By Mary P. Hansen and Nicolette J. Zulli
On June 22, 2020, the Supreme Court, in an 8 to 1 decision, held in Liu v. SEC that the U.S. Securities and Exchange Commission (“SEC” or “Commission”) may seek “disgorgement” in federal court actions in amounts which do not exceed a wrongdoers’ net profits and are, if possible, ultimately returned to victims pursuant 15 U.S.C. § 78u(d)(5), which authorizes the SEC to seek “equitable” relief.[1]
What is Disgorgement?
Disgorgement is generally defined as “the act of giving up something on demand or by legal compulsion.”[2] Functionally, disgorgement is a remedy or penalty that has been used by the SEC as an enforcement tool for violations of the federal securities laws. More specifically, the SEC has sought to disgorge “ill-gotten gains” from violators of federal securities laws as an equitable remedy in federal civil actions since the 1970’s.[3] The SEC has consistently argued that disgorgement is an equitable remedy because it seeks to deprive the violators of illicit profits and prevents violators from unjustly enriching themselves as a result of their unlawful misconduct.
The SEC has employed this tool in a broad range of cases, including, but not limited to, insider-trading, Ponzi schemes, and investment adviser cases. For example, disgorgement would include, any profits made as a result of trading on material non-public information, any amounts raised from investors in a Ponzi scheme, and undisclosed fees charged or monies earned without proper disclosure by an investment adviser.
Background
The SEC has always maintained the statutory authority to obtain civil monetary penalties, injunctions, and equitable relief in enforcement matters.[4] The SEC administers four statutes that provide for civil monetary penalties: the Securities Act of 1933; the Securities Exchange Act of 1934; the Investment Company Act of 1940; and the Investment Advisers Act of 1940.[5] A civil monetary penalty is defined in relevant part as any penalty, fine, or other sanction that: (1) is for a specific amount, or has a maximum amount, as provided by federal law; and (2) is assessed or enforced by an agency in an administrative proceeding or by a federal court pursuant to federal law.[6] This definition covers the monetary penalty provisions contained in the statutes administered by the SEC.[7]
Despite its authority to obtain penalties, no statute expressly authorizes the SEC to seek disgorgement in federal court actions. Nevertheless, the SEC has continuously utilized a disgorgement remedy in enforcement cases filed in federal court.[8]
In 2016, Charles Liu and Xin Wang were charged in an SEC enforcement action in the Central District of California for defrauding investors in an EB-5 Immigrant Investor Program scheme. Under the EB-5 Program, foreign citizens can obtain lawful permanent residence if they make a significant investment in a U.S. commercial enterprise.[9] The SEC alleged that Liu and Wang raised more than $27 million from investors for a purported new cancer center development that never materialized.[10] Instead, they diverted investor money to their personal and certain other overseas accounts.[11] In April 2017, the Court granted the SEC summary judgment and ordered disgorgement of more than $26 million.
The Supreme Court’s decision in Kokesh v. SEC came down shortly before Liu and Wang’s appeal to the Ninth Circuit. In Kokesh, the Supreme Court addressed whether the SEC’s ability to seek disgorgement was subject to a five-year statute of limitations. There, the Court held that the SEC’s disgorgement remedy constitutes a “penalty” under 28 U.S.C. § 2642 and is therefore subject to the five-year statute of limitations.[12] The immediate impact of the 2017 Kokesh decision was to limit the SEC’s ability to seek disgorgement of ill-gotten gains older than five years. While the unanimous Court in Kokesh concluded that SEC disgorgement “bears all the hallmarks of a penalty,” the Court noted in Footnote 3 of its opinion that it was not broadly addressing “whether courts possess authority to order disgorgement in SEC enforcement proceedings filed in federal courts, or on whether courts have properly applied disgorgement principles in this context.”[13] This opened the door for defendants to challenge the SEC’s authority to disgorge altogether, but lower courts, in the wake of the Kokesh decision, nevertheless continued to uphold SEC disgorgement authority and awards.
