On June 22, 2020, the U.S. Supreme Court held that courts may impose disgorgement as equitable relief under Section 21(d)(5) of the Securities Exchange Act of 1934, 15 U.S.C. § 78u(d)(5), in SEC enforcement actions, but limited the remedy to the defendant’s net profits.
Section 78u(d)(5) provides that “[i]n any action or proceeding brought or instituted by the [SEC] under any provision of the securities laws, the [SEC] may seek, and any Federal court may grant, any equitable relief that may be appropriate or necessary for the benefit of investors.” The Supreme Court unanimously held in Kokesh v. SEC, 137 S. Ct. 1635 (2017), that court-ordered disgorgement in an SEC enforcement action is a penalty — punitive in nature and intended to defer offenses against the public — and therefore subject to the five-year statute of limitations in 28 U.S.C. § 2462. But the Court noted it was an open question whether federal courts could order disgorgement at all, since equitable relief usually does not include punitive sanctions. The Court’s decision this week answered that question affirmatively — within limits.
LIU v. SEC
In Liu v. SEC, the Supreme Court held that disgorgement is available as equitable relief under Section 78u(d)(5); however, except under certain limited circumstances, such as when the entire profit of a business or undertaking results from wrongdoing, the disgorgement ordered must not exceed the net profits the defendant earned through the offending conduct. The defendants in Liu — a married couple — raised $27 million from foreign investors through the EB-5 investment and immigration program, purportedly to construct a cancer treatment center. The SEC alleged that the couple diverted nearly $20 million of the raised funds to unapproved expenses, and persuaded the district court to order the couple to disgorge nearly the entire amount raised. The Ninth Circuit affirmed.
In reversing and remanding, the Supreme Court noted two principles of equitable relief: (1) it is meant to strip the defendant of its ill-gotten gains and (2) it is restricted to net profits, which should go to the victims of the defendant’s conduct. The Court found that disgorgement in SEC enforcement actions embodies these principles, as long as it remains properly limited. Therefore, the Court remanded the case to the Ninth Circuit to consider whether to return funds to victims, impose joint-and-several liability, and deduct business expenses — legal, accounting and administrative costs outlined in the investment prospectus — from the disgorgement award.
The Court expressly did not address circumstances where it is infeasible to distribute disgorged funds to investors. And the Court noted that the SEC’s practice of pursuing joint-and-several liability against defendants for disgorgement could, except under certain circumstances, transform what would otherwise be equitable relief into a penalty. These elements of the Court’s decision may result in a renewed focus by the SEC on obtaining civil money penalties in enforcement actions where distribution of collected funds to investors through a fair fund or otherwise may be impractical, or ill-gotten gains do not flow to certain participants in a fraudulent scheme — for example, a tipper in an insider trading case.
Justice Sonia Sotomayor, who wrote the opinion in Kokesh for a unanimous court, also wrote the opinion in Liu, though with one dissent. Justice Clarence Thomas argued that disgorgement is not a traditional equitable remedy and noted the open questions that remain on remand: (1) Should the entire disgorged amount be returned to victims? (2) Should the defendants be subjected to joint-and-several liability? (3) Should legitimate business expenses be deducted from the disgorgement amount? Thomas also observed that the Court’s holding could lead to “disgorgement” taking on a different meaning in court-based enforcement actions versus the SEC’s internal administrative proceedings.
The Court admitted that if not carefully limited, disgorgement awards ordered by courts in SEC enforcement actions could be in “considerable tension” with traditional equity practices such as accountings, constructive trusts and equitable liens. Indeed, the Court’s focus on returning net profits to victims is arguably in tension with its reasoning in Kokesh, where it stressed that disgorgement, as a deterrent penalty, is not meant to be compensatory. In addition, the Court left unclear under what circumstances, if any, portions of disgorgement awards obtained by the SEC can be sent to the Treasury or even returned to defendants in cases where, for example, a fair fund is created but the SEC cannot substantiate sufficient investor claims to exhaust the fund.
We will track the case as it proceeds on remand. If you have any questions regarding the matters covered in this alert, please contact Jack Yoskowitz, Philip Moustakis, or your primary attorney in Seward & Kissel’s Capital Markets, Investment Management, or Litigation Groups.