In an 8-1 decision issued on June 22, 2020, the US Supreme Court concluded that an SEC disgorgement award may be considered equitable relief permissible under Section 21(d)(5) of the Securities Exchange Act of 1934 (Exchange Act) if the award does not exceed a wrongdoer’s net profits and is awarded for the benefit of victims. The decision appears at first blush to be a victory for the SEC and its ability to obtain disgorgement. But, the Court recognized limitations on equitable disgorgement which may reign in overly ambitious disgorgement claims by the SEC, offering some potential relief to defendants.
The Liu case
As discussed in a prior alert, the SEC initially brought suit against Charles Liu, Xin (Lisa) Wang, and others in June 2016, alleging they had misappropriated at least $20 million of almost $27 million they had raised from investors through the EB-5 Immigrant Investor Program. Lui and Wang represented that they were raising funds for the construction of a cancer treatment center. The district court granted summary judgment in favor of the SEC and ordered disgorgement of the entire $27 million raised from investors (less amounts still available to be returned to investors). The district court rejected the defendants’ arguments that the disgorgement amount failed to exclude amounts legitimately spent on developing the project. The Ninth Circuit affirmed the district court’s decision. The Supreme Court granted certiorari on the question of whether the SEC may seek disgorgement beyond a defendant’s net profits through the agency’s ability to seek equitable relief under Section 21(d)(5) of the Exchange Act which allows the SEC to seek and federal courts to grant “any equitable relief that may be appropriate or necessary for the benefit of investors.”
The Liu petitioners’ argument centered on the Supreme Court’s prior decision in Kokesh v. Securities and Exchange Commission which found that disgorgement was a penalty within the five-year statute of limitations under 28 U.S.C. §2462, but expressly left open the question of whether disgorgement could qualify as equitable relief under Exchange Act §21(d)(5). The petitioners asserted that under Kokesh, disgorgement is a penalty and therefore is not the type of relief available as an equitable remedy in SEC enforcement proceedings.
The Supreme Court’s decision
The Supreme Court rejected the petitioners’ attempts to extend Kokesh, holding that the SEC does have the power to seek disgorgement of illicit profits. The Court expressly stated that Kokesh 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.” The Court relied on established equity principles which have long allowed courts to deprive a wrongdoer of their ill-gotten gains, while also acknowledging the “countervailing equitable principle” that the remedy must be tied to the wrongdoer’s net unlawful profits.
The Court found that while equity courts did not limit profit remedies to particular types of cases, they did impose certain restrictions to avoid transforming the remedy into a penalty. Specifically, equity courts:
- ensured that the remedy is designed to compensate the victims of the wrongdoing
- imposed the relief against individuals or partners engaged in concerted wrongdoing, rather than against multiple wrongdoers under a joint-and-several liability theory and
- limited the award to the net profits from the wrongdoing after deduction of legitimate expenses unless the entire profit of a business results from the wrongful activity.
The Court observed, however, that in recent SEC cases, “courts have occasionally awarded [the SEC] disgorgement in three main ways that test the bounds of equity practice: by ordering the proceeds of fraud to be deposited in Treasury funds instead of disbursing them to victims, imposing joint-and-several disgorgement liability, and declining to deduct even legitimate expenses from the receipts of fraud. The SEC’s disgorgement remedy in such incarnations is in considerable tension with equity practices.”
The Supreme Court concluded that Section 21(d)(5) of the Exchange Act restricts equitable relief to that which “may be appropriate or necessary of the benefit of investors.” As such, the Court concluded that courts may enter disgorgement in favor of the SEC for the victim’s benefit only after deducting legitimate expenses incurred and if the disgorgement is awarded for the benefit of the victims. Disgorgement of funds beyond the wrongdoer’s net profit is not permitted.
Implications and open questions
While Liu has preserved the SEC’s ability to obtain disgorgement in federal court proceedings, the restrictions on that power imposed by the Court will likely provide ammunition to defendants seeking to limit their exposure by arguing that any disgorgement award must be reduced by legitimate expenses and that disgorgement amounts must be tied only to net profits of an individual wrongdoer rather than all wrongdoers jointly and severally.
Liu is unlikely to end battles over disgorgement. The Court’s disgorgement framework leaves a number of open questions in its wake. Here is what the post-Liu landscape may look like:
- The SEC will continue to seek disgorgement
Liu confirms that the SEC is entitled to seek disgorgement of ill-gotten gains and the agency will continue to do so.