Liu and Wang argued on appeal that in light of Kokesh, SEC disgorgement was not an equitable remedy and that the district court lacked statutory authority to award SEC disgorgement. Citing Footnote 3, the Ninth Circuit rejected these arguments, finding that Kokesh “expressly refused to reach this issue.”[14]
What You Need to Know About the Liu Holding
Following a grant of certiorari on Liu and Wang’s petition, the Petitioners argued to the Supreme Court that the disgorgement award in their case was unlawful because it failed to return funds to victims, imposed joint and several liability, and declined to deduct business expenses from the award.[15]
The Court held that disgorgement constitutes proper equitable relief and is not a penalty under 15 U.S.C. § 78u(d)(5)[16], provided that the amount disgorged does not exceed the wrongdoer’s “net profits” and the disgorged proceeds are awarded to investors as equitable relief. In so holding, the Court vacated the Ninth Circuit’s judgment and remanded the case for further proceedings. Justice Thomas was the lone dissenter, arguing that disgorgement is not available under § 78u(d)(5) because it is not a traditional equitable remedy.[17]
The Court reasoned that Congress has incorporated two long-standing equitable principles into § 78u(d)(5), which provide that “equity practice has long authorized courts to strip wrongdoers of their ill-gotten gains.”[18] It explained (1) “whether it is called restitution, an accounting, or disgorgement, the equitable remedy that deprives wrongdoers of their net profits from unlawful activity reflects both the foundational principle that ‘it would be inequitable that [a wrongdoer] should make a profit out of his own wrong’[19], and (2) the countervailing equitable principle that the wrongdoer should not be punished by ‘paying more than a fair compensation to the person wronged.’”[20]
Notably, the Court agreed with Petitioners that certain versions of the SEC’s disgorgement remedy have occasionally tested the bounds of equity practice by (i) failing to return funds to victims, (ii) imposing joint and several liability, and (iii) declining to deduct business expenses from the award.[21] However, it expressly declined to address these narrower questions, and instead provided principles to help guide the lower courts’ assessment of these arguments.[22]
The Court advised that “legitimate expenses” must be deducted prior to a court ordering a disgorgement award under § 78u(d)(5).[23] It also informed that the SEC is required to distribute disgorged funds back to victims, if pursuing the equitable disgorgement remedy. The Court noted this is because such equitable relief under § 78u(d)(5) is restricted only to that which “may be appropriate or necessary for the benefit of investors.”[24] However, the Court also acknowledged the possibility that the SEC’s practice of depositing disgorgement funds with the U.S. Treasury may satisfy this aim where it is not feasible to distribute the collected funds to investors.[25] Finally, the Court remarked that common-law requires individual liability for wrongful profits, but left to the Ninth Circuit on remand the determination of whether the facts are such that violators can, consistent with equitable principles, be found jointly and severally liable for profits as “partners in wrongdoing.”[26]
Notably, the Liu holding applies only to federal court actions. It does not affect the SEC’s authority to seek disgorgement in administrative proceedings. However, the Court’s refusal to address some of the narrower questions raised in the case may well complicate the SEC’s efforts to seek disgorgement and will likely be the subject of further judicial review.
Client Corner: Liu’s Unresolved Questions and Practical Impact
The Liu decision makes one thing clear: In a federal court action for violations of the securities laws, the SEC may seek disgorgement against a violator as an equitable remedy, albeit with certain limitations. And, in cases where it will be difficult to distribute wrongful gains back to the victims of a violator, the SEC may seek disgorgement against the violator as a penalty. In this regard, the Liu decision is a “win” for the SEC, which now has flexibility to pursue the disgorgement remedy against violators at law or in equity. By the same token, however, the Court has severely muddled the mechanics of this pursuit, by failing to address three main questions:
(1) What Constitutes a “Legitimate Business Expense?”
