One of the Securities and Exchange Commission’s core enforcement powers may soon be overhauled or even scrapped entirely. For fifty years the SEC has sought “disgorgement” of the proceeds of unlawful activity as one of its main remedies in federal court, even though there is no explicit statutory authority for doing so. On March 3, 2020, the Supreme Court will hear oral argument in Charles C. Liu and Xin Wang v. SEC, No. 18-1501, in which the Justices have agreed to consider whether courts can order disgorgement as an “equitable remedy” for a violation of the securities laws. This post discusses the case’s legal backdrop, some of the ways the Court could decide it, and some of its potential consequences.
Background
The History of SEC Disgorgement
When the disgorgement remedy first appeared in SEC cases around 1970, it was justified as an exercise of courts’ inherent equitable powers to deprive a defendant of unjust enrichment via a restitution-style remedy. In 1990, Congress gave the SEC the power to order disgorgement in its in-house administrative proceedings. In 2002, the Sarbanes-Oxley legislation amended the Securities Exchange Act of 1934 to provide, in the current Section 21(d)(5) of that Act, that in any of its enforcement actions, the SEC may seek, and the courts may grant, “any equitable relief that may be appropriate or necessary for the benefit of investors.”
These days the SEC annually obtains disgorgement orders totaling in the billions of dollars, and much of this money, when collected, is paid into the Treasury, not turned over to victims. For most of the remedy’s history, its availability was not seriously questioned. Indeed, many amendments to the securities laws from the 1980s forward referred to disgorgement and reflected an assumption that the remedy was available in federal court.[1]
But then came Kokesh v. SEC.[2] In that case the Justices considered whether SEC disgorgement is subject to the catch-all five-year statute of limitations for a federal “civil fine, penalty, or forfeiture.”[3] The Court held unanimously that disgorgement functions as a “penalty” for purposes of that statute because, among other things, (1) it is imposed for the traditionally punitive purpose of general deterrence, (2) it is not purely compensatory in that disgorged funds are often paid to the Treasury rather than to victims, and (3) at times a disgorgement order “does not simply restore the status quo” before the violation but rather “leaves the defendant worse off,” including by requiring the defendant to “disgorge” the gains of third parties or to pay back a gross gain, rather than the net profits the defendant received after deducting for expenses.[4]
Along the way, five Justices openly wondered about the authority for disgorgement.[5] And the Court’s ruling famously included this footnote: “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.”[6]
The Liu Case
Now, with Liu, the Supreme Court has decided just two years later to consider the issues reserved in the Kokesh footnote. The Court did so despite the lack of discord in the courts of appeals regarding authority to order disgorgement, and despite the absence of any amicus briefs supporting Liu’s petition for certiorari.[7] It is safe to say that some Justices are probably inclined to disturb the status quo on SEC disgorgement.
By way of brief background, the defendants in Liu are a married couple who violated the Securities Act of 1933 by misappropriating money they had raised from investors under the EB-5 Immigrant Investor Program. They had promised to use most of the $27 million they raised to create and run a cancer treatment center; instead, they diverted at least $8.25 million directly to themselves and $12.9 million to three marketing firms to solicit investors. The couple was ordered to pay as disgorgement the gross total amount raised from investors, less a small amount available to be returned to investors—$26.7 million in all. The lower courts refused the defendants’ request to deduct the “legitimate business expenses” of the venture from the disgorgement payment. In addition, the defendants were ordered to pay civil penalties equal to the undisputed amount they received personally—$8.25 million. In a non-precedential Memorandum, the Ninth Circuit ruled that Kokesh did not deprive the district court of power to impose this amount of disgorgement, and upheld the district court’s decision not to give the defendants credit for the “legitimate business expenses.”