- A potential for increased administrative proceedings
While courts will more closely scrutinize disgorgement requests to ensure they align with the principles laid out in Liu, the ruling did not explicitly address whether there are limits on the SEC’s separate authority to seek disgorgement through administrative proceedings, although the majority opinion suggested that may be the case. As the dissent from Justice Thomas points out, however, it remains possible that because disgorgement is expressly statutorily authorized in SEC administrative proceedings, the limitations outlined by the Liu majority may not apply administratively. As a result, the SEC may elect to bring even more claims in its administrative courts to avoid the constraints placed on judicially ordered disgorgement awards under Liu, at least until the question is resolved.
The administrative process is not without its own limits, however, and the SEC has faced assertions that termination protections enjoyed by its administrative law judges are unconstitutional. Until that question is finally resolved, the SEC may be wary of drawing additional scrutiny on the administrative process by pushing for disgorgement awards that run counter to Liu.
- More legal battles over “legitimate expenses” deductions
Prior to Liu, the SEC staff and courts did not always allow deduction of legitimate expenses from disgorgement amounts; that is now required. Under Liu, something more than a reasonable approximation or disgorgement amounts is likely necessary. Post Liu, defendants have already started to ask courts to revisit prior decisions denying deductions for legitimate business expenses from an SEC disgorgement award. In addition to such claims, we anticipate disputes over what types of expenses are properly viewed as offsets. There is pre-Liu case law on disgorgement offsets for business expenses, but Liu has increased the potential for a broader view of what constitute legitimate expenses to offset against disgorgement. Questions remain over which party will have the burden to show that an expense is legitimate or not.
- Legal battles on whether the SEC can impose joint-and-several liability for disgorgement
Liu also left open the question of whether the SEC’s imposition of joint-and-several liability was at odds with the common law rule requiring individual liability for wrongful profits. Holding defendants jointly and severally liable for the profits wrongfully accrued by another, the Court reasoned, could transform disgorgement into a penalty. Joint-and-several liability would only be appropriate if defendants engaged in “concerted wrongdoing.” We anticipate that this potential limitation on disgorgement will become an area of dispute involving issues such as what constitutes “concerted wrongdoing.” We also anticipate disputes over the extent to which the SEC may seek to hold a tipper liable for tippee profits in insider trading cases.
- Disputes over whether disgorgement is permissible when disbursement to investors isn’t feasible
Liu declined to address what equitable principles govern when a wrongdoer’s profits cannot be disbursed to the victims – either because there is no identifiable victim due to the nature of the wrongful act or disbursement to the victims is not feasible. While the SEC often tries to return disgorged funds to investors, often disgorged funds are deposited in the US Treasury – a practice that Liu expressly stated “tests the bounds of equity practice.” Cases involving violations of the Foreign Corrupt Practices Act or insider trading laws often lack an identifiable harmed investor to whom ill-gotten gains could be returned. Liu leaves open the question of whether disgorgement of profits is available as an equitable remedy in such instances.
- Potentially Increased civil penalty amounts
Within the confines of applicable statutes, the SEC has flexibility in assessing civil penalties. The agency has exercised that flexibility in enforcement proceedings. To the extent Liu limits the disgorgement the SEC can seek by requiring the deduction of “legitimate expenses” and imposing other equitable limitations, the SEC may try to seek higher civil penalties as an alternative way to ensure that securities law violators do not benefit from their wrong-doing.
- Debates over whether the SEC may seek disgorgement if it has indicia of a penalty or is a penalty
While the SEC may seek disgorgement as an equitable remedy provided that the disgorgement sought conforms to the requirements of equity, the Court did not address the situation where the SEC obtains a disgorgement award that has some, but not all indications of a penalty. We anticipate continued disputes over whether a disgorgement award that does not strictly conform to the Court’s description of an equitable remedy is permissible.
- Debates over whether truly equitable disgorgement will be treated as deductible for tax purposes
The US federal tax code prohibits deductions for a “fine or similar penalty paid to a government for the violation of any law.” Following the Court’s pronouncement in Kokesh that disgorgement may, in some instances, constitute a “punishment” subjecting it to rules applicable to punishments (such as statutes of limitations), the IRS has sought to extend this prohibition further. In May of this year, the IRS proposed a rule change that, if adopted, would prohibit the deduction of disgorgement and forfeiture from wrongdoers’ taxes, in addition to fines and penalties. Liu’s recognition that equity does allow disgorgement if it is limited to net profits may provide a rationale for those opposed to the IRS’ proposed rule to argue that the IRS should allow deduction of equitable disgorgement awards. .
Liu has reminded the SEC that if it pursues disgorgement as an equitable remedy, it must do so within the limitations of an equitable constraints on that remedy. The precise contours of those limitations remain open to debate and will play out over time. While many questions remain open, Liu provides those defending against SEC disgorgement claims with strong arguments to limit the amount the SEC is entitled to obtain and offers hope for more reasonable disgorgement demands.
To learn more about the potential ramifications of the Liu decision, please contact any of the authors or your DLA Piper relationship partner.