This answer is unclear. The Court, in offering its guidance on this narrower issue, failed to define what constitutes a “legitimate business expense” for purposes of the mandatory deduction calculation. Instead, it placed this obligation on the lower courts, to examine whether including [certain] expenses in a profit-based remedy is consistent with the equitable principles underlying § 78u(d)(5).[27]
The impact of this lack of clarity, and probable lack of uniformity among lower courts in making this determination, is likely to lead to complications in the disgorgement award calculation for the SEC. Prior to the Liu holding, the SEC typically relied on a “reasonable approximation” of wrongful gains (i.e., net profits) to obtain disgorgement.[28] Now, it must account for so-called “legitimate expenses,” which will likely prove difficult to identify, trace, and assess. Practically, it may also provide violators greater leverage to negotiate defensive settlements with the SEC, since there are currently no clear boundaries as to what qualifies as a legitimate expense to support a fraudulent scheme. This issue remains ripe for clarification on remand to the Ninth Circuit and/or via future judicial review.
(2) Must the SEC Return Funds Disgorged “In Equity” to Investors?
This answer is unclear. When the SEC collects disgorgement, it has the option to return funds to the U.S. Treasury’s Disgorgement Fund or Fair Fund.[29] To do so, in most cases, the SEC must get a distribution consultant and go through extensive analyses to figure out what the proper method of disgorgement would be. In many cases, any disgorgement obtained goes straight to the Treasury.
In Liu, the Court acknowledged that, in practice, the SEC does not always return the entirety of recovered funds to investors due to the cumbersome nature and expense of the claims process.[30] Nevertheless, it said that, in the context of disgorgement as equitable relief under § 78u(d)(5), the SEC has an obligation to award relief “for the benefit of investors.”[31] This, the Court said, means that the wrongdoer’s profits must be disbursed to the victims.[32] However, the Court left it up to the lower courts, to determine what traditional equitable principles govern when the disgorged profits cannot practically be disbursed to the victims, and whether directing disgorged proceeds to the U.S. Treasury can satisfy equitable principles in such situations.[33]
Until this issue is further clarified, the lack of guidance leaves the SEC with a choice: It may attempt a distribution to justify a disgorgement award, or argue that excessive cost to distribute the funds is equivalent to impracticality and is consistent with the Court’s decision—even where funds are not returned to investors.
In addition, in many Ponzi schemes, the violator has no funds to pay disgorgement. In those instances, the SEC still seeks an order of disgorgement in the final judgment, in the event that the violator ever has funds. In this situation, it is unclear whether an order of disgorgement will be considered appropriate where it is clear that the defendant will not make any payments, at least in the near future.
(3) Can Violators Be Held Jointly and Severally Liable for Funds Disgorged “In Equity”?
This answer is unclear. The Court noted that common-law requires individual, not collective, liability for wrongful profits.[34] Accordingly, it expressed skepticism about whether disgorgement may be sought against multiple violators on a joint and several liability theory. But, it also acknowledged that an equitable profits remedy might be justifiably punitive, since there tends to be a wide spectrum of relationships between participants and beneficiaries of unlawful schemes.[35]
In the end, the Court left it to the lower courts to determine, on a fact-specific basis, whether the imposition of joint and several liability against “partners in wrongdoing” for a disgorgement award is consistent with equitable principles. Practically, this means that until this issue is further decided, it is possible for the SEC to justify joint and several liability as appropriate punitive relief against multiple defendant-violators.
Overall, the Liu decision handed the SEC a partial victory, but certainly signals that the SEC will continue to face hurdles in its continued pursuit of disgorgement in federal court actions.
Notes
[1] Securities Exchange Act of 1934, 15 U.S.C. § 78u-2(e). (The SEC has had specific statutory authority to seek disgorgement is Administrative proceedings.).
[2] Disgorgement Definition, Black’s Law Dictionary(9th ed. 2009),available at Westlaw.
