Three years ago, in a footnote to its unanimous opinion in Kokesh v. S.E.C., the Supreme Court left open two questions: “whether courts possess authority to order disgorgement in SEC enforcement proceedings” and “whether courts have properly applied disgorgement principles in this context.”[1] On June 22, the Court in Liu v. S.E.C.[2] answered the first question with a simple “yes,” but, as to the second, significantly limited the authority of a court to grant the remedy.
In extended commentary, the Supreme Court stated that courts generally may not grant disgorgement:
(1) when the proceeds are not remitted to investors, though it left open for the future any possible exception when it would not be feasible to identify the investors who had been harmed;
(2) when one defendant is made to disgorge profits that were received by someone else, with possible exceptions for certain relationships such as business partners or married couples; or
(3) when the amount of disgorgement fails to deduct legitimate business expenses, except where the business as a whole constitutes a fraudulent scheme.
Statutory Background
There is no provision in the federal securities laws explicitly authorizing courts to order “disgorgement” in SEC enforcement proceedings. Initially, the securities laws did not contain provisions for any kind of monetary remedies; the only statutory remedies available to the SEC were injunctions barring future violations. In the 1960s and ’70s, however, the SEC’s Enforcement Division began to argue that courts could order defendants to give back their illicit profits under their inherent equitable powers. This theory was accepted for the first time in SEC v. Texas Gulf Sulphur Co.[3] (a case well known for recognizing that insider trading constitutes a violation of the federal securities laws). After Texas Gulf, courts widely embraced disgorgement as a remedy.
As one former assistant director of the Enforcement Division has written, “the temptation for the SEC to request and the courts to grant disgorgement” during this period of time “was understandable, lest securities law violators appear to avoid punishment by suffering a mere injunction against future wrongdoing without any accompanying monetary sanctions.”[4] However, Congress later amended the securities laws to explicitly permit civil penalties for insider trading in 1984 and for other securities violations in 1990. Congress also explicitly authorized the SEC to seek “disgorgement” in administrative and cease-and-desist proceedings.
More recently, as part of the Sarbanes-Oxley Act, Congress authorized courts in 11 U.S.C. § 78u(d)(5) to award “equitable relief” in civil enforcement actions, but Congress did not clarify whether disgorgement, as sought by the SEC, was a form of “equitable relief.” This question has arguably been complicated by the lack of a clear historical practice of describing any form of equitable relief as “disgorgement.” The term was not widely used prior to its application in the SEC enforcement context. As one court noted in 1974, “The word ‘disgorgement’ appears to be a term of modern vintage utilized in connection with [SEC] suits seeking to deprive the defendants of the gains from their wrongful conduct . . . .”[5]
The Facts in Liu
Petitioner Charles C. Liu operated a regional center under the EB-5 Immigrant Investor Program, the stated purpose of which was to develop and operate a cancer treatment center. The project raised $27 million from at least 50 investors, consisting of $24.7 million in capital contributions and $2.3 million in administrative fees. The project’s offering documents stated that all capital contributions would be used to develop the cancer treatment center, while marketing expenses would be drawn solely from administrative fees. However, according to the SEC, Liu paid nearly $13 million to overseas marketers, exceeding the total amount of administrative fees paid by investors. In addition, the SEC alleged that Liu paid himself approximately $6.7 million, purportedly as “salary,” and his wife, petitioner Xin Wang a/k/a Lisa Wang, $1.4 million. At the end of the day, no significant construction on the cancer treatment center took place and petitioners “burned” through nearly the entire investment.
On the SEC’s motion for summary judgment, the district court held Liu and Wang liable under Section 17(a)(2) of the Securities Act of 1933. Among other remedies, the court ordered Liu and Wang, jointly and severally, to disgorge an amount equivalent to nearly the entire $27 million raised from investors. Petitioners argued that the court should disgorge only net profits and was therefore required to deduct nearly $16 million in “legitimate business expenses.” The court, however, declined to afford petitioners any deductions, reasoning that “‘[i]t would be unjust to permit the defendants to offset against the investor dollars they received the expenses of running the very business they created to defraud those investors . . . .’”
After the district court’s decision in Liu, the Supreme Court decided Kokesh, in which it held that SEC disgorgement was a “penalty” within the meaning of 28 U.S.C. § 2462, the federal statute of limitations. Thereafter, on appeal to the Ninth Circuit in Liu, petitioners argued that Kokesh undermined the SEC’s authority to seek disgorgement, on the theory that a penalty cannot be equitable. The Court of Appeals rejected this argument and affirmed the disgorgement order.
The Supreme Court’s Decision
On Nov. 1, 2019, the Supreme Court granted certiorari on the following question: “Whether the Securities and Exchange Commission may seek and obtain disgorgement from a court as ‘equitable relief’ for a securities law violation even though this Court has determined that such disgorgement is a penalty.”
By an 8-1 majority (with Justice Thomas dissenting), the Court answered this question in the affirmative. Disgorgement was a form of “equitable relief,” the Court held, and therefore could be ordered by a court in SEC enforcement proceedings, because “depriv[ing] wrongdoers of their net profits … has been a mainstay of equity courts” under the rubric of “restitution” or “accounting.”[6] The Court declined to read its earlier Kokesh decision to foreclose disgorgement as equitable relief.
The Court then addressed petitioners’ fallback argument: Even if SEC disgorgement is not per se unlawful, the particular order entered by the district court “crosses the bounds of traditional equity practice in three ways: [1] It fails to return funds to victims, [2] it imposes joint-and-several liability, and [3] it declines to deduct business expenses from the award.”[7] Rather than rule on the merits of these arguments, the Court remanded to the Ninth Circuit to address them in the first instance. At the same time, to “guide the lower courts’ assessment of these arguments on remand,” the Supreme Court discussed general principles that will significantly limit SEC disgorgement moving forward.[8]
1. SEC disgorgement should compensate victims where feasible. SEC disgorgement does not always result in a return of funds to injured investors; the funds may instead be deposited into the Treasury. Under the Dodd-Frank Act, disgorgement proceeds that are not distributed to victims may be used to pay whistleblowers reporting securities fraud or to fund the activities of the inspector general.
The funds that the district court ordered to be disgorged in Liu had not yet been collected, and it was unclear whether they would be deposited into the Treasury or distributed to investors after collection. Thus, the Court did not wade into whether the particular disgorgement order before it improperly failed to compensate victims. Nevertheless, the Court questioned whether it was lawful to deposit disgorged funds into the Treasury, stating that “[t]he equitable nature” of disgorgement “generally requires the SEC to return a defendant’s gains to the wronged investors for their benefit.”[9] This conclusion was based on a...
