On March 3, 2020, the US Supreme Court heard oral argument on whether the SEC has the authority to obtain disgorgement of “ill-gotten gains” in federal court for securities law violations. During the oral argument, in their questioning, the Justices frequently referred back to district courts’ inherent authority to enter equitable relief. Based on this long-recognized equitable authority, and the specific grant of that authority in the federal securities laws, we expect the Court to determine that disgorgement is properly ordered in SEC enforcement actions in federal court.
The courts’ equitable authority to order disgorgement was considered in the argument as an appropriate remedy intended to promote deterrence by ensuring that one held liable for wrongdoing is not permitted to benefit from his or her ill-gotten gains. This, of course, is distinguished from restitutionary remedies, which focus solely on returning assets to victims; however, while those distinctions were not significantly probed, the issue of returning funds to investors was an important point of the discussion.
And, a good deal of the Justices’ questions focused on the circumstances where a disgorgement order can appropriately be described as equitable, as opposed to penal. Based on the Justices’ questions, while it is very possible that the Court will not impose actual limitations on district courts’ exercise of equitable jurisdiction, we anticipate some language in the Court’s decision that recognizes the limits of disgorgement to the actual “ill-gotten gains,” and cautions that any amounts included in an order that might be seen as more than that, could be limited by an appeals court as, in fact, a penalty.
Challenge to SEC Disgorgement Power
In SEC v. Liu, the Ninth Circuit affirmed the trial court’s decision to grant summary judgment in the SEC’s favor imposing disgorgement of approximately USD 27 million in addition to an USD 8 million civil penalty against the defendants. 1 The defendants appealed, arguing that the SEC does not have the authority to seek disgorgement for violations of the federal securities laws. For decades, the SEC has sought disgorgement in federal court as a form of “equitable relief.” The defendants argue, however, that because equitable relief is meant to be remedial rather than punitive, disgorgement is not an equitable remedy. This argument stems in part from the Supreme Court’s decision in Kokesh, in which the Court held that SEC disgorgement operates as a “penalty” and thus is subject to the five-year statute of limitations that governs such penalties. 2 The Supreme Court granted the writ of certiorari by petitioners Liu and others.
In its appeal to the Supreme Court, the Petitioners argue in their brief that SEC disgorgement is a penalty and does not have the characteristics of traditional equitable relief. Petitioners argue that unlike traditional equitable relief to make victims whole, the SEC often deposits disgorgement funds into the US Treasury and does not return the funds to harmed investors. They point to the SEC’s practice of seeking disgorgement beyond the “net profit” of the alleged wrongdoer and not discounting legitimate costs, contrary to traditional equitable relief.
Our Takeaways
District Courts Will Continue to Be Able to Enter Disgorgement Orders
During oral argument, the questioning by a number of the Justices suggested that the Court might be willing to allow the SEC to continue to seek disgorgement in federal district court actions as an equitable remedy. This inclination seems based on the specific grant of equity jurisdiction provided to federal district courts by the federal securities laws. For example, Section 21(d)(5) of the Securities Exchange Act of 1934 provides that “[i]n 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.” The Justices appeared willing to permit the SEC to seek, and a federal district court to issue, disgorgement orders based on this and other similar grants of authority.
Disgorgement Amounts Should More Closely Reflect the Real-World Economic Reality
In recent years, the Staff has been very aggressive in calculating disgorgement amounts, often disregarding any costs or expenses borne by potential defendants in any business enterprise against which the Staff alleges securities fraud. Often in the context of settlement dialogues, the SEC Enforcement Staff has taken the position that, at most, only certain variable costs, but not legitimate fixed costs, could be offset against the gross profits number when calculating disgorgement. In FCPA cases, in particular, these SEC-imposed limitations can result in public companies paying back amounts greater than their economic benefit from a particular transaction or course of conduct. Any language in the opinion that purports to draw a line between “disgorgement” and “penalty” that suggests more care in determining what comprises “ill-gotten gains,” could open the door to arguments over whether any particular “gain” is causally connected to an alleged securities law violation — for example in FCPA cases alleging books and records and internal controls violations, where the SEC seeks disgorgement of the value of an entire contract or set of transactions.
Importantly, this litigation challenged only the ability of the SEC to seek disgorgement in federal district court actions. It does not challenge the SEC statutory power to seek disgorgement through administrative proceedings. However, if the Court opines or cautions on the scope of disgorgement, such a ruling may similarly limit the amount and scope of disgorgement in SEC administrative proceedings.
Pressure on SEC (and Potentially Settling Defendants) to Return Money to Investors
Another area of focus during the argument was the fact that disgorged funds are often not slated to be returned to investors, but instead are ordered to be paid to the US Treasury. Of course, this goes directly to the distinction between disgorgement and restitution, which was not really considered at the oral argument. Although the Justices plainly had some interest in this issue, they did not appear to question whether the SEC was exercising good faith efforts in trying to distribute disgorged funds.
However, the SEC has been struggling to return disgorged funds to investors. For instance, our recent analysis of SEC statistics from 2019 shows that the SEC has taken a significant amount of time to return funds to victims. And in our experience, the process of returning funds to investors is resource intensive and complex. Often, identifying victims and determining the appropriate monetary amounts to which they are entitled is not an easy task. Any comments in the Court’s opinion, even if offered as guidance in dicta, that can be seen as requiring the SEC to make more significant efforts to return funds to victims will increase the pressure on the SEC to accomplish this task. One danger is that the SEC may decide, as it has done in the past, to require defendants, as part of a settlement, to bear the cost and burden of returning funds to victims, including, for instance, the hiring of an independent fund administrator by settling defendants.
We will continue to monitor this matter and offer our insights when the Court does issue its ruling.
1 See SEC v. Liu, 262 F. Supp. 3d 957 (C.D. Cal. 2017), aff’d, 754 F. App’x 505 (9th Cir. 2018).
2 See Kokesh v. SEC, 137 S. Ct. 1635 (2017).
