Supreme Court Conditionally Recognizes the SEC’s Right to Disgorgement

 

Written by Taher Kameli & Chathan Vemuri

The Securities and Exchange Commission (SEC) has long argued that as part of penalties sought from parties accused of unlawful activities in violation of securities laws, the SEC had a right to disgorge from the profits of the liable party as part of the remedies it could seek.[1] Disgorgement refers to a remedy by which parties who profited from illegal or wrongful conduct (“ill-gotten gains” so to speak) must return those profits that they made from that conduct to those they harmed in order to make them whole.[2] There has been debate however as to the scope of relief in terms of how much to disgorge.[3] Specifically, there was concern as to whether SEC had such extensive disgorgement authority as to disgorge all funds of defendant investors, including those used for legitimate expenses.[4] Furthermore, legal commentators questioned the practice due to the fact that the SEC’s authorizing statutes do not list disgorgement as a remedy.[5] The SEC is granted authority to obtain disgorgement in enforcement proceedings brought before administrative law judges under the Remedies Act of 1990 but not the authority to seek disgorgement as an equitable remedy in federal court under the federal securities laws.[6] Yet the SEC traditionally has sought disgorgement as one of its equitable remedies available and its disgorgement awards have dwarfed awards from other forms of relief secured by the SEC.[7]

Yet in a new case from this summer, Liu v. SEC, the Supreme Court has finally ruled on whether the SEC can seek disgorgement as a remedy in federal securities cases. The Court approved the seeking of disgorgement as an equitable remedy by the SEC but subjected it to particular limitations as to when and how much disgorgement should take place.[8] In an 8-1 ruling issued by Justice Sonia Sotomayor, the Court ruled that a disgorgement award must “not exceed a wrongdoer’s net profits and is awarded for victims” in order to be permissible equitable relief under §78u(d)(5) of the Securities Exchange Act of 1934.[9] This has important implications for the scope of the SEC’s litigation strategies and represents a challenge to the extent to which the SEC can extract compensation from defendants, forcing it to make key changes to how it litigates its cases. Not to mention also allowing defendants to challenge SEC damages that violate the restricted contours set out by the Supreme Court.

This case involved a couple (Petitioners) accused of scheming to defraud foreign nationals under the EB-5 program which helps noncitizens apply for permanent US residence by investing in approved commercial enterprises for the purpose of “promoting economic growth”.[10] Specifically, the Petitioners sent out a private offering memorandum that solicited contributions from potential immigrant investors to purportedly help build a cancer-treatment center, with a clause stipulating that “only small amounts collected from a small administrative fee would fund “legal, accounting and administration expenses.”[11] Yet as it turned out, the Petitioners were found to have solicited nearly $27 million from these investors, of which $20 million was spent on marketing expenses and salaries, far beyond the “small amounts collected from a small administrative fee” that the memorandum said would fund such expenses.[12] Not to mention much of the funds were sent to personal accounts and one of the Petitioner’s companies, with only a fraction being put toward the cancer treatment center in question.[13] The SEC filed suit against the petitioners for misappropriation of funds under the terms of the offering memorandum and won 1.) an injunction barring Petitioners from further participation in the EB-5 program; 2.) a civil penalty set at the highest authorized tier; and 3.) disgorgement equal to the amount petitioners had raised from investors, minus that sum that remained in the corporate accounts for the investment project.[14] The Petitioners appealed the decision to the Ninth Circuit, objecting to what they saw as an excessive disgorgement award that did not fairly take into account their business expenses.[15] The Ninth Circuit affirmed the decision and the Petitioners filed a writ of certiorari with the US Supreme Court over the issue over whether the SEC could seek disgorgement beyond a defendant’s net profits from the alleged wrongdoing as well as whether courts had the authority to order disgorgement to begin with under the existing statute.[16]

