The other shoe drops: Supreme Court will decide whether the SEC may obtain disgorgement as an equitable remedy
In Kokesh v. Securities and Exchange Commission, the Supreme Court concluded that the longstanding disgorgement remedy of the Securities and Exchange Commission (SEC) was a penalty within the five-year statute of limitations under 28 U.S.C. §2462, as covered in a previous DLA Piper alert. During oral argument, several justices questioned the SEC's authority to seek disgorgement. And, in footnote 3 of the Kokesh opinion, the Court stated that nothing in its 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."
Since the Kokesh decision, a number of defendants have challenged, without success, the SEC's ability to obtain disgorgement as an equitable remedy, given the Supreme Court's conclusion in Kokesh that disgorgement is a penalty. Among the defendants who have lost that battle to date are Charles Liu and Lisa Wang. That may change since the Supreme Court just accepted their certiorari petition in Liu and Xin Wang A/K/A Lisa Wang v. SEC on the issue of whether the SEC is entitled to seek and obtain disgorgement as equitable relief. The Supreme Court's decision on this issue has the potential to upend decades of authority where courts have ruled that the SEC is entitled to disgorgement with minimal limitations.
The Liu case and the disgorgement award
In June 2016, the SEC sued and obtained an asset freeze against Mr. Liu, Ms. Wang, and others, alleging securities law violations arising from their involvement in an allegedly fraudulent EB-5 offering. The offering allegedly related to the proposed construction and operation of a proton-therapy cancer treatment center, for which almost $27 million of funds were raised through the EB-5 Immigrant Investor Program. The SEC alleged that Mr. Liu diverted at least $20 million of those funds to himself, Ms. Wang and companies they controlled.
In April 2017, before the Supreme Court issued its decision in Kokesh, the district court granted summary judgment against Mr. Liu and Ms. Wang. As part of its decision, the district court ordered disgorgement of nearly $27 million, representing the entire amount of funds raised by investors less amounts still available to be returned to investors. Relying on Ninth Circuit precedent, the district court rejected the defendants' argument that the disgorgement amount should be offset by all amounts spent for legitimate business purposes. The district court also imposed civil penalties based on the personal gains to each of Liu (approximately $6.7 million) and Wang (approximately $1.5 million.)
As a result, Liu and Wang were obligated to pay disgorgement in an amount far greater than the amounts actually received from the alleged scheme. Just two months later, the Kokesh court determined that disgorgement operates as a penalty, in part because disgorgement may be ordered without consideration of a defendant's legitimate business expenses that reduced the amount of ill-gotten gains, exactly what happened to Mr. Liu and Ms. Wang.
In October 2018, and despite Kokesh, the Ninth Circuit affirmed the district court's judgment in Liu in favor of the SEC, including the disgorgement order. The Ninth Circuit noted that the Kokesh court had "expressly refused to reach" the issue of whether the SEC could seek and a court could order disgorgement and Kokesh was not, therefore, "clearly irreconcilable" with prior Ninth Circuit precedent. The Ninth Circuit also rejected the defendants' claims that they were entitled to an offset for legitimate business expenses. Additionally, the Ninth Circuit opinion did not analyze the significance of the conclusion in Kokesh that disgorgement orders represent a penalty within the meaning of 28 U.S.C. §2462.
The Supreme Court's grant of certiorari
The issue raised by the petition on which the Supreme Court granted certiorari is whether the Securities and Exchange Commission may seek and obtain disgorgement from a court as "equitable relief" for a securities law violation even though the Supreme Court has determined that such disgorgement is a penalty.
While some might conclude that the framing of the question suggests the answer, the result is not a foregone conclusion.
Challenges elsewhere: We anticipate that others facing potential disgorgement claims will press issues similar to those raised by Liu. For example, earlier this year, the Seventh Circuit, in Federal Trade Commission v. Credit Bureau Center, LLC and Michael Brown, vacated a restitution award obtained by the FTC. In doing so, the Seventh Circuit overturned decades-old precedent and held that the FTC lacked authority to obtain restitution because the statute under which the FTC obtained the restitution award only authorizes restraining orders and injunctions. This trend will continue.
SEC disgorgement will continue: Disgorgement is statutorily authorized in SEC administrative proceedings. Consequently, the agency may elect to bring even more claims in its administrative courts. That process has some limitations, since in cases where an effective asset freeze is deemed necessary by the SEC (and Liu was such a case), the agency will need to continue to bring those matters in federal court. In addition, the SEC administrative process remains under attack based on assertions that the multiple layers of protection from removal enjoyed by the SEC's administrative law judges is unconstitutional. Simple resort to the administrative courts is not, therefore, a cure-all for any decision that the SEC is not entitled to obtain disgorgement as equitable relief.
Agencies seeking disgorgement or the courts may tailor disgorgement claims: In Kokesh, the Supreme Court rejected the government's claims that disgorgement is remedial because it restores the status quo in part because disgorgement awards can exceed the ill-gotten gains earned as a result of the violation and can also ignore a defendant's legitimate expenses that reduce the profit from the violation. Agencies seeking to distinguish their disgorgement remedy, or courts considering such requests, may tailor disgorgement demands so that they more closely track the defendant's allegedly ill-gotten gains after expenses.
Civil penalty amounts may increase: The SEC has the power to order distribution for civil penalties it obtains to harmed investors. We anticipate that to the extent there remains uncertainty regarding its ability to obtain and the appropriate method of calculating disgorgement, the SEC may seek increased penalties and direct distribution to harmed investors.
Potential legislative action: Congress may act to minimize the impact of any decision in Liu. A bipartisan effort to address the Kokesh decision is already under way. The Securities Fraud Enforcement and Investor Compensation Act (Act), introduced in the Senate earlier this year, would provide specific authorization for the SEC to seek and courts to award disgorgement (keeping a five-year statute of limitations), while also giving the SEC the right to seek restitution with a 10-year statute of limitations. If the act becomes law, the impact of a decision adverse to the SEC in Liu may be minimized.
If nothing else, the Supreme Court's decision to take up Liu indicates that disgorgement as an SEC remedy requires scrutiny. Where that scrutiny will lead remains uncertain, but the SEC will continue to seek disgorgement and may even receive congressional support.