It is a classic situation: the Securities and Exchange Commission brings an action in federal court against an alleged fraudster, the SEC prevails at summary judgment or trial, and the court orders the defendant to disgorge the ill-gotten gains. But this familiar scenario may become extinct if the U.S. Supreme Court decides that disgorgement lacks any statutory basis and is not a valid form of equitable relief in SEC enforcement proceedings for violations of the federal securities laws. In that event, the SEC will, barring congressional action, lose its principal means of depriving wrongdoers of illicit profits.
This surprising possibility arose when the Supreme Court on Nov. 1 agreed to hear argument in Liu v. SEC, 18-1501, on appeal from a decision by the 9th U.S. Circuit Court of Appeals. A decision in Liu is expected by the current term's end in June. But the origin story dates to the Supreme Court's decision in Kokesh v. SEC, 137 S. Ct. 1635 (2017), holding that disgorgement in SEC enforcement actions is punitive and therefore subject to the federal five-year statute of limitations set forth in 28 U.S.C. Section 2462, which covers "any action, suit or proceeding for the enforcement of any civil fine, penalty or forfeiture, pecuniary or otherwise."
The Kokesh Decision
There is no express statutory authority for disgorgement in SEC actions. But for nearly 50 years, since SEC v. Texas Gulf Sulphur Co., 401 F.2d 833 (2d Cir. 1968), the lower federal courts had held that the ability to order disgorgement of ill-gotten gains was inherent equitable relief ancillary to the SEC's statutory authority to seek injunctive relief under Section 21(d)(1) of the Securities Exchange Act of 1934 and Section 20(b) of the Securities Act of 1933. Section 21(d)(5) of the Exchange Act also permits the SEC to seek and the federal courts to grant any form of equitable relief that may be appropriate or necessary for the benefit of investors.
In what was considered an outlier, the 11th Circuit, in SEC v. Graham, 823 F.3d 1357 (11th Cir. 2016), held that disgorgement was a form of forfeiture and therefore subject to Section 2462. Shortly thereafter, the 10th Circuit hued to the traditional view in SEC v. Kokesh,834 F.3d 1158 (10th Circuit 2016), holding that disgorgement was an equitable remedy that was not a forfeiture or penalty. Charles Kokesh was an investment adviser who was found by a jury to have misappropriated $34.9 million from two business-development companies that he advised. Both Kokesh and the SEC appealed to the Supreme Court.
Any expectation by the SEC that the court would ratify the historic view of disgorgement as an equitable remedy was dashed in oral argument, when the justices expressed substantial hostility to SEC disgorgement actions. Several justices suggested that there was no statutory authority for any disgorgement; others remarked that disgorgement was valid only if it compensated fraud victims, but not for payment to the government.
Justice Sonia Sotomayor, writing for a unanimous court, noted that initially the only statutory remedy available to the SEC was to seek an injunction to prevent future violations of the securities laws. But in 1990, Congress enacted the Securities Enforcement Remedies and Penny Stock Reform Act which left the SEC with a "full panoply of enforcement tools." Nonetheless, the SEC continued seeking disgorgement in enforcement proceedings.
The court observed that disgorgement is imposed as a consequence of violating "public laws," which meant that the SEC sought disgorgement in the public interest rather than on behalf of aggrieved parties. Second, disgorgement is imposed for punitive purposes. Even the Texas Gulf court emphasized the need for disgorgement to provide an effective deterrent against future violations. But now "it has become clear that deterrence is not simply an incidental effect of disgorgement" and courts consistently hold that a primary purpose of disgorgement is to deter violations of the securities laws. However, "[s]anctions imposed for the purpose of deterring violations of public laws are inherently punitive" because deterrence is not a legitimate nonpunitive governmental objective. Echoing statements at oral argument, the court noted that disgorgement was not always compensatory; disgorged profits may be paid to the district courts, which have discretion to determine to whom and how the funds are distributed. While some disgorged funds may be paid to victims, other funds may be dispersed to the U.S. Treasury, and an order directing an individual to pay a noncompensatory sanction to the government operates as a penalty.