Possible Outcomes
Strictly speaking, Liu turns on two questions: (1) Is SEC disgorgement a proper exercise of the courts’ traditional inherent powers of equity? and (2) If not, did Congress otherwise authorize the remedy, including in the 2002 amendment authorizing “any equitable relief that may be appropriate or necessary for the benefit of investors”? Remarkably, the Solicitor General, speaking for the SEC, all but threw in the towel on the first question after certiorari was granted, distancing himself from the case law that first recognized the remedy. Instead, the government’s brief on the merits argued that Congress has ratified and authorized disgorgement via the 2002 amendment and other legislation that preceded it. (A number of amicus briefs have urged a broader view of the courts’ inherent powers of equity.)
One possible outcome in Liu is that the Court’s conservative majority agrees with the defendants that SEC disgorgement is simply not available. The argument runs as follows: disgorgement functions as a penalty for the reasons laid out in Kokesh; penalties are not equitable relief; penalties must be expressly authorized by statute; and SEC disgorgement has not been so authorized.
However, the Court could also adopt a middle ground and hold that SEC disgorgement can be valid if it is confined to something more traditionally “equitable” and less punitive.[8] For example, picking up on Kokesh, the Court could say that a disgorgement award should not leave a defendant worse off than he was before committing the violations. Thus, the Court might observe, a defendant should be able to deduct legitimate expenses from a disgorgement award and should not be ordered to “disgorge” monies paid to a third party and never possessed by the defendant. The Court could potentially also say that for a disgorgement order to be a permissible exercise of equitable powers, the award must be given over to injured investors as traditional restitution would be, not paid into the Treasury essentially as a damage award.
A ruling along these lines (which could potentially command support from more Justices than the “scrap disgorgement entirely” approach) would presumably result in a remand to the lower courts to assess whether the disgorgement award in this case was a proper exercise of the court’s equitable authority. The disgorgement order here, ironically, seems to have been more punitive than the civil penalty award, which was limited to the undisputed amounts personally received by the defendants. The expenses that they were not allowed to deduct from their disgorgement obligation included millions of dollars paid to third parties for property improvement and rent, consulting services to design the treatment center, and a deposit on medical equipment.[9] An even larger component of the disgorgement award (nearly $13 million out of $27 million) was paid to the three marketing companies. Liu and Wang apparently controlled at least one of these three companies.[10] But the lower-court rulings are not entirely clear as to whether and how Liu and Wang benefited from the payments to these companies. Also, the payments to one of these companies seem to have been allowed by the disclosures made to investors.[11] A ruling from the Supreme Court limiting (instead of abolishing) disgorgement would probably require the trial court to revisit this disgorgement award.
Potential Consequences of a Decision Narrowing or Abolishing Disgorgement
A Legislative Reaction
There is no policy reason to allow a law-breaker to keep the profits from a fraud. (The civil penalty provisions were designed not as a substitute for disgorgement, but rather as a supplement to it. See supra note 1.) In addition, the petitioners and their amici have not identified any clear reason why Congress would want disgorgement to be available in SEC administrative proceedings but not federal-court actions.
Accordingly, if the Supreme Court were to abolish disgorgement, or even severely curtail it, Congress may well react by enacting a statute expressly authorizing disgorgement (and possibly also restitution to investors as a separate remedy).[12] In fact, two such bills are pending now; one of them passed the House, 314 to 95, after the grant of certiorari in Liu.[13] If such a bill becomes law, federal courts’ authority to impose disgorgement would be settled, and the SEC might also gain a longer statute of limitations. However, there could be disputes about retroactivity, that is, whether disgorgement may be ordered in pending and future cases for violations committed before the legislation was enacted. There may also be disputes about the proper scope and measure of disgorgement. Both bills expressly contemplate “disgorgement of any unjust enrichment obtained” or “that a person obtained” as a result of a violation, but neither bill clarifies whether a defendant may be ordered to disgorge, as the Liu petitioners were, “enrichment” received by someone else.
