Upon starting work at on SEC enforcement cases – on either side – one quickly learns that the SEC isn’t authorized to seek money damages in its cases. Instead, the SEC seeks disgorgement of what it contends is a defendant’s illicit profits. Disgorgement? What’s that? A number of cases call it “an equitable remedy designed to deprive defendants of all gains flowing from their wrong, rather than to compensate the victims of the fraud. The purpose of disgorgement is to deter violations by making them unprofitable . . .” See, e.g., SEC v. Johnston, 922 F. Supp. 1220, 1222 (E.D. Mich. 1996).
And that is where the scrutiny of disgorgement largely ends. After all, the SEC has broad authority to seek equitable remedies, both pursuant to a federal court’s inherent powers and, since 2002, under Section 21(d)(5) of the Exchange Act. Disgorgement is equitable relief, so what else is there to talk about? Well, Russ Ryan has found something to discuss.
In The Equity Façade of SEC Disgorgement, just published in the Harvard Business Law Review, Ryan opens up the hood on this remedy to see what’s inside. As he asks at the start, “What if disgorgement is an equitable remedy only some of the time? What if in many cases it is actually a remedy at law, or even a punitive remedy? And what if in some cases the very label of disgorgement is a misnomer?”
At the core of these questions is the Supreme Court’s decision in Great-West Life & Annuity Ins. Co. v. Knudson, 534 U.S. 204 (2002). There, the Court articulated the circumstances in which a restitutionary remedy constitutes equitable relief, as opposed to legal relief, in the context of a federal statute that explicitly allows the former but not the latter.
Here is how the Court described “restitution at law”:
In cases in which the plaintiff “could not assert title or right to possession of particular property, but in which nevertheless he might be able to show just grounds for recovering money to pay for some benefit the defendant had received from him,” the plaintiff had a right to restitution at law through an action derived from the common law-writ of assumpsit. In such cases, the plaintiff’s claim was considered legal because he sought “to obtain a judgment imposing a merely personal liability upon the defendant to pay a sum of money.”
The Court then distinguished the separate concept of “restitution in equity”:
In contrast, a plaintiff could seek restitution in equity, ordinarily in the form of a constructive trust or an equitable lien, where money or property identified as belonging in good conscience to the plaintiff could clearly be traced to particular funds or property in the defendant’s possession. A court of equity could then order a defendant to transfer title (in the case of the constructive trust) or to give a security interest (in the case of the equitable lien) to a plaintiff who was, in the eyes of equity, the true owner. But where “the property [sought to be recovered] or its proceeds have been dissipated so that no product remains, [the plaintiff’s] claim is only that of a general creditor,” and the plaintiff “cannot enforce a constructive trust of or an equitable lien upon other property of the [defendant].” Thus, for restitution to lie in equity, the action generally must seek not to impose personal liability on the defendant, but to restore to the plaintiff particular funds or property in the defendant’s possession.
Here’s the issue, or one of them: in many cases the defendants don’t actually have the money the SEC claims has been illicitly obtained. Often the cash has been spent, squandered, or transferred to an accomplice. In those cases, recovering that money is not just a matter of transferring title or giving a security interest in the cash to the SEC. According to Great West, when the money has been dissipated, the SEC’s claim “is only that of a general creditor.” Under Ryan’s reading, it is really a legal claim because it seeks “to obtain a judgment imposing a merely personal liability upon the defendant to pay a sum of money.” Disgorgement of those funds therefore should not be available to the SEC in those cases because the agency has authority to see equitable, not legal, relief.
One problem with this theory is that using it to void a disgorgement order does not feel like the right result for a court. It essentially means that a defendant can spend the proceeds of securities fraud on cocaine and blackjack and be immune to a disgorgement order. The D.C. Circuit was confronted with this scenario two years before Great West was decided and held that it would amount to a “monstrous doctrine for it would perpetuate rather than correct an inequity.” SEC v. Banner Fund Int’l, 211 F.3d 602, 617 (D.C. Cir. 2000). Other remedies would remain intact, including civil money penalties. Still, courts are going to have a hard time saying that what sounds like a relatively simple order – pay back what you illegally took – should not apply because the money has already been spent. But after Great West, that position is . . . maybe the right one? Anyone interested in the theory behind SEC enforcement actions should read Ryan’s piece. If nothing else, it includes a complete rundown of the SEC’s powers and available remedies, and is worth reading for that.
Full disclosure: I am sort of friends with Ryan, and am happy to see his work get wide circulation. But you should read his article despite that, as he’s onto an interesting idea here.
Also, this may be my last post of 2013. If it is, take some advice for the new year from somebody in my house last night: “Be happy what you got, okay?”