The court rejected the SEC's argument that disgorgement was merely remedial because it sought to restore the status quo. SEC disgorgement sometimes exceeded the amount obtained by the wrongful conduct, such as when someone who provided confidential nonpublic information was required to disgorge the profits obtained by those who illegally traded on the information. Disgorgement orders often did not consider the defendant's expenses that reduced the amount of illegal profit. Courts justified orders that left the defendant worse off as necessary to deter future violations, i.e., punitive. For all these reasons, the court held, SEC disgorgement "bears all the hallmarks of a penalty" and was subject to the five-year statute of limitations. (As a result of the decision, Mr. Kokesh was able to retain $29.9 million in misappropriated funds that resulted from violations outside the limitations period. The SEC estimates that in 2018 it had to forego disgorgement of nearly $1 billion.)
Virtually inviting a challenge to disgorgement, the court stated in a footnote that nothing in its decision "should be interpreted as an opinion on whether courts have the authority to order disgorgement in SEC enforcement proceedings or whether the courts have properly applied disgorgement principles in this context," given that the sole question before the court was whether SEC disgorgement was subject to Section 2462. And so came the Liu case.
Liu v. SEC
The SEC alleged that Charles Liu and his wife, Xin Wang, raised nearly $27 million from Chinese investors in an EB-5 Immigrant Investor Program, which enables foreigners to obtain legal residence in the U.S. by investing in job-producing projects, particularly in high unemployment areas. According to the SEC, rather than using the investment proceeds to construct and operate a cancer treatment center in Montebello, California, as defendants had represented, nearly $13 million was used to pay marketing firms to find more investors and $8.2 million was diverted to the defendants themselves. The cancer therapy center was never built, which meant that investors lost both any opportunity for a profit and their eligibility for legal U.S. residence. The district court granted the SEC's motion for summary judgment, finding that defendants violated Section 17(a) (2) of the Securities Act, and ordered defendants to disgorge nearly the full amount raised, pay civil monetary penalties, and be enjoined from future violations of the securities laws.
On appeal, defendants, citing Kokesh, argued that the district court lacked the power to order the required disgorgement. The 9th Circuit, noting that Kokesh expressly declined to reach that issue and citing longstanding precedent, affirmed the district court's disgorgement order. The 9th Circuit also agreed with the district court's refusal to permit defendants an offset for purportedly $16 million in "legitimate" business expenses, stating that it would be unjust to allow defendants to deduct expenses that were incurred in operating the fraudulent scheme. SEC v. Liu, 754 Fed.Appx. 505 (9th Cir. 2018).
The defendants in May filed a petition for a writ of certiorari with the Supreme Court seeking review of whether the SEC may seek and obtain disgorgement from a court as "equitable relief." Petitioners argued that while Congress expressly had granted the SEC authority to seek injunctions, civil monetary penalties and equitable relief, there was no authority for the SEC to seek disgorgement, which Kokesh had declared to be a penalty. Further, petitioners asserted that the disgorgement order was afflicted with the flaws that Kokesh identified: Petitioners had been left "worse off" by not being able to deduct $16 million in expenses while being subject to $8 million in penalties in addition to $26.7 million in disgorgement; and the order did not require the disgorgement to be paid to the defrauded investors but allowed payment to the government. The SEC argued in response that Kokesh held that disgorgement was punitive only for purposes of the statute of limitations and that there was substantial and longstanding authority that disgorgement of improper profits was a valid equitable remedy -- including post-Kokesh decisions by the lower federal courts -- confirmed by congressional action that assumed the availability of disgorgement as a remedy in SEC enforcement proceedings.
The Supreme Court's decision to grant the petition was telling. The 9th Circuit's decision was not for published. Each circuit court to consider the issue had held that the SEC had the authority to seek disgorgement (although the 11th Circuit in Graham ruled that disgorgement was a penalty for purposes of Section 2462). The government initially thought so little of the petition that it waived its right to respond until requested by the court. The court appears committed to deciding expeditiously the issue reserved in Kokesh -- the authority and/or limits of the SEC to obtain disgorgement of ill-gotten gains in enforcement proceedings.
Potential Consequences of the Liu Decision
The aftermath of the Supreme Court's Liu decision will depend on the reach of court's action. A decision striking completely the SEC's power to seek disgorgement would torch much of the SEC's enforcement program. In 2018 the SEC obtained orders imposing $2.51 billion in disgorgement. While the SEC may still seek civil monetary penalties, they are limited in amount by statute and rule. In 2018, the SEC obtained orders imposing $1.44 billion in penalties, only slightly more than one-half of the amount of the ordered disgorgement. Of course, the SEC's enforcement agenda might seem pointless if miscreants were permitted to keep their illicit profits while their victims remained uncompensated. Eliminating the threat of disgorgement also would remove a major bargaining chip for the SEC in settlement discussions. The ability of other regulatory agencies to seek disgorgement remedies could be imperiled.