The Court specifically contended with an earlier ruling from three years ago, Kokesh v. SEC, one of whose footnotes the Petitioners cited to show that the Court did not have a formal position on whether courts held the authority to order disgorgement.[17] The Court in that case expressed concern at how the SEC used disgorgement liberally to pay disgorgement sums into the US Treasury with no obligation to actually carry out restitution by returning those funds to the fraud victims.[18] While it held that disgorgement was a valid penalty for violating the securities laws, it refused “to decide whether it was a penalty for all purposes,” such as providing an equitable remedy.[19]

The Court finally ruled it to be an acceptable equitable remedy in Liu v. SEC, provided that it was restricted to a defendant’s net profits from his or her wrongdoings; a defendant’s “ill gotten gains” so to speak.[20] This would be awarded to a defendant’s victims rather than going to the US Treasury, thereby ensuring its purpose as an equity practice rather than as a punitive sanction.[21] Specifically, the Court measured its efficacy as an equity practice by defining equitable relief under the statute as one that would be “appropriate or necessary for the benefit of investors.”[22] The Court held that this standard would be meaningless if it simply meant depriving a wrongdoer of his or her net profits for the sake of punitive damages but and that it required returning those “ill gotten gains” to the victims of the defendant’s financial wrongdoing.[23] The Court also ruled that disgorgement could not apply in the form of joint and several liability as that would “transform any equitable profits-focused remedy into a penalty” and violate “the rule to not impose joint liability in favor of holding defendants ‘liable to account for such profits only as have accrued to themselves . . . and not for those which have accrued to another, and in which they have no participation.’”[24] Finally, the Court limited such disgorgement to that which fraud victims could claim as theirs and nothing beyond that as the purpose of disgorgement would be to provide restitution.[25] As such, a defendant’s legitimate expenses could not be part of the disgorgement award.[26]

This restriction as to how SEC can seek disgorgement has broad consequences for how SEC can prosecute securities fraud cases in the future. The SEC will no longer enjoy the wide latitude it once did in its pursuit of disgorgement. It won’t be able to go after all profits and it  won’t able to pursue joint and several liability against partners of those it sues, except if they can prove those were “partners in wrongdoing”.[27] Nor will it be able to regularly send disgorged funds to the US Treasury as opposed to returning it to investors if it cannot justify sending those funds to the Treasury.[28]

Likewise, companies and individuals being investigated by the SEC can use these limitations to avoid disgorgement or at least seek lower disgorgement penalties, as well as demand that all legitimate business expenses be deducted from any possible disgorgement amount.[29] These companies can also inquire from SEC regarding its use of the disgorged funds and resist the SEC’s claim for disgorgement if they cannot identify any harmed investors.[30] Furthermore, the SEC will probably be unable to get disgorgement from a court in “victimless” cases” where the wrongdoer benefitted from his misconduct without harming any investors, as that would violate the requirement that disgorgement be strictly to compensate the investors.[31] SEC defendants can also fend off separate claims by victims of their wrong doing by pointing out that the SEC should be returning the disgorged funds to the victims, not the defendants, thereby avoiding “double dipping” and deterring “piggy-back” investor lawsuits for securities violations, making litigation easier on defendants.[32]

Restrictions on imposing joint-and-several liability will increase the SEC’s burden of showing that “affiliates or family members of alleged wrongdoers were co-conspirators…or held funds as nominees of defendants.”[33] This would be a very fact-intensive inquiry into whether either third parties are connected to the wrongdoing or whether the defendant is tied to those parties’ funds, with challenges for federal courts as to defining standards of proof under which to touch assets under each theory.[34] SEC may also have to rely more on civil penalties as there are no limits on those and would have to look at its budget to determine which form of compensation, disgorgement or civil penalty, it should prioritized.[35]

Overall, Liu v. SEC may allow SEC use of one of its most popular tools for extracting wrongly acquired profits from those who violate US securities laws, but it also represents a limitation on the scope of the SEC’s power and its discretion with regards to which penalties to pursue. It also allows some leeway to defendants to avoid aspects of SEC litigation that may be deemed punitive at the expense of bringing about actual restitution. Whether the Court follows this line of reasoning to clarify and limit the scope of the SEC’s investigatory power and discretion in litigation remains to be seen.

