In an 8-1 opinion issued Monday, the U.S. Supreme Court confirmed the ability of the Securities and Exchange Commission to seek disgorgement in district court actions against individuals and businesses charged with defrauding investors. The Court also indicated, however, that certain conditions apply. Liu v. SEC, 591 U.S. __ (2020).
Since the Court’s decision in Kokesh v. SEC, 137 S. Ct. 1635 (2017), the SEC’s ability to pursue disgorgement in civil enforcement actions has been shrouded in some doubt. The remedy – by which the SEC recovers the money, or “ill-gotten gains,” that defendants procured from investors – has been a mainstay of the SEC’s enforcement regime for decades. It emerged from the authority that district courts have under 15 U.S.C. § 78u(d)(5) to grant equitable relief for the benefit of investors.
In Kokesh, the Court held that disgorgement constitutes a “penalty” for purposes of the statute of limitations applicable to enforcement actions. In so holding, the decision raised the question whether, and to what extent, the SEC may seek disgorgement in the first place, given that “equitable relief ” under Section 78u(d)(5) is remedial in nature and historically excludes punitive sanctions.
The Liu Court’s answer: “[A] disgorgement award that does not exceed a wrongdoer’s net profits and is awarded for victims is equitable relief permissible under § 78u(d)(5).” Implicit in the Court’s holding are several caveats to the scope of disgorgement that the SEC may permissibly seek. The Court expanded on the caveats, but declined to incorporate them in its holding because the parties did not fully brief the respective issues. Rather, the Court discussed them as “principles that may guide the lower courts’ assessment” on remand of the appropriate disgorgement order to be entered in the case.
Caveat #1: “The equitable nature of the [disgorgement] remedy generally requires the SEC to return a defendant’s gains to wronged investors for their benefit.”
The SEC does not always distribute the disgorgement proceeds it collects to the investors who have been harmed. Making distributions to investors may not be feasible, due to the costs associated with doing so or inability to identify victims. In such cases, the SEC deposits what it collects in a fund in the Treasury.
According to the Court, however, this practice is not an inherently equitable one, because “the SEC’s [disgorgement] remedy must do more than simply benefit the public at large by virtue of depriving a wrongdoer of ill-gotten gains.” The Liu Court declined to comment on the equitable considerations that apply when it is impractical for the SEC to arrange for disgorged funds to be returned to investors, but noted in a footnote that “lower courts are well equipped to evaluate the feasibility of returning funds to victims of fraud.” The Court also suggested in the same footnote that proof from the SEC of failed attempts to return funds to investors may be necessary to support a disgorgement order that does not include a distribution plan.
Caveat #2: “[C]ourts must deduct legitimate expenses before ordering disgorgement under § 78u(d)(5).”
The defendants in Liu took their appeal from a district court judgment that ordered disgorgement equal to the full amount that they had raised from investors, less the funds on hand in their corporate accounts when the SEC halted the investment project. The defendants had asked for a credit for legitimate business expenses, but the district court declined the request on the ground that the expenses were incurred for the purposes of furthering an entirely fraudulent scheme.
The Liu Court sided with defendants, and indicated that all legitimate business expenses are eligible for a credit in disgorgement calculations, even if incurred only to front a fraudulent scheme. As long as the items “arguably have value independent of fueling a fraudulent scheme” and are not merely more wrongful gains masquerading “under another name,” they are beyond the reach of disgorgement.
The Court instructed the lower court to ascertain on remand whether certain lease payments and equipment purchases made by defendants were in fact legitimate expenses. With Liu, the SEC can expect more pushback on its disgorgement calculations in court and from the subjects of its fraud investigations.
Caveat #3: Disgorgement is not available against multiple defendants on a joint-and-several liability basis unless they engaged in concerted wrongdoing.
The district court ordered defendants – husband and wife – jointly and severally liable for the full amount of the judgment against them. The Liu Court questioned joint and several liability under the disgorgement order due to the equitable nature of the remedy. Imposing such liability absent proof of concerted misconduct would, in the Court’s view, constitute a penalty.
In remanding, the Court instructed the lower court to determine whether the husband and wife were actually partners in wrongdoing, and noted considerations relevant to the determination. Apart from the husband’s role in forming the project and soliciting investments, considerations relevant to the spouse included whether she held herself out as an officer or manager in the project or was a “mere passive recipient of profits,” whether she “enjoy[ed] any fruits of the scheme,” and whether the two commingled their finances.
Disgorgement is alive and well in the SEC’s arsenal of remedies. Any contrary result would have caused quite a stir, given that disgorgement has been a bedrock of the enforcement regime for so long. The SEC, however, can expect greater scrutiny from the courts on how it calculates disgorgement and what it does with the funds.
Jason C. Rodgers is a trial lawyer who helps clients navigate investigations and defend actions brought by federal regulatory agencies, as well as resolve complex commercial disputes between civil litigants. His background spans investigative and trial work on behalf of the SEC, together with civil cases and arbitrations involving private securities fraud, mortgage-backed securities, private equity partnership disputes, public contracts, and licensing agreements. Prior to joining the SEC, Jason defended individuals and entities entangled in accounting scandals that led to the enactment of the Sarbanes Oxley Act of 2002.
The opinions expressed are those of the author and do not necessarily reflect the views of the firm, its clients, or any of its or their respective affiliates. This article is for informational purposes only and does not constitute legal advice.