On June 22, 2020, in Liu v. SEC, the Supreme Court held in an 8-1 decision that the SEC is authorized under 15 U.S.C. § 78u(d)(5) (2015) to seek disgorgement as “equitable relief” in district court actions, as long as the disgorgement award “does not exceed a wrongdoer’s net profits and is awarded for victims.”[i] In reaching this decision, the Court upheld a key piece of the SEC’s enforcement arsenal, while at the same time restricting the SEC’s ability to obtain disgorgement and raising a number of open questions, including the impact of Liu on the Court’s 2017 decision in Kokesh v. SEC,[ii] that will need to be sorted out by lower courts.
This article discusses the holding in Liu and a number of these outstanding questions, including the following:
- How will the principles discussed in Liu impact the SEC’s ability to obtain disgorgement? In particular, will the SEC be able to transfer disgorged funds to the Treasury rather than returning them to victims, how will Fair Funds be affected, and will the SEC ever be able to obtain disgorgement on a joint-and-several basis?
- Will the manner in which disgorgement is calculated change going forward and will previously disallowed expenses now be permitted?
- Will some types of cases be affected more than others?
- If a disgorgement award qualifies as equitable relief under Liu, does that mean it is not a “penalty” for purposes of the five-year statute of limitations in 28 U.S.C. § 2462?
- Will defendants be able to obtain indemnification, insurance coverage, or tax deductions for disgorgement if it is deemed to be equitable relief, rather than a penalty?
- Will the SEC still be able to obtain disgorgement from relief defendants?
- How, if at all, will the decision affect the calculation and award of disgorgement in administrative proceedings?
- Will defendants be able to challenge previously-entered disgorgement awards that do not comply with Liu?
BACKGROUND ON LIU V. SEC
In Kokesh, the Court held that an SEC disgorgement order in a district court action was a “penalty” for purposes of 28 U.S.C. § 2462, and thus subject to the five-year statute of limitations. In footnote 3 of that opinion, the Court expressly declined to address whether courts had disgorgement authority in SEC enforcement proceedings or whether disgorgement was properly applied.[iii] As we have discussed in prior alerts, footnote 3 served as an invitation to challenge the SEC’s disgorgement authority, and it was only a matter of time until the Court had to address the issue.[iv]
Enter, Charles Liu and Xin Wang (“Petitioners”), participants in the EB-5 United States Immigrant Investor Program, which allows foreigners to seek visas by participating in commercial enterprises. Through a “regional center” that aggregated qualifying investments as securities, Petitioners collected almost $25 million in capital contributions, much of which they allegedly misappropriated by diverting funds to overseas marketing firms and paying themselves nearly $7 million in salaries.[v] The SEC filed suit and moved for summary judgment, which the district court granted on April 20, 2017, holding that Petitioners violated Section 17(a)(2) of the Securities Act.[vi] The court issued a permanent injunction barring Liu and Wang from participating in the Immigrant Investor Program, ordered Liu and Wang to pay civil penalties in the amount of their personal gains, and ordered disgorgement of $26,733,018.81. The SEC argued that disgorgement should equal the full amount that Liu and Wang raised from their investors, because this was the “reasonable approximation of profits causally connected to the violation” and Petitioners’ “expenses” were not “actual and legitimate” costs but rather payments to themselves or efforts to disguise the fraud.[vii]
The Supreme Court decided Kokesh shortly after the district court entered final judgment. On appeal, Liu and Wang argued that under Kokesh, disgorgement is a form of penalty, and thus the district court lacked statutory authority to award it under the “guise” of equitable relief.[viii] A panel of Ninth Circuit judges affirmed the district court, holding that because the Supreme Court had expressly reserved the question of the SEC’s statutory authority to seek disgorgement, the district court’s disgorgement award was not “clearly irreconcilable” with “longstanding precedent.”[ix]
Liu and Wang filed a cert petition, which the Court granted on November 1, 2019.
