Instead, disgorgement has been used by the SEC and courts to prevent wrongdoers from unjustly enriching themselves through violations, which has the effect of deterring subsequent fraud. A district court order of disgorgement forces a defendant to account for all profits reaped through his securities law violations and to transfer all such money to the court, even if it exceeds actual damages to victims.” SEC v. Cavanagh, 445 F.3d 105, 117 (2d Cir. 2006). According to the SEC’s Division of Enforcement’s 2019 Annual Report, in fiscal year 2019, the SEC brought 862 enforcement actions and obtained judgments and orders totaling more than $3.2 billion in disgorgement of ill-gotten gains.
Charles Liu and his wife Xin (Lisa) Wang were accused of fraudulently obtaining $27 million from selling securities to foreign investors in connection with a project approved under the EB-5 Immigrant Investor Program. Contrary to the offering documents, Liu and Wang misused investor funds to funnel money to their personal accounts and paid excessive fees to overseas marketers instead of using the funds to build a cancer treatment center, as was promised in the materials. In May 2016, the SEC filed an action in the U.S. District Court for the Central District of California. During discovery, Liu and Wang refused to testify during depositions, which formed the basis for an adverse inference and summary judgment in favor of the SEC. In addition to imposing an injunction and civil penalties, the court ordered Liu and Wang to disgorge $26,733,018.81, which represented the total amount they collected from investors minus $234,899 that remained in the corporate accounts for the project. The Ninth Circuit Court of Appeals affirmed, rejecting the argument that the disgorgement amount failed to account for the project’s legitimate business expenses and acknowledging that Kokesh did not reach the issue of whether the SEC had the authority to obtain disgorgement in the first place.
The Liu Opinion
Writing for the majority, Justice Sotomayor, who also authored the opinion in Kokesh, began by confirming that the five-year statute of limitations of 28 U.S.C. § 2462 applies to SEC-sought disgorgement because that remedy “is imposed as a consequence of violating public laws, it is assessed in part for punitive purposes, and in many cases, the award is not compensatory.” (Liu, slip op., at 3).
Consistent with the reality that 15 U.S.C. § 78u(d)(5) does not mention “disgorgement” and does not provide any definition of what Congress meant when it authorized the SEC to obtain “equitable relief,” much of the Liu opinion justifies its conclusion by conducting an examination of equity courts taking ill-gotten gains from wrongdoers and returning such amounts to their victims. The opinion does not restrain itself to disgorgement cases but instead relies on its view that the same “profits-based relief” has also been labeled “restitution” and “accounting” so those cases are included in the discussion. (Slip op., at 6). Liu’s exercise results in an observation that “equity practice long authorized courts to strip wrongdoers of their ill-gotten gains” but “to avoid transforming an equitable remedy into a punitive sanction, courts restricted the remedy to an individual wrongdoer’s net profits to be award for victims.” Accordingly, Liu holds that the SEC may obtain disgorgement but places limits on that remedy.
Limits on the SEC’s Ability to Obtain Disgorgement as “Equitable Relief” for Securities Law Violations
After reviewing equity cases from 1854 through 2017, Liu concludes that the SEC’s ability to obtain disgorgement should be limited and the opinion expressly incorporates “these longstanding equitable principles into § 78u(d)(5).” (Slip op., at 12).
Amounts disgorged must be returned to victims: The first equitable principle limit derives from constructive trust cases. There, equitable courts imposed constructive trusts upon wrongful gains, transforming wrongdoers into trustees bound to distribute their gains to their wronged victims. (Slip op., at 9). Based on this, and the language in § 78u(d)(5) that the SEC may only obtain “equitable relief that may be appropriate or necessary for the benefit of investors,” Liu holds that “[t]he equitable nature of the profits remedy generally requires the SEC to return a defendant’s gains to wronged investors for their benefit” and such a remedy “must do more than simply benefit the public at large.” This indicates that any practice of depositing disgorgement proceeds into a U.S. Treasury fund to pay whistleblowers and fund other government activities will be unacceptable, and going forward disgorgement orders should include instructions that the SEC identify the relevant investors and distribute the disgorged assets to them.
Court orders should not impose joint and several disgorgement liability: “The rule against joint-and-several liability for profits that have accrued to another appears throughout equity cases awarding profits.” (Slip op., at 10). Accordingly, the second equitable principle limit is that the SEC may not attempt to place joint and several liability upon co-defendants, whereby each would be responsible for an entire disgorgement amount if any of it is unpaid notwithstanding each co-defendant’s actual, respective profit from the wrongdoing. Liu, however, indicates an exception to this limit exists to “permit liability for partners engaged in concerted wrongdoing.” (Slip op., at 18). Accordingly, future courts will need to decide whether only true partners with co-equal culpability may be jointly and severally liable, or if this limit is merely perfunctory and not a prohibition on the regulator seeking settlements that impose joint and several liability upon broker-dealers, registered investment advisors and others based on the conduct of employees acting outside their scope, independent contractors acting without authority, or affiliated entities that are found to have separately committed a securities law violation.
Disgorgement must be limited to net profits: The third equitable principle limit is disgorgement must be limited to “the gain made upon any business or investment, when both the receipts and payments are taken into the account.” (Slip op., at 10). Interestingly, the opinion’s language here is stronger, instructing “courts must deduct legitimate expenses before ordering disgorgement under § 78u(d)(5).” (Slip op., at 19). Of course, this opens the door to those negotiating with the SEC to better argue what the true net profit may be from a specific securities violation. For example, in calculating profit, revenues generated from a market manipulation could be offset by legitimate expenses such as “commissions, telephone charges, underwriting expenses and a proportionate share of overhead.” SEC v. Thomas James Assocs., Inc., 738 F. Supp. 88, 92 (W.D.N.Y. 1990). Offset arguments rejected in insider trading cases, that gains should be offset by trading losses and taxes paid on the gains, may now be raised again in light of the directive in Liu. See United States SEC v. Svoboda, 409 F. Supp. 2d 331, 345 (S.D.N.Y. 2006). In sum, when facing a request for disgorgement – which could take the form of profits from market manipulation violations, funds raised in fraudulent offering schemes, conflicted revenue or forms of kickbacks, or commissions from trading violations – firms should conduct an analysis to identify and carve out any legitimate revenue streams and expenses, as well as any amounts paid as restitution or paid in settlement of private investor claims, in addition to carving out amounts resulting from conduct that occurred more than five years prior to the filing of an enforcement action. See Gabelli v. SEC, 568 U.S. 442, 454 (2013) (finding the five-year statute of limitations commences when alleged misconduct occurs and stating “Given the lack of textual, historical, or equitable reasons to graft a discovery rule onto the statute of limitations of §2462, we decline to do so.”).
The opinion in Liu v. SEC, dated June 22, 2020, may be accessed at https://www.supremecourt.gov/opinions/19pdf/18-1501_8n5a.pdf