The court could take a middle path that falls short of a complete death blow for disgorgement. For instance, the court could limit disgorgement only to compensating victims and forbid payment to anyone else, such as the SEC or the U.S. Treasury. But that approach too is fraught with problems. First, it would affect disgorgement for violations in which there are no truly defrauded victims, such as actions for violations of the Foreign Corrupt Practices Act. The SEC hardly will demand that a company that paid overseas bribes to obtain or retain business return its wrongfully obtained profits to the bribe-taking foreign officials. Second, it may also be impracticable in some circumstances to compensate victims where they are numerous or difficult to identify or locate, such as in Liu itself, where there could be obstacles in locating and/or returning funds to the Chinese investors.
The court may also prohibit disgorgement orders that leave the defendant "worse off" than prior to the wrongful conduct. Thus the court could require disgorgement to be offset by any "legitimate" business expenses such as sought in Liu. Disgorgement conceivably could be offset by taxes paid on illegal profits; brokerage commissions for insider or manipulative stock trading; or trading losses that were incurred in a fraudulent scheme. The court could prohibit the situation described in Kokesh, in which those who provide material nonpublic information may be held liable for the trading profits of others. Such a decision could also affect court orders that attempt to approximate the amount of illegal profits where precision is difficult.
The SEC's Options in the Event of an Adverse Ruling
First, Congress could expressly authorize disgorgement in SEC proceedings. Indeed, the House Financial Services Committee has approved a bipartisan bill that would codify the SEC's authority to seek and federal courts to grant disgorgement of unjust enrichment and extend the statute of limitations for disgorgement, injunctions and officer and director bars to 14 years. But no vote by the full House is scheduled and no companion bill is pending in the Senate, although bills to extend the statute of limitations have been introduced. Congress could also increase the amount of civil monetary penalties, which under the Sarbanes-Oxley Act may added to a disgorgement or other fund for the benefit of fraud victims (although there would be the tricky issue of whether penalties could be contributed to a disgorgement fund if there is no more disgorgement). But in an extremely polarized and paralyzed Congress and in the face of industry opposition, there is no certainty that any legislation will pass in the foreseeable future.
Second, the SEC already possesses statutory authority for disgorgement in in-house administrative proceedings. But the Supreme Court in Lucia v. SEC, 138 S. Ct. 2044 (2018), held that the administrative law judges had been appointed in an unconstitutional manner. The SEC subsequently changed the appointment process, but new lawsuits contend that the appointments still fail to pass constitutional muster. Further, the defense bar has long contended that administrative proceedings are inappropriate forums for complex securities actions, given that there is no right to a jury trial; the extensive discovery allowed in federal court is not available; and there is a compressed time period for the hearing, which provides the SEC's Division of Enforcement that conducted the private investigation with an unfair advantage. The SEC in 2016 modified the rules governing administrative proceedings to allow for some limited discovery and greater time before hearings, but these changes failed to quench the criticism of defense attorneys. Nonetheless, the SEC likely will resort to bringing more actions as administrative proceedings in the event of an unfavorable outcome in Liu. The SEC could also take the hint in Kokesh and promulgate regulations permitting disgorgement or other enforcement devices under the Remedies Act of 1990.
The Liu decision may also clarify whether nonmonetary sanctions should be considered penalties. In the Matter of John M. E. Saad, (Rel. No. 86751 Aug. 23, 2019), the SEC held that Kokesh did not apply to nonmonetary sanctions and therefore was no impediment to the authority of FINRA -- the self-regulator of the securities industry -- to bar a person from associating with FINRA member firms. The U.S. Court of Appeals for the D.C. Circuit previously held that FINRA sanctions may only be remedial and not punitive. (When the D.C. Circuit in 2017 remanded Saad to the SEC for further consideration, then Judge and now Justice Brett Kavanaugh wrote that industry bars were punitive sanctions under Kokesh because they were not intended to compensate victims). Subsequently, SEC v. Gentile, 939 F.3d 549 (3rd Cir. 2019), held that a "properly framed and issued" nonpecuniary obey-the-law injunction and a bar on participating in the penny stock industry were not subject to the federal statute of limitations if the SEC demonstrated a meaningful threat of future harm, because the sanctions would be remedial and not punitive. However, various commentators have stated that Kokesh indisputably applies to industry and director and officer bars.