If you are or will possibly in the future face litigation from the Securities and Exchange Commission and have questions or concerns regarding how disgorgement may apply to you, please contact the Law Offices of Kameli and Associates at info@kameli.com or give us a call at +1 (312) 233-1000.

 

[1] Ronald Mann, Opinion analysis: Justices accept, but cabin, SEC’s right to disgorgement in securities litigation, SCOTUSblog (Jun. 22, 2020, 3:30 PM) https://www.scotusblog.com/2020/06/opinion-analysis-justices-accept-but-cabin-secs-right-to-disgorgement-in-securities-litigation/

[2] Ronald L. Israel and Brian P. O’Neill, Disgorgement as a Viable Theory of Restitution Damages, CSGLAW.COM (Jan. 2014) https://www.csglaw.com/B8D11B/assets/files/News/israel_oneill__commercial_damages_reporter_jan_2014_lead_article.pdf

[3] Ronald Mann, Opinion analysis: Justices accept, but cabin, SEC’s right to disgorgement in securities litigation, SCOTUSblog (Jun. 22, 2020, 3:30 PM) https://www.scotusblog.com/2020/06/opinion-analysis-justices-accept-but-cabin-secs-right-to-disgorgement-in-securities-litigation/

 

[4] Id.

[5] Kyle DeYoung, Lex Urban, and Wesley Wintermeyer, Disgorgement’s Role in SEC Enforcement Actions: An Analysis of the Supreme Court’s Decision in Liu v. SEC, Cadwallader, Wickersham & Taft LLP (June 24, 2020) https://corpgov.law.harvard.edu/2020/07/04/an-analysis-of-the-supreme-courts-decision-in-liu-v-sec/ (Originally posted on law firm’s website and the reposted on Harvard Law’s Forum on Corporate Governance Blog).

[6] Id.

[7] Id.

[8] Liu v. SEC, 140 S. Ct. 1936, 1940 (2020).

[9]Id.

[10] Id. at 1941.

[11] Id.

[12] Id.

[13] Id. at 1942.

[14] Id.

[15] Id.

[16] Id.

[17] Kokesh v. SEC, 137 S. Ct. 1635, 1642 n.3 (2017).

[18] Joseph Gallagher, In ‘Liu v. SEC,’ Disgorgement Survives, But With Conditions, New York Law Journal (Jul. 28, 2020, 10:00 AM) https://www.law.com/newyorklawjournal/2020/07/28/in-liu-v-sec-disgorgement-survives-but-with-conditions/

[19] Id.

[20] Id.

[21] Id.

[22] Liu, 140 S. Ct. at 1947.

[23] Id. at 1948.

[24] Id. at 1945 (citing Belknap v. Schild, 161 U.S. 10, 25-26 (1896)).

[25] Id. at 1957.

[26] Id. at 1945.

[27] Kyle DeYoung, Lex Urban, and Wesley Wintermeyer, Disgorgement’s Role in SEC Enforcement Actions: An Analysis of the Supreme Court’s Decision in Liu v. SEC, Cadwallader, Wickersham & Taft LLP (June 24, 2020) https://corpgov.law.harvard.edu/2020/07/04/an-analysis-of-the-supreme-courts-decision-in-liu-v-sec/

[28] Id.

[29] Id.

[30] Id.

[31] Joseph Gallagher, In ‘Liu v. SEC,’ Disgorgement Survives, But With Conditions, New York Law Journal (Jul. 28, 2020, 10:00 AM) https://www.law.com/newyorklawjournal/2020/07/28/in-liu-v-sec-disgorgement-survives-but-with-conditions/

[32] Id.

[33] Id.

[34] Id.

[35] Id.