THE COURT’S DECISION
The Court’s opinion framed the issue presented in Liu as whether the SEC was authorized under 15 U.S.C. § 78u(d)(5) to seek disgorgement “beyond a defendant’s net profits from wrongdoing.”[x] It referred to the task of determining if a particular remedy falls within “equitable relief” as a “familiar one” that involved analyzing two equity principles. First, that “equity practice long authorized courts to strip wrongdoers of their ill-gotten gains,” and second, “to avoid transforming an equitable remedy into a punitive sanction, courts restricted the remedy to an individual wrongdoer’s net profits to be awarded for victims.”[xi]
The opinion then described a history of equity courts depriving wrongdoers of net profits from unlawful activity, “even though that remedy may have gone by different names.” The Court concluded that “[n]o matter the label” these cases reflected a “foundational principle” that it would be “inequitable that [a wrongdoer] should make a profit out of his own wrong,” while also recognizing the “countervailing equitable principle” that a wrongdoer should not be “punished by paying more than a fair compensation to the person wronged.”[xii] It also noted that the Court’s prior decisions confirmed that a “remedy tethered to a wrongdoer’s net unlawful profits, whatever the name, has been a mainstay of equity courts.”[xiii]
The Court discussed several limits courts have imposed on profits remedies to ensure they were not transformed into penalties and focused on profits directly gained by a culpable actor as the barometer to bring such a remedy “comfortably within” categories of relief typically available at equity.[xiv] First, it noted that profits remedies “often imposed a constructive trust on wrongful gains for wronged victims.” Second, it noted that profits-based remedies were generally awarded not under a joint-and-several liability theory, but instead based upon the amount accrued to the wrongdoer. Third, it noted that courts limit awards to net profits, defined as “the gain made upon any business or investment, when both the receipt and payments are taken into account.” It did, however, acknowledge an exception to preclude the offset of “unconscionable claims for personal services or other inequitable deductions.”[xv]
The Court held that Congress incorporated these longstanding equitable principles into 15 U.S.C. § 78u(d)(5), and thereby “prohibited the SEC from seeking an equitable remedy in excess of a defendant’s net profits from wrongdoing.” The Court then observed that SEC disgorgement cases had originally conformed to that limitation, but over time had expanded in three main ways that “test[ed] the bounds of equity practice”: (1) ordering proceeds of fraud to be deposited into the Treasury rather than distributed to victims; (2) imposing joint-and-several liability; and (3) “declining to deduct even legitimate expenses.”[xvi]
The Court summarily rejected the Petitioners’ contention that the holding in Kokesh meant that disgorgement was a penalty for all purposes, and thus not available as a form of equitable relief.[xvii] The Court acknowledged that Kokesh evaluated a version of disgorgement that “seemed to exceed the bounds of traditional equitable principles,” but went on to state that this did not prohibit the SEC from requesting disgorgement that was limited to a wrongdoer’s net gains.[xviii] At the same time, the Court rejected the Government’s argument that because the SEC had over time expanded disgorgement beyond net gains, Congress must have explicitly condoned this expansion by favorably referencing disgorgement in statutes enacted after the expansion occurred.[xix]
The Court ultimately vacated the district court’s disgorgement award and remanded the case to the Ninth Circuit to determine narrower questions it deliberately left unanswered, including whether the present district court’s disgorgement award transcended traditional equity bounds because it failed to return funds to victims, imposed joint-and-several liability, and did not allow the deduction of any arguably legitimate business expenses. As further discussed below, the Court discussed “principles that may guide the lower courts’ assessment” of these issues on remand, but did not provide definitive answers.[xx] The following unanswered questions and others likely will be sources of debate in multiple cases and negotiations between defense counsel and the SEC staff in the years to come.
What Questions Remain Open?
1. Do disgorged funds always have to be returned to investors for disgorgement to meet equity standards?
Yes, in most instances. While the Court’s decision did not categorically mandate that disgorged funds be returned to victims in order to make an award equitable, it strongly suggested that some form of victim compensation is necessary in light of “the statute’s command that any remedy be ‘appropriate or necessary for the benefit of investors.’”[xxi] The Court noted that the Government had not cited any common-law precedent permitting a wrongdoer’s profits to be withheld indefinitely without being returned to known victims. The Government argued that, because the SEC brought an enforcement action to deprive a wrongdoer of ill-gotten gains, and because the Treasury earmarks funds to support other investor protection initiatives, those activities were sufficient to satisfy the statute’s requirement that the disgorgement be “for the benefit of investors.” The Court did not accept that argument, reasoning...