Greater Reliance on Civil Penalties, with the Prospect of Lower Total Awards
Another possible consequence of a ruling invalidating or curtailing disgorgement is that the SEC might seek to accomplish via civil penalties alone what until now has been accomplished with the combination of disgorgement and civil penalties. However, this may not always work. For most violations of the securities laws, court-ordered penalties are capped, for each “violation,” at the larger of the “gross amount of pecuniary gain to [the] defendant” or a prescribed dollar maximum. Although there is no agreed-upon way of counting “violations,” and courts have a fair amount of flexibility in setting penalty amounts, courts could find it difficult in some cases (Liu itself may be such a case) to calculate the civil penalties in a way that both strips the defendant of ill-gotten gains (as disgorgement would have done), and also imposes whatever additional deterrent the SEC would have obtained under the current regime. Accordingly, if disgorgement were taken out of the equation, the SEC could in some cases be limited to a lower total recovery.
Greater Reliance on Administrative Proceedings
Yet another possible consequence of a Liu ruling is that the SEC could rely more heavily on administrative proceedings, where the authority to obtain disgorgement is not questioned. For example, it is conceivable that, if the SEC loses in Liu, in certain future contested cases the SEC simultaneously initiates judicial and administrative proceedings, but pauses the administrative proceeding. If the defendant lost in court, the SEC could ask an administrative law judge to decide on a potential disgorgement award (along with other possible sanctions commonly imposed in “follow-on” administrative proceedings, like occupational bars). This method would be somewhat more cumbersome and consume more agency resources than the status quo. This outcome would also be somewhat ironic in that the SEC’s system of administrative adjudication recently has been the subject of controversy and legal challenges, and it is not clear whether most defendants really would prefer to have the SEC itself rather than a federal judge decide the issue of disgorgement.
Footnotes
[1] For example, in the 1980s and in 1990 Congress authorized civil penalties (i.e., fines) in SEC cases. The drafters of these amendments clearly believed that such penalties were called for to supplement disgorgement. The theory was that merely being forced to give up ill-gotten gains is not a sufficient ex ante deterrent because a defendant who is only returned to the position he occupied before the fraud will not have paid any price for the violation. See H.R. Rep. No. 101-616 (1990), 1990 U.S.C.C.A.N. 1379, 1384, 1398; S. Rep. No. 101-337, at 8 n.7, 9–10, 13 (1990); H.R. Rep. No. 100-910, at 11 (1988); H.R. Rep. No. 98-355, at 7–8 (1983). The drafters of the 2002 amendments also believed that disgorgement was available and were trying, if anything, to broaden the SEC’s powers. See S. Rep. No. 107-205, at 27 (2002).
[2] 137 S. Ct. 1635 (2017).
[3] 28 U.S.C. § 2462.
[4] 137 S. Ct. at 1643–44.
[5] See April 18, 2017 Oral Arg. Tr., Kokesh v. SEC, at 8 (Justice Kennedy), 9 (Justice Sotomayor), 13 (Justice Alito), 31–32 (Chief Justice Roberts), 52 (Justice Gorsuch).
[6] 137 S. Ct. at 1642 n.3 (emphasis added).
[7] In fact, the Solicitor General initially elected not to even respond to the petition for certiorari, but the Justices requested a response.
[8] It is of course also possible, if less likely, that the Court will broadly uphold disgorgement.
[9] SEC v. Liu, 262 F. Supp. 3d 957, 964–65 (C.D. Cal. 2017).
[10] See id. at 962–64.
[11] See id. at 962–63, 978 n.23.
[12] It is worth remembering that amendments affecting the SEC’s remedial powers are often enacted in consultation with (and sometimes at the request of) the SEC, which traditionally views disgorgement as a higher and more important remedy than civil penalties.
[13] See H.R. 4344, 116th Cong., 1st Sess. (passed Nov. 18, 2019) (expressly authorizing judicial disgorgement with 14-year limitations period); S. 799, 116th Cong. (expressly authorizing judicial disgorgement and, under some circumstances, restitution to injured investors; five-year statute of limitations for disgorgement).
Daniel Walfish, a former SEC Enforcement senior counsel, is a partner in Walfish & Fissell PLLC.
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