June 25, 2020
Earlier this week, in Liu v. SEC, the Supreme Court laid to rest significant uncertainty over the Securities and Exchange Commission’s (“SEC”) ability to seek equitable disgorgement in civil enforcement actions, a remedy it had routinely sought in connection with federal securities fraud laws and Foreign Corrupt Practices Act matters. Liu v. SEC, 591 U.S. ____ (2020). Although the availability of such a remedy in SEC enforcement actions had long been presumed and permitted, the Court’s 2017 decision in Kokesh v. SEC threatened to upset that precedent. In Kokesh, the Court ruled that the SEC’s disgorgement practices function as a “penalty” for the purpose of determining the applicable statute of limitations, unexpectedly leaving open the question of whether courts had authority to order disgorgement in SEC enforcement actions, a question it resolved yesterday in favor of the SEC. Kokesh v. SEC, 137 S. Ct. 1635 (2017); Liu v. SEC, 591 U.S. ____ (2020). In Liu, the Court held that the SEC’s statutory authority to seek “equitable relief” under 15 U. S. C. § 78u(d)(5) permits the SEC to pursue court-ordered disgorgement in civil enforcement actions. Nevertheless, the Court set forth some restrictions on the practice, holding that because disgorgement must be limited to equitable relief, a court’s imposition of disgorgement may not exceed the wrongdoer’s net profits, must be awarded for the victim’s benefit, and can be offset by deductions for legitimate expenses. Liu v. SEC, 591 U.S. ____ (2020).
In so holding, the Court relied on two principles derived from equity jurisprudence. First, judicially-imposed equitable remedies have long been used to strip wrongdoers of their net profits from unlawful activity. Second, to prevent the remedy of disgorgement from functioning punitively, and thus acting outside of equitable powers, courts have restricted disgorgement to “an individual wrongdoer’s net profits to be awarded for victims.” Id.
Significantly, the Court identified three limitations on the ability of federal courts to award disgorgement in SEC civil enforcement actions. First, courts must evaluate whether the destination of the funds collected from disgorgement is consistent with the requirement in Section 78u(d)(5) that equitable relief is “appropriate and necessary for the benefit of investors.” While the Court noted that the equitable nature of the remedy generally requires that the defendant’s gains be returned to wronged investors in order to “benefit” them, the Court also pointed out that the statute provides limited guidance as to whether the practice of depositing proceeds with the Treasury, a routine practice when it is not feasible to disburse the proceeds back to investors directly, satisfies the command to benefit investors. The Court, however, declined to answer that question in the instant case because the parties did not identify such an order. Id.
Second, courts must consider whether ordering disgorgement for benefits that accrue to “affiliates” through joint-and-several liability would be consistent with equitable principles, which the Court stated would be appropriate if the parties are “partners in wrongdoing,” otherwise, individual liability is the general rule. Id.
Lastly, courts must deduct legitimate business expenses before ordering disgorgement. Id. In Monday’s ruling, the Supreme Court remanded the case to the Ninth Circuit to determine whether the SEC’s disgorgement award against the Lius conformed to these limitations.
While this ruling provides needed certainty and settles lingering questions surrounding the authority of courts to award disgorgement in SEC civil enforcement actions, it may also significantly circumscribe the SEC’s current approach to disgorgement. Deducting legitimate business expenses could, in some corporate cases, significantly reduce the disgorgement award. In the wake of the Court’s decision, we anticipate that the SEC will develop and publish guidelines addressing how the agency will calculate net profits for disgorgement purposes going forward, identifying the expenses it will credit as legitimate business expenses, and perhaps addressing factors weighing on the feasibility of returning proceeds to investors. Companies facing SEC enforcement actions will need to be prepared to address these issues. We will continue to monitor how the SEC – and the courts – address the limits on disgorgement in future cases.