SCOTUS OKs SEC Disgorgement—But Imposes New Limitations
Last month, the Supreme Court's decision in Liu v. SEC put to rest any concerns about the SEC's general authority to seek disgorgement as an equitable remedy. One of the SEC's main enforcement weapons, disgorgement requires wrongdoers to give up profits earned from illegal activity. The SEC routinely seeks disgorgement to prevent unjust enrichment and to deter future violations. In Liu, the Court held that the SEC can continue to seek disgorgement as proper equitable relief—so long as the amount disgorged does not exceed the wrongdoer's net profits and the disgorged funds are generally transferred to victims.
In 2017, the Court held in Kokesh v. SEC that SEC disgorgement constitutes a "penalty"—but only within the meaning of the applicable statute of limitations. Indeed, the Court specifically noted that its decision should not be "interpreted as an opinion on whether courts possess authority to order disgorgement in SEC enforcement proceedings." If disgorgement were considered a penalty per se it would be unavailable pursuant to the SEC's authority to seek equitable remedies, and would thus limit the SEC's enforcement powers.
Liu now sets forth principles for determining whether disgorgement is proper equitable relief or an impermissible penalty. In other words, even though the Court's decision allows the SEC to continue seeking disgorgement, such awards must now comply with Liu's standards in order to avoid being deemed improperly punitive. Specifically, courts are required to consider the following principles in order to ensure that the remedy sought is proper disgorgement:
1. Legitimate Business Expenses Must Be Deducted From the Disgorgement Award
Liu holds that legitimate business expenses must be deducted from disgorgement awards to the extent they have value independent of fueling the allegedly fraudulent scheme. Historically, the SEC typically disallowed deductions on the theory that such expenses were almost always made in furtherance of illegal conduct. The Court in Liu did acknowledge that there may be some schemes in which all expenses may be considered fraudulent and thus nondeductible.
2. Disgorgement Awards Must Comply With Historical Limitations on Collective Liability
The Court noted that the SEC's practice of requiring disgorgement from all defendants, including on a joint and several basis, may be at odds with the common law rule requiring individual liability for wrongful profits. But the Court also noted that the common law allowed liability for partners acting in concert. The Court did not identify the specific types of relationships that might warrant collective liability, but stated that there may be specific circumstances in which a disgorgement remedy would be impermissibly punitive as applied to multiple defendants.
3. Disgorgement Awards Must Be Returned to Victims.
Pursuant to 15 U.S.C. § 78u(d)(5), the SEC's authority to obtain equitable relief is explicitly limited to relief that "may be appropriate or necessary for the benefit of investors." But the SEC has not always given all disgorgement proceeds to victims. Instead, the SEC often deposits disgorged funds in the US Treasury. This is particularly true for enforcement actions alleging insider trading, where victims may be impossible to identify. Liu holds that disgorgement "must do more than simply benefit the public at large by virtue of depriving a wrongdoer of ill-gotten gains"—although the Court did not resolve whether it is permissible for the SEC to deposit funds with the Treasury when distributing the award is not feasible.
The Court declined to apply these new principles to the facts presented in Liu, and instead remanded the case to the Ninth Circuit to determine whether disgorgement was proper.
While Liu is a litigation win for the SEC, the Court's decision imposes meaningful limitations on the SEC's ability to seek disgorgement. In particular, before demanding disgorgement, the SEC will now need to delve more deeply into an entity's records to identify legitimate expenses in order to calculate a defendant's net profits. And the SEC will need to think twice before requiring disgorgement from defendants whose connection to the charged conduct is attenuated, or for whom liability might be otherwise impermissibly punitive. Such considerations will be a factor not only in future litigation, but also in settlement negotiations. Either way, the Liu decision will arm defendants with new arguments to limit the amount of money they are required to disgorge.
For further information on Liu et al. v. Securities and Exchange Commission, please see our Advisory, "Supreme Court Upholds—But Also Limits—SEC Disgorgement Authority," which includes a more comprehensive summary and analysis of the decision and its implications.
© Arnold & Porter Kaye Scholer LLP 2020 All Rights Reserved. This blog post is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.