SEC Wins Fight to Retain Disgorgement Power But There's a Catch
On June 22, 2020, the U.S. Supreme Court issued its highly anticipated decision in Liu v. Securities and Exchange Commission, which found that disgorgement awards that do not exceed a wrongdoer’s net profits (gross profits reduced by legitimate expenses) are considered equitable relief under 15 U.S.C. §78u(d)(f). This ruling comes after the Court signaled its desire to rein in the Securities and Exchange Commission’s (“SEC”) disgorgement powers without eliminating them entirely. Notably, the Court also ruled that the equitable remedy of disgorgement requires that funds be collected for the “benefit of investors” rather than merely deposited into the U.S. Treasury in the ordinary course. The Court likewise observed that the law of equity placed some limitations on the SEC’s ability to seek joint and several liability under an equitable profits recovery theory.
Challenges to the SEC’s Disgorgement Power
Liu began in 2016 when the SEC sued Charles Liu and Xin “Lisa” Wang for defrauding investors by misusing funds solicited under the EB-5 program authorized by U.S. Citizenship and Immigration Services for an alleged private placement offering in a cancer treatment center. In 2017, the district court ruled against Liu and Wang, and ordered penalties in the form of $27 million in disgorgement and $8.2 million in civil monetary penalties. The Ninth Circuit affirmed the disgorgement award, and Liu and Wang petitioned the Supreme Court to review whether the SEC may seek disgorgement in federal court as a penalty for violating the securities laws.
As detailed in our prior alert, disgorgement is a remedy that the SEC uses to recover wrongdoers’ ill-gotten gains and, in many cases, to return those gains to the victims. The federal securities laws authorize the SEC to seek injunctive relief in federal district courts as well as “any equitable relief that may be appropriate or necessary for the benefit of investors.” The Securities Exchange Act of 1934 (“Exchange Act”) specifically authorizes the SEC to obtain disgorgement as a civil remedy in administrative proceedings but is silent as to whether the remedy is available in federal court actions. The SEC has historically sought and been successful in obtaining disgorgement beyond administrative proceedings under the “equitable relief” provision of the Exchange Act.
In 2017, however, the Supreme Court held in Kokesh v. SEC that disgorgement is a punitive remedy rather than a restorative remedy for the purposes of statute of limitations. Specifically, the Court found that disgorgement is a penalty and therefore subject to the five-year statute of limitations under 28 U.S.C. § 2462. The Court did not reach the question of whether courts have the authority to order disgorgement in the first instance.
The Liu petitioners relied heavily on Kokesh and argued that it foreclosed the SEC’s argument that its authority to seek equitable relief and injunctions justifies a disgorgement remedy. Moreover, the petitioners reasoned that disgorgement is punitive in nature because money obtained from defendants is not always returned to victims but, instead, given to the U.S. Treasury. This would not, in petitioners’ view, be viewed as an equitable remedy because it fails to restore the status quo that existed prior to the alleged wrongdoing.
Finally, the petitioners argued that, assuming disgorgement is allowable, it should be limited to a defendant’s net profits rather than the net loss to aggrieved investors. In other words, disgorgement, according to petitioners, seeks payments without consideration of expenses that reduced the amount of the illegal profit. For example, the district court found that petitioners gained more than $8 million from their alleged scheme, but the court nevertheless ordered them to disgorge – jointly and severally – nearly $27 million. Petitioners averred that, in this sense, disgorgement is a true penalty that leaves defendants worse off.
The Court’s Ruling
In an 8-1 decision considered to be a partial victory for the SEC, the Supreme Court upheld the SEC’s power to disgorge ill-gotten gains in federal court actions but limited the recovery to the amount of net income generated from the unlawful conduct. Justice Sotomayor’s opinion also noted that the remedy must sound in equity, and found that prior awards that (1) ordered proceeds to be deposited with the U.S. Treasury, (2) imposed joint-and-several disgorgement liability, or (3) declined to deduct legitimate expenses from the receipts of fraud are “in considerable tension with equity practices.” Indeed, the Court held, “[c]ourts may not enter disgorgement awards that exceed the gains “made upon any business or investment, when both receipts and payments are taken into the account.” The Court noted, however, that there may still be some instances under common law in which collective liability for concerted wrongdoing was appropriate, and also noted that while the court must deduct legitimate business expenses in calculating disgorgement, there may be inequitable deductions for personal services that should not be allowed. In the case before it, the Court determined that the lower courts are empowered to decide which of Liu’s expenses may be deducted and whether Liu and his wife engaged in concerted action such that joint and several liability would be appropriate. The Court also cast doubt on the SEC’s long-standing practice of depositing disgorgement proceeds with the U.S. Treasury as such an approach may not be for the “benefit of investors” as the statute commands. However, the Court declined to reach the specific issue raised by the SEC of whether the SEC was empowered to seek disgorgement in cases where it intended to deposit the funds into the U.S. Treasury only because it was not feasible to distribute collected funds to investors. The case was remanded to the Ninth Circuit with instructions to reconsider the calculation of the award with these questions in mind.
The Court firmly rejected petitioners’ argument under Kokesh that because disgorgement is treated as a penalty for statute of limitations purposes, it cannot be an equitable remedy, which by definition is not allowed to be punitive. The Court noted that in Kokesh, the Court “expressly declined to pass on the question.” Moreover, while the Court evaluated a “version of the SEC’s disgorgement remedy that seemed to exceed the bounds of traditional equitable principles,” it found that the Kokesh decision “has no bearing on the SEC’s ability to conform future requests for a defendant’s profits to the limits outlined in common-law cases awarding a wrongdoer’s net gains.”
This decision will undoubtedly put more pressure on the SEC to return ill-gotten gains to investors rather than to government bodies, such as the U.S. Treasury. This will likely present the SEC with a host of issues, however, including dealing with the costs of identifying victims, and determining appropriate monetary amounts to which they are entitled in situations where the monetary awards are not large. One potential solution to this issue is that the SEC may attempt to require defendants as a matter of course to bear the cost and burden of returning funds to injured investors, including the costs of an independent Fair Fund administrator. Alternatively, the SEC could seek appropriated funds to be able to fulfill this role or obtain statutory authority to obtain disgorgement even in situations where it is impractical to distribute the funds to investors and either deposit those funds into a fund to be used for costs of a Fair Fund administrator or deposit the funds into the U.S. Treasury.
Practically, the decision may also make it easier for defendants and the SEC to reach settlements now that the Court has weighed in on the defendant’s right of an offset against disgorgement amounts for legitimate expenses, and ruled that joint and several liability appears to be disfavored in many instances.
Finally, the decision will likely lead to further challenges of the Federal Trade Commission’s (“FTC”) own authority to obtain equitable monetary relief under Section 13(b) of the FTC Act. Numerous former FTC senior officials collectively filed a brief of amici curiae in Liu in an effort to urge the Court “to be cautious not to restrict enforcement cases seeking compensatory equitable remedies.” The FTC also cited Liu in its petition for certiorari following the Seventh Circuit’s decision in FTC v. Credit Bureau Center, regarding whether the authority to grant a permanent injunction under Section 13(b) includes the authority to require wrongdoers to return money illegally obtained. Liu could therefore influence the Court’s decision in granting cert in Credit Bureau Center, although there is a major distinction between the Exchange Act and the FTC Act. Specifically, Section 13(b) solely authorizes injunctive relief and does not include language authorizing other forms of equitable relief. The Court’s textualist justices may not be so quick to embrace the FTC’s broad position on its abilities to seek equitable relief beyond an injunction.
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