For the past three years, since the Supreme Court explicitly declined to address the issue in Kokesh v. SEC in 2017, there had been an open question as to whether the US Securities and Exchange Commission (SEC) has authority to seek and obtain disgorgement as a remedy in civil enforcement actions filed in district courts for violation of the securities laws.
On Monday, the Supreme Court answered that question in Liu v. SEC, holding, in an 8-1 decision, that the SEC can obtain disgorgement as a form of “equitable relief,” with some key limitations that may significantly alter the SEC’s practice going forward. In answering one question, however, the Court created several more for lower courts to consider.
The SEC brought a civil action against petitioners Charles Liu and Xin Wang for operating a fraudulent investment fund that solicited $27 million from foreign investors under an immigration program that offers a path to permanent residency in the US by investing in certain approved enterprises.
The District Court for the Central District of California found in favor of the SEC and imposed both a civil penalty and disgorgement equal to the full amount that Liu and Wang had raised from investors. In its disgorgement calculation, the district court deducted a small portion that had remained in the accounts for the project, but disagreed with Liu and Wang that the disgorgement amount should be offset by their legitimate business expenses. The district court also found Liu and Wang to be jointly and severally liable for the full amount.
Liu and Wang appealed, arguing that under Kokesh, in which the Supreme Court held that disgorgement constituted a “penalty” for statute of limitations purposes, disgorgement was not a permissible form of “equitable relief” that the SEC is permitted to seek in civil actions as provided by 15 U.S.C. § 78u(d)(5). The Ninth Circuit affirmed the district court’s decision, relying on Ninth Circuit precedent and acknowledging that the Supreme Court in Kokesh expressly declined to reach the issue.
The Supreme Court’s decision
The Supreme Court, in an opinion by Justice Sotomayor, reviewed the history of disgorgement (under various names) in courts of equity and struck a middle ground, holding that disgorgement is a permissible form of “equitable relief” under § 78u(d)(5), but with certain key limitations informed by history. Specifically:
- The SEC is prohibited from obtaining a disgorgement award in excess of a defendant’s net profits (i.e., the court must deduct legitimate business expenses); and
- The SEC is “generally require[d]” to return the disgorgement award to the victims of the scheme.
While the Supreme Court’s decision appears straightforward, the Court left open numerous questions for lower courts to consider.
Net profits and legitimate business deductions. Although the Supreme Court made clear that courts must deduct legitimate business expenses when calculating disgorgement, the Court provided no framework for determining when an expense was legitimate (and thus must be deducted) as opposed to when an expense was simply “fueling a fraudulent scheme” (in which case the expense should not be deducted). Instead, the Court left it to lower courts to make this determination in a manner that is “consistent with the equitable principles underlying § 78u(d)(5).”
Distribution of disgorgement funds to investors. In holding that the law “generally requires” the SEC to return disgorged funds to harmed investors, the Court explicitly left open the possibility that the SEC could instead deposit disgorgement funds with the Treasury, as is the SEC’s common practice, in cases where it is infeasible to distribute the funds to investors. The Court noted that it is “an open question whether, and to what extent, that practice nevertheless satisfies the SEC’s obligation to award relief ‘for the benefit of investors.’”
Joint-and-several liability. The Court noted that imposing joint-and-several liability on multiple defendants may at times be inconsistent with the common-law rule requiring individual liability for wrongful profits, and thus may transform an equitable remedy into a penalty. The Court declined, however, to take a definitive stance on this issue, commenting that imposing joint-and-several liability makes sense in a situation where, like in the case before it, the defendants are married, or otherwise maintain comingled finances or equally profited from the scheme.
Applicability to administrative proceedings. Finally, the Court’s decision is unclear as to whether the new limitations on disgorgement are equally applicable to administrative proceedings, where, unlike civil enforcement actions, statutory law specifically provides that disgorgement is an available remedy. As Justice Thomas noted in his lone dissent, if the new limitations are applicable only to civil enforcement actions, then “the result will be that disgorgement has one meaning when the SEC goes to district court and another when it proceeds in-house.”