In Liu v. SEC, the Supreme Court answered the question that remained following its 2017 opinion in Kokesh v. SEC:  “whether, and to what extent, the SEC may seek ‘disgorgement’ in the first instance through its power to award ‘equitable relief’” in a federal district court action under Section 21(d)(5) of the Securities Exchange Act of 1934 (15 U.S.C. § 78u(d)(5)).  Liu v. SEC, No. 18-1501 at 1.  In an opinion written by Justice Sotomayor (who also wrote Kokesh), the Court held that disgorgement, properly tailored, was an equitable remedy available in federal court SEC enforcement actions.  Liu, however, leaves the scope of the disgorgement remedy uncertain—as well as whether the five-year statute of limitations interpreted in Kokesh continues to apply to disgorgement claims that are properly tailored as “equitable relief” under the framework set forth in Liu.

In Kokesh, the Supreme Court determined that the five-year statute of limitations for penalties, 28 U.S.C. § 2462, applied not only to civil monetary penalties but also when the SEC sought disgorgement of a wrongdoer’s ill-gotten gains.  SEC v. Kokesh, 137 S. Ct. 1635, 1639 (2017).  That decision rested on the Court’s recognition of three features of disgorgement that the Court observed in SEC enforcement actions: (1) disgorgement was imposed as a consequence of violating a public law, an offense against the United States, and not an individual; (2) disgorgement was imposed for punitive purposes to deter wrongdoers, with the amount of disgorgement often exceeding the amount of net profits; and (3) disgorgement was not compensatory because disgorged funds are paid to the Treasury.  Id. at 1643-44.  In the Kokesh Court’s view, these three qualities of disgorgement confirmed that the disgorgement remedy was a penalty subject to the five-year statute of limitations.  Although § 2462 is a different provision from Section 21(d)(5), Kokesh called into question whether disgorgement was within Section 21(d)(5)’s authorization of “any equitable relief that may be appropriate or necessary for the benefit of investors.”  15 U.S.C. § 78u(d)(5).  The Court recognized this potential tension in Kokesh, but explicitly refused to address “whether courts possess authority to order disgorgement in SEC enforcement proceedings or . . . whether courts have properly applied disgorgement principles in this context,” thus setting the stage for Liu.  See id. at 1642 n.3.

To determine whether disgorgement was “equitable relief” for purposes of Section 21(d)(5), the Supreme Court in Liu analyzed whether disgorgement was within “those categories of relief that were typically available in equity.”  Liu at 5.  Surveying multiple cases involving equitable relief, the Court recognized that (1) equity had long authorized courts to strip wrongdoers of their ill-gotten gains, but (2) courts had only been authorized to strip net profits from wrongdoers to avoid converting an equitable remedy into a punitive sanction.  Id. at 6.  The Court also noted that Section 21(d)(5) stated the purpose of the equitable remedy was “for the benefit of investors,” suggesting that Congress intended the funds recovered through disgorgement to be returned to those who were harmed.  Id. at 14-15.  The rule itself that the Supreme Court crafted in Liu is thus clear:  Section 21(d)(5) authorizes the SEC to seek, and a court to order, “a disgorgement award that does not exceed a wrongdoer’s net profits and is awarded for victims.”  Id. at 1.

However, while the Court held that Section 21(d)(5) granted a court the power to order disgorgement in an SEC enforcement action, it set limitations on that power, stating that the traditional principles of equity imposed a limit on what the SEC could obtain through disgorgement.  Id. at 12.  In setting these limitations, however, the Court offered little guidance regarding how its interpretation of the disgorgement remedy is to be practically applied.  Specifically, the Liu decision left the resolution of three critical questions to the lower courts:  (1) how to determine what the “net profits” of a fraudulent scheme are and what expenses may be deducted from the proceeds of the scheme to arrive at the “net profits” subject to disgorgement; (2) whether and under what circumstances disgorged funds may be deposited with the Treasury or whether the funds must be disbursed to victims in every instance; and (3) under what circumstances a defendant can be ordered to disgorge another’s ill-gotten gains.  See id. at 12.

