In brief
While the SEC may seek disgorgement, it may not, under the guise of disgorgement, seek a remedy beyond traditional equitable principles
In a much anticipated ruling, the United States Supreme Court held today in Liu v. Securities and Exchange Commission that a disgorgement award that does not exceed a wrongdoer’s net profits and is awarded for “the benefit of investors” is “equitable relief” permissible under 15 U. S. C. §78u(d)(5).[1] In reaching its decision, the Court analyzed categories of relief “typically available in equity,” concluding that “equity practice [has] long authorized courts to strip wrongdoers of their ill-gotten gains.”[2] However, in vacating the decision of the Ninth Circuit Court of Appeals and remanding for further proceedings, the Court left open the questions of whether disgorgement awards not paid to victims can be consistent with the statutory requirement that such a remedy be imposed “for the benefit of investors,” and whether concepts of equity contemplate any circumstance under which a joint-and-several award of disgorgement would be appropriate.
Contents
Challenge to SEC Disgorgement Power
This case arises from a lawsuit filed by the SEC in federal court against two operators of an investment fund who allegedly spent funds inconsistently with their promises to investors. The district court ruled against the defendants, ordering penalties equal to the “personal gain” that the defendants received from the fund (about USD 8 million) and also “disgorgement” of the remaining USD 19 million that investors contributed to the fund. The Ninth Circuit affirmed, and the defendants successfully petitioned the Supreme Court to review the question of whether the SEC may obtain disgorgement in federal court as a penalty for securities law violations.
For years, the SEC has sought disgorgement in federal court as a form of “equitable relief.” Section 21 of the Securities Exchange Act of 1934, added in 2002, includes “any equitable relief that may be appropriate or necessary” among the remedies available to the SEC in judicial enforcement proceedings. The question presented in Liu is whether this statutory reference to “equitable relief” includes “disgorgement.” In 2017, the Supreme Court, in Kokesh v. SEC, held that, for purposes of 28 U.S.C. § 2462, disgorgement operates as a “penalty” and thus is subject to the federal five-year statute of limitations.[3] However, Kokesh did not present the more fundamental question of whether courts possess authority to order disgorgement in SEC proceedings at all.
The defendant-petitioners in Liu argued that their disgorgement award was unlawful for (a) failing to return funds to victims; (b) imposing joint-and-several liability; and (c) declining to deduct business expenses from the award. They emphasized that unlike traditional equitable relief, which is intended to make victims whole, the SEC often deposits disgorgement funds into the US Treasury and does not return the funds to harmed investors. Petitioners cited the SEC’s practice of seeking disgorgement beyond the “net profit” of the alleged wrongdoer and not discounting legitimate costs, thereby imposing a “penalty” additional to the value of traditional equitable relief.
District Courts Will Continue to Be Able to Enter Disgorgement Orders
In its 8-1 ruling, the Supreme Court struck somewhat of a compromise between business as usual for the SEC, on one hand, versus eliminating disgorgement altogether in judicial enforcement proceedings. Justice Sotomayor’s opinion holds that disgorgement is an appropriate judicial remedy pursuant to Section 21 of the Exchange Act, but the remedy must be applied in a manner that actually achieves equitable principles. For example, district courts must deduct legitimate expenses to determine the ill-gotten profits obtained by defendant, rather than simply awarding the gross amount invested. “Courts may not enter disgorgement awards that exceed the gains ‘made upon any business or investment, when both the receipts and payments are taken into the account.’”[4]
The trial court in Liu declined to deduct expenses on the theory that they were incurred for purposes of furthering the fraudulent scheme. The Supreme Court acknowledges that when the entire profit results from the wrongdoing, the defendants may be denied deductions. However, the Court cautioned, district courts must ascertain “whether expenses are legitimate or whether they are merely wrongful gains ‘under another name.’”[5] Ultimately, the Court left it to the lower courts to decide which of Liu’s expenses might be deducted, but raised the question whether certain expenses, such as lease payments and payments for cancer-treating equipment, have some value independent of the fraudulent scheme.
Overall, a Win for the SEC
After a string of losses at the Supreme Court, the pendulum has finally swung in the other direction with a win for the SEC. However, this ruling on the Commission’s authority may result in some limitations to the tools available to settle cases, and may extend litigation in cases that do not so resolve.
For example, the Court discusses the SEC’s practice of seeking to impose disgorgement through joint-and-several liability awards, noting that it is “sometimes seemingly at odds with the common-law rule requiring individual liability for wrongful profits.”[6] The Court notes that the practice “could transform any equitable profits-focused remedy into a penalty,” while also acknowledging that common law permitted “liability for partners engaged in concerted wrongdoing.”[7] Again, the Court declined to decide the issue directly, leaving it to the lower courts on remand. But joint-and-several liability is a tool often used by the SEC Staff in settling cases and, depending on where the law goes on this issue, courts may have a more difficult time approving such settlements, even where there is no objection from the defendants. Plainly, one can also anticipate additional litigation or procedure related to what are and what are not “legitimate” costs and expenses that should be excluded from a disgorgement award.
Finally, the decision likely will put more pressure on the SEC to return ill-gotten gains to investors noting that “the SEC’s equitable, profits-based remedy must do more than simply benefit the public at large by virtue of depriving a wrongdoer of ill-gotten gains.”[8] In recent years, the SEC has struggled to return disgorged funds to investors. For instance, our recent analysis of SEC statistics from 2019 showed that the SEC can often take a significant amount of time to return funds to victims. In our experience, the process of returning funds to investors can be resource intensive and complex. Often, identifying victims and determining the appropriate monetary amounts to which they are entitled is not an easy task. While the Court declined to address the issue directly, it did question whether the SEC’s practice of “depositing disgorgement funds with the Treasury may be justified where it is infeasible to distribute the collected funds to investors.”[9] One potential outcome, which we have seen in the past, is that the SEC may decide 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. One wonders whether an equity court might also order that a portion of the disgorged funds be used for such a purpose. But these are questions that will have to wait for further proceedings.
[1] Liu v. Securities and Exchange Commission, 591 U. S. ____ (2020) (hereinafter, “Slip Opinion”).
[2] Id. at 5-6.
[3] See Kokesh v. Securities and Exchange Commission, 200 U.S. 321 (2017).
[4] Slip Opinion at 18-19 (citations omitted).
[5] Id. at 19 (citations omitted).
[6] Id. at 17.
[7] Id. at 17-18.
[8] Id. at 16.
[9] Id.
