Supreme Court Upholds SEC Disgorgement Powers, With Limitations
Securities Litigation Update
Date: June 24, 2020
On June 22, 2020, the U.S. Supreme Court issued its decision in Liu v. Securities and Exchange Commission, in which it upheld, 8-1, the authority of the Securities and Exchange Commission to seek disgorgement in civil enforcement actions as long as the disgorged amount does not exceed “a wrongdoer’s net profits and is awarded for victims.”
By upholding the SEC’s disgorgement power, the decision marks a retreat from a recent trend of decisions curtailing the SEC’s enforcement tools. At the same time, the decision limits this power, providing defendants a meaningful shield to reduce their liability.
The petitioners’ challenge in Liu stemmed from the Supreme Court’s 2017 decision in Kokesh v. Securities and Exchange Commission, which held that SEC disgorgement constitutes a “penalty” for statute of limitations purposes. The Court, however, declined to address the more fundamental question of whether the SEC possesses authority to seek disgorgement as “equitable relief,” which typically excludes penalties. Liu picked up where Kokesh left off, placing this question squarely before the Court.
The Court’s Decision
In Liu, the Court refused to strip the SEC of its disgorgement power and instead ruled that, under certain conditions, disgorgement constitutes an equitable remedy. Specifically, in order to qualify as an “equitable” remedy, the disgorgement must be limited to the wrongdoer’s net profits and must be awarded for the benefit of victims. The Court held that disgorgement can cross the line from equity to penalty if (1) it fails to return funds to victims, (2) it imposes joint-and-several liability, or (3) it declines to deduct legitimate business expenses from the award.
The Court did not provide clear guidance as to what constitutes a “legitimate expense” to be deducted from a wrongdoer’s gross profits. It did, however, suggest that payments made by the Liu defendants for leases and for certain equipment could be considered legitimate expenses. The Court also recognized a potential exception to the requirement to deduct legitimate business expenses where the “entire profit of a business or undertaking” is the result of wrongdoing.
Further, though the Court cited the statutory requirement that equitable relief be “appropriate and necessary for the benefit of investors,” it left open the question of how this requirement applies where it is impractical or impossible to distribute the disgorged funds to investors. In the past, the SEC has allowed disgorgement in these circumstances to be deposited with the U.S. Department of the Treasury in order to fund the whistleblower program. The Court observed that the statute did not answer whether this practice was “for the benefit of investors,” but implicitly took exception to it given that the new disgorgement test requires funds to be awarded to victims.
The Implications of Liu
While Liu overwhelmingly affirms the SEC’s disgorgement power, it also provides an important tool for future defendants, who may significantly reduce their exposure in civil enforcement or administrative proceedings through the deduction of legitimate expenses. How powerful this tool is remains to be seen as it will largely depend on future decisions delineating what constitutes a “legitimate expense.”
Parties facing potential civil disgorgement may be well advised to quickly assess the evidence for, and the extent of, their legitimate expenses. As SEC actions often settle to include disgorgement, knowing the amount of legitimate expenses may be important in assessing potential exposure, litigation risk, and negotiation strength.
Liu also has implications for victims, who, in light of the requirement that disgorged funds be returned to them, may be more encouraged to come forward. Indeed, the ruling may make cooperation with the SEC a more efficient means of (partial) recovery than a civil action. The SEC may be similarly incentivized to proactively identify victims. For example, a critical mass of known victims may afford the SEC significant leverage in demonstrating proper disgorgement.
Finally, Liu raises interesting questions about whether its limitation on SEC civil enforcement disgorgement might be raised in other contexts, such as insider trading cases where tippers may object to disgorging tippee profits or cases involving Foreign Corrupt Practices Act violations.
Although Liu unequivocally upheld the SEC’s power to pursue disgorgement as an equitable remedy, it also imposed meaningful limitations on disgorgement that will allow defendants to argue for reduced liability and should incentivize investor victims to become more proactive in cooperating with the SEC.
FOR MORE INFORMATION
For more information, please contact:
Marc B. Minor
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