Earlier this week, a near-unanimous[1] United States Supreme Court issued its much anticipated ruling on the SEC’s ability to obtain disgorgement of ill-gotten gains in cases involving securities fraud, FCPA violations, and other securities violations.[2] Justice Sotomayor, writing for the majority, confirmed in Liu v. SEC[3] that the SEC has the authority to obtain such relief. The SEC’s authority to obtain disgorgement had seldom been questioned until the Supreme Court itself raised the issue in a footnote in its landmark Kokesh v. SEC decision in 2017.[4]
In Kokesh, the Court held that disgorgement of ill-gotten gains was punitive in nature and therefore subject to the five-year statute of limitations for “penalties, fines and forfeitures” in 28 U.S.C. § 2642. If disgorgement is punitive, how can it constitute an equitable remedy designed to restore the status quo? That was the essential question presented in Liu.
The Court in Liu held that a disgorgement award that does not exceed a wrongdoer’s net profits and is awarded for victims constitutes equitable relief permissible under 15 U.S.C. § 78u(d)(5). In reaching this conclusion, the Court framed the question as whether disgorgement is a remedy “typically available in equity.”
The Court noted that courts of equity “have long authorized courts to strip wrongdoers of their ill-gotten gains.” To avoid moving the deprivation of ill-gotten gains outside equitable relief and into the category of a penalty, “courts restricted it to an individual wrongdoer’s net profits to be awarded for victims.”
The Court noted that disgorgement is a relatively recent term for this remedy. It has also been described as a form of restitution or an accounting.[5] But whatever its name, the Court reasoned, this remedy has long been recognized as a one “typically available in equity.” (A rose by any other name would smell as sweet.).
In dicta, the Court recognized three historical limitations on disgorgement. First, the so-called “profits remedy” resulted in the imposition of “a constructive trust on wrongful gains for wronged victims.” The remedy was a mechanism to return the defendant’s wrongful gains to those harmed by the defendant’s malfeasance. The SEC frequently sends disgorgement funds to the U.S. Department of Treasury. Liu will certainly complicate efforts by the SEC to send funds to Treasury, rather than to the victims of wrongdoing.
In addition, some cases do not lend themselves to victim compensation. For instance, it is sometimes difficult if not impossible to identify the victims of insider trading. Assuming the victims are the parties on the opposite sides of the transactions, they may be unidentifiable, especially if the insider trading involves options transactions. Does this mean that disgorgement will be unavailable in insider-trading actions? Or that inability to identify victims will be a valid reason to pay disgorgement funds to the Treasury?
Second, the Supreme Court took aim at the courts’ use of joint-and-several liability, suggesting that it should be employed sparingly. The traditional equitable rule has been that individual, not joint-and-several, liability should be imposed for individual wrongdoing. The rationale for this is that the remedy is rooted in the defendant’s profits, and therefore has generally been limited to the profits obtained by each individual defendant; the remedy would not ordinarily support relief “against multiple wrongdoers under a joint-and-several liability theory.” But, the Court noted, if “partners” are “engaged in concerted wrongdoing,” it might be appropriate to impose joint-and-several liability.
Third, in focusing on “net” rather than “gross” profits, the Court noted that “legitimate deductions” for business expenses are permitted. Consider an oil-and-gas business that functioned as a genuine business enterprise, but also defrauded investors. Expenses such as oil-and-gas equipment, drilling, and leases might well qualify as legitimate deductions.
On the other hand, when the “entire profit of a business or undertaking” results from the wrongdoing, a defendant may be denied “inequitable deductions.” Consider a company that sells securities for the purpose of investing in a discrete business purpose, but spends no money on the stated business purpose. Instead, it uses investor proceeds to fund a lavish lifestyle, such as sports cars, fine dining, and other expenditures wholly unrelated to the stated business purpose. Those expenses might be considered “inequitable,” illegitimate items that could not be deducted from the disgorgement calculation.
In sum, the Supreme Court in Liu affirmed the SEC’s long-standing authority to obtain disgorgement. But instead of creating a bright-line rule, the majority’s opinion left open important questions about situations when disgorgement can be used to compensate a third-party government agency and not the victims of the wrongdoing, the circumstances under which joint-and-several liability may be imposed, and what expenses may be deducted from disgorgement. These issues will likely be the focus of considerable litigation for years to come. The Liu decision, however, will undoubtedly make it more difficult for the SEC to send disgorgement funds to the Treasury, rather than as compensation for victims.
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[1] Justice Thomas was the lone dissenter in the 8-1 ruling because, he said, disgorgement is not a “traditional equitable remedy.”
[2] Disgorgement would be in addition to other remedies available to the SEC, such as injunctive relief, civil money penalties, officer-and-director bars, other industry and associational bars, and the like.
[3] 591 U.S. ___ (2020) (slip op.).
[4] 581 U.S. ___, 137 S. Ct. 1635, at 1642, n. 3 (2017) (slip op., at 5, n. 3).
[5] Disgorgement can indeed be considered a restitutionary remedy. It is a form of restitution aimed at depriving wrongdoers of ill-gotten gains and is based on an unjust-enrichment theory. But it is fundamentally different from the form of restitution that is ordered in criminal cases. In the criminal context, restitution is typically calculated by reference to the loss to victims, as opposed to the amount of ill-gotten gains. These two distinct concepts — ill-gotten gains and loss caused by wrongdoing — may or may not be the same amount.
