Buckley Commentary & Analysis
"Supreme Court decision upholds but limits SEC’s disgorgement authority" by Olivia A. Rauh
Buckley Commentary & AnalysisOlivia A. Rauh
A recent Supreme Court decision allows the Securities and Exchange Commission to continue pursuing disgorgement in its enforcement actions, but with significant limitations that will curb disgorgement’s scope and could complicate the SEC’s future efforts to seek it.
Whether the SEC has legal authorization to compel disgorgement is a question the Supreme Court appears to have had on its mind for a while. Three years ago, the court held that the five-year civil penalty statute of limitations applied to SEC disgorgement claims, but in a footnote said “nothing in this opinion should be interpreted as an opinion on whether courts possess authority to order disgorgement in SEC enforcement proceedings or on whether courts have properly applied disgorgement principles in this context.” The Court’s 8-1 decision in Liu v. SEC answered these questions, holding that “a disgorgement award that does not exceed a wrongdoer’s net profits and is awarded for victims is equitable relief permissible under” securities laws.
But the court also ruled that lower courts and the SEC had not properly applied disgorgement principles in the past — a holding that threatens to upend settled precedent. While disgorgement was allowed by the language of 15 U.S.C. § 78u(d)(5), which provides that in SEC actions a federal court may grant “any equitable relief that may be appropriate or necessary for the benefit of investors,” the Supreme Court found that lower courts had gone beyond equitable principles in awarding disgorgement by: (i) “ordering the proceeds of fraud to be deposited in Treasury funds instead of distributing them to victims”; (ii) “imposing joint-and-several disgorgement liability”; and (iii) “declining to deduct even legitimate expenses from the receipts of fraud.”
The limitations articulated in Liu pose new challenges to almost all of the SEC’s future enforcement actions. Certainly, it will no longer be able to reflexively demand disgorgement in every enforcement action. But courts will have to define the borders of each of the decision’s limitations, and determine whether Liu applies retroactively.
Disgorgement must benefit victims
Prior to Liu, the SEC approached disgorgement with almost a singular focus on depriving defendants of “ill-gotten gains,” regardless of whether doing so made victims whole. The SEC indeed argued in Liu that “the disgorged funds may go to the Treasury rather than to the victims.” The Supreme Court rejected this approach, holding that the statutory language of Section 78u(d)(5), “restricts equitable relief to that which ‘may be appropriate or necessary for the benefit of investors.’” The SEC’s approach of “simply benefit[ing] the public at large by virtue of depriving a wrongdoer of ill-gotten gains” ran contrary to the requirement that disgorgement be “appropriate or necessary for the benefit of investors.”
Some securities fraud scams, such as Ponzi schemes, include easily identifiable victims. But for other securities violations such as insider trading, FCPA bribery, false filings, or a failure to register, the SEC may find it very difficult, if not impossible, to identify victims and ensure that money can be distributed to “investors.” What happens when illicit profits simply cannot be distributed to victims? Is disgorgement unavailable at the start of a case, or is the question deferred until after a judgment and the SEC fails to find victims to repay? The Supreme Court did not address those issues. Going forward, defendants outside of the traditional investor-fraud context are likely to argue that disgorgement is unavailable; the requirement of both “wrongdoers” and “victims” read together indicates that the case must sound in fraud.
No joint-and-several disgorgement liability
The Supreme Court criticized the SEC for seeking disgorgement liability on a joint-and-several liability basis rather than an individual liability basis, which conflicted with traditional application of equitable relief and “could transform any equitable profits-focused remedy into a penalty.” While the common law recognized “liability for partners engaged in concerted wrongdoing,” there was a “wide spectrum of relationships between participants and beneficiaries of unlawful schemes” that could allow for abuse of collective liability in certain circumstances.
Ultimately, the decision requires lower courts — including the Ninth Circuit on remand in Liu — to determine when individual liability is required or when partners who are engaged in a concerted wrongdoing can be held liable on that basis. That will demand highly fact-specific inquiries based on the specific personal and business relationships between the defendants.
Legitimate expenses must be considered
There will also be plenty of litigation to define “legitimate expenses” in securities cases. The Supreme Court in Liu rejected the district court’s conclusion that all of the revenues that Liu and his wife received from foreign investors were subject to disgorgement as a “reasonable approximation of the profits causally connected to [their] violation.” Citing a case from 1870, the Court emphasized that the proper measure was “gain,” and therefore consideration of both “receipts and payments,” which requires courts “to deduct legitimate expenses before ordering disgorgement.”
For example, the Court noted that some of the Lius’ expenses, such as “lease payments and cancer-treatment equipment,” could have “value independent of fueling a fraudulent scheme.” Ultimately, as with the first two principles, the Supreme Court left it to lower courts for resolution.
Disgorgement in SEC administrative proceedings
Even beyond interpreting the three principles above, lower courts will be asked to address numerous other issues resulting from Liu. For example, as the Supreme Court noted, the SEC has separate statutory authorization under 15 U.S.C. § 77h-1(e) to seek limited penalties and disgorgement in administrative proceedings. It will fall to administrative law judges and then federal courts to determine whether the SEC can continue to pursue “victimless” disgorgement in administrative actions for insider trading, and argue the funds can go to the U.S. Treasury.
Revisiting prior disgorgement orders
Will defendants in prior cases who have already paid, or are about to pay, a disgorgement order that violates one or more of the three Supreme Court limitations be able to move to set aside those disgorgement orders and potentially recoup those payments? Defendants may find different answers depending on whether they have already paid, or have appealed their disgorgement order. Previously entered settlements with the SEC may potentially be challenged as well.