[3] Kyle DeYoung, et al., United States: Disgorgement’s Role In SEC Enforcement Actions: An Analysis Of The Supreme Court’s Decision in Liu v. SEC, MONDAQ.COM (2020), available at https://www.mondaq.com/unitedstates/trials-appeals-compensation/958392/disgorgement39s-role-in-sec-enforcement-actions-an-analysis-of-the-supreme-court39s-decision-in-liu-v-sec.
[4] 15 U.S.C. § 77t(d)(1).
[5] Final Rule: Adjustments to Civil Monetary Penalty Amounts, SEC.GOV (2001), available at https://www.sec.gov/rules/final/33-7946.htm.
[6] 28 U.S.C. 2461(3)(2).
[7] See supra note 3.
[8] See Securities Enforcement Remedies and Penny Stock Reform Act, 104 Stat. 932, codified at 15 U.S.C. § 77t(d); see also Remedies and Relief in SEC Enforcement Actions: PLI White Collar Crime 2018: Prosecutors and Regulators Speak, SEC.GOV (2018), available at https://www.sec.gov/news/speech/speech-peikin-100318.
[9] The Lasting Impact of Kokesh: Footnote 3 and Beyond, JDSUPRA.COM (2019), available at https://www.jdsupra.com/legalnews/the-lasting-impact-of-kokesh-footnote-3-72176/#_edn9.
[10] Id.
[11] Id.
[12] See Kokesh v. SEC, 137 S. Ct. 1635, 1635 (2017).
[13] Kokesh, at 1642 n. 3.
[14] SEC v. Liu, et al., D.C. No. 8:16-cv-00974-CJC-AGR, at 7 (9th Cir. 2018), available at https://www.scotusblog.com/wp-content/uploads/2019/06/18-1501-opinion-below.pdf.
[15] Liu v. Sec, No. 18-1501 slip op., at 14 (US June 22, 2020), available at https://www.supremecourt.gov/opinions/19pdf/18-1501_8n5a.pdf.
[16] 15 U.S.C. § 78u(d)(5) (“In any proceeding under paragraph (1) against any person participating in, or, at the time of the alleged misconduct who was participating in, an offering of penny stock, the court may prohibit that person from participating in an offering of penny stock, conditionally or unconditionally, and permanently or for such period of time as the court shall determine.).
[17] Liu, No. 18-1501 slip op., at 1 (Thomas, J., dissenting).
[18] Id., at 2.
[19] Id. (citing Root v. Railway Co., 105 U.S. 189, 207 (1881)).
[20] Id. (citing Tilghman v. Proctor, 125 U.S. 136, 145–46 (1888)).
[21] Id., at 12, 14.
[22] Liu, No. 18-1501 slip op., at 14.
[23] Id., at 19.
[24] Id., at 14 (emphasis added).
[25] Id., at 14.
[26] Id., at 17–18.
[27] Liu, No. 18-1501 slip op., at 19–20.
[28] See S.E.C. v. Warde, 151 F.3d 42, 50 (2d Cir. 1998).
[29] See U.S. Securities and Exchange Commission Rules of Practice and Rules on Fair Fund and Disgorgement Plans, SEC.GOV 1, 116 (Sep. 2019), available at https://www.sec.gov/about/rules-of-practice-2019-09.pdf (“In any agency process initiated by an in order instituting proceedings (OIP) in which the Commission . . . issues an order requiring the payment of disgorgement by a respondent and also assessing a Penalty against that respondent, the Commission . . . may order the amount of disgorgement of the Penalty . . . be used to create a fund for the benefit of investors who were harmed by the violation, known as a “fair fund.”).
[30] Liu, No. 18-1501 slip op., at 14.
[31] Id., at 16–17.
[32] Id., at 17.
[33] Id.
[34] Id. (citing SEC v. Contorinis, 743 F.3d 296, 3023 (CA2 2014).
[35] Liu, No. 18-1501 slip op., at 18.