The rule articulated in Liu—that disgorgement is limited to net profits awarded for victims—is easy to state and appears to be firm.  Yet the Court’s discussion of the questions above makes clear that the rule does not establish a bright line, making it uncertain how the courts will apply Liu going forward, inviting the “great mischief” that Justice Thomas recognized in his dissent.  See id. at 6 (Thomas, J., dissenting).  For instance, while the Court held that “legitimate expenses” must be deducted from the proceeds of an unlawful undertaking before disgorgement could be ordered, the Court also held there was an exception for schemes where a business’s entire profit was attributable to wrongdoing.  Id. at 11-12.  Courts must therefore ascertain “whether expenses are legitimate or whether they are merely wrongful gains under another name.”  Id. at 19 (quotation marks omitted).  The Court also confronted the SEC’s practice of holding multiple defendants jointly and severally liable for disgorgement, a practice that was at odds with traditional equitable principles.  Id. at 10.  However, despite acknowledging a general rule against joint and several liability at equity, the Court did not set a firm rule prohibiting a court from entering an order disgorging from one defendant profits that accrued to another.  Instead, the Court recognized that the common law permitted liability for partners engaged in concerted wrongdoing, opening the door for “some flexibility to impose collective liability.”  Id. at 18.  The Court did not provide significant guidance to the lower courts to determine when joint liability might be appropriate, essentially directing courts to undertake a case-by-case analysis given “the wide spectrum of relationships between participants and beneficiaries of unlawful schemes.”  Id.  Lastly, although the SEC is required “to return a defendant’s gains to wronged investors for their benefit,” the Court ultimately offered no guidance regarding how a court should evaluate a potential claim by the SEC in instances where “the wrongdoer’s profits cannot practically be disbursed to the victims,” because such an order was not before the Court.  Id. at 16-17.  Liu left the question whether an order to pay funds to the Treasury can ever be consistent with equitable principles to the lower courts.

Liu’s impact may be more significant than recognizing that Section 21(d)(5) authorizes disgorgement and setting bounds on that remedy.  It is possible to read the decision to suggest that the Court’s holding in Kokesh no longer applies to disgorgement that is consistent with equitable principles.  The Liu Court’s holding that the SEC may only obtain net profits and as a general rule disgorgement should be paid to the injured limits the remedy authorized by Section 21(d)(5) in a way that eliminates two of the reasons the Kokesh court relied on to conclude that disgorgement was a penalty.  The Kokesh court observed that disgorgement was often punitive because (1) the amount of disgorgement exceeded net profits and (2) disgorgement was not compensatory because disgorged funds were paid to the Treasury.  But under Liu, neither of these features of disgorgement is authorized under Section 21(d)(5).  Indeed, the Liu decision acknowledges that the disgorgement remedy it approves is different from its understanding of disgorgement in Kokesh, noting that in Kokesh it considered a “version of the SEC’s disgorgement remedy that seemed to exceed the bounds of traditional equitable principles.”  Liu at 12 (emphasis added).  Therefore, although the Court did not reach the question, Liu could support the argument that Kokesh’s holding with respect to the statute of limitations applied only to non-equitable disgorgement, which under Liu is not an authorized form of disgorgement.  Thus, under this reading, properly tailored disgorgement under Liu would no longer be subject to the five-year statute of limitations.

On the other hand, there are strong reasons to believe that Liu did not alter the prevailing understanding of Kokesh’s holding and that the five-year statute of limitations continues to apply to all SEC enforcement actions in federal court seeking disgorgement.  Kokesh decided whether the disgorgement remedy was limited by § 2462, whereas Liu interpreted Section 21(d)(5), two different statutes with different language, and thus an interpretation of one should not control the other.  Liu also did not disturb the first reason that the Court gave in Kokesh for concluding that disgorgement was a penalty: that SEC disgorgement is imposed as a consequence for violating public laws, an offense against the United States, and not an individual.  The Court in Kokesh acknowledged that, even though disgorgement might serve “compensatory goals in some cases,” the fact that it had punitive purposes suggested disgorgement was a penalty for purposes of § 2462.  Thus, because Liu does not contradict or qualify Kokesh’s holding that disgorgement’s punitive character arises from the fact it is imposed as a consequence for a violation against the United States, there is an argument that disgorgement should continue to be limited by the five-year statute of limitations.

It is also not clear whether Liu will have a limiting effect on the SEC’s ability to obtain disgorgement in administrative proceedings.  A separate statute, Section 21C(e) of the Exchange Act, grants the SEC the authority to obtain “an order requiring accounting and disgorgement” in an administrative cease-and-desist proceeding.  25 U.S.C. § 77h-1(e).  As Justice Thomas observed in his dissent, “[i]t is unclear whether the majority’s new restrictions on disgorgement will apply to these proceedings as well,” creating the possibility that the SEC could obtain greater disgorgement of funds in administrative proceedings than in a litigated action in federal court.  See Liu at 7-8 (Thomas, J., dissenting).

Liu states a simple holding, that the SEC’s power to order disgorgement is limited to net profits awarded for victims.  Nevertheless, the holding leaves ample room for debate on how it impacts Kokesh, and how the SEC, litigants, and the courts will apply Liu to claims of disgorgement.  For sure, the industry can expect the SEC to reasonably advance the argument that Liu eliminated the concerns the Supreme Court identified in Kokesh and that disgorgement consistent with the principles of equity is no longer punitive and thus not subject to the five-year statute of limitations.