Congress Confirms SEC's Disgorgement Power: Recovery for Investors or Revenue for Government?

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Tucked into the 2021 National Defense Authorization Act (NDAA)1  passed over a presidential veto on January 1, 2021,2  on page 1,238 of the 1,480-page bill, was a modification to the Securities Exchange Act of 1934 (Exchange Act)3 that constitutes a response to a couple of recent Supreme Court cases that had limited the U.S. Securities and Exchange Commission’s (SEC) ability to obtain disgorgement from defendants in enforcement actions. Prior to the NDAA, the SEC did not have explicit statutory authority to obtain disgorgement from securities law violators; instead, federal courts have conferred such authority in a patchwork of cases over the past 50 years. In the NDAA, Congress modified a section of the Exchange Act that sets out the remedies available to the SEC in addressing violations of the securities laws4  and granted explicit authority for the SEC to seek disgorgement.5  The new authority comes with an enhanced, ten-year limitation period for disgorgement related to certain fraud violations.6  However, the new statute and authority do not necessarily sweep aside the limitations imposed by the Supreme Court in two recent, seminal cases, Kokesh v. SEC7  and Liu v. SEC.8

Governments, like private businesses, seek to obtain, retain, and expand streams of income. There are, however, at least two operational differences regarding what the payer receives and what motivates the payee. In typical commercial transactions, customers receive a positive; in interactions with the government citizens usually avoid a negative.9  Profit motivates business managers while increased administrative power motivates governmental managers. The multiple government-directed revenue streams include cash inflows from income, excise, wealth, and other taxes, duties, tariffs, transfer payments from other governments, and multifarious fines collected for conduct deemed unlawful. Until very recently, the SEC had exercised its disgorgement power as simply another revenue stream.

In Liu, the Supreme Court held that disgorged funds must be returned to the harmed investors—what we call the “First Liu Rule.” In addition, the Court ruled that the disgorged amount must be net of unlawfully obtained funds and lawful expenses incurred in obtaining and using the funds—what we call the “Second Liu Rule.” In its amendment of the Exchange Act on January 1, Congress failed to address either the First or Second Liu Rule and, thus, the SEC will still be curtailed from returning to its prior “revenue stream” approach to disgorgement.

Origins of the SEC’s Disgorgement Power

Federal courts gave the SEC power to obtain disgorgement from violators by reading it into the Exchanger Act provision that authorized the Agency to investigate and litigate violations of federal securities laws.10  This judicially-created remedy, originally called restitution, became a penalty imposed on violators, often representing funds that investors had lost and violators gained, that was collected for the benefit of the United States Department of the Treasury (“Treasury”).

Although negative injunctions are a type of equitable remedy, Exchange Act Section 21 made no reference to equity generally or disgorgement specifically. It granted the SEC no ability to impose a penalty. Section 21 simply provides that, “[w]henever it shall appear to the Commission that any person is engaged or is about to engage in” violations of the federal securities laws, the SEC may bring an action “to enjoin such acts or practices, and upon a proper showing a permanent or temporary injunction or restraining order shall be granted.”11

In the 1970 case SEC v. Texas Gulf Sulphur Co.,12  the U.S. Court of Appeals for the Second Circuit, having just adopted a new theory of fraud liability for the SEC—insider trading13 — affirmed the district court’s granting of the new remedy of restitution—to the SEC—on the very same matter.14  The district court and Second Circuit extracted the SEC’s purported authority to seek, and the federal district courts’ authority to compel, defendants to return ill-gotten gains from Section 21.15  The SEC later came to employ the term “disgorgement” as the equivalent of “restitution-based awards.”16

The Second Circuit nonetheless ignored Congress’ very specific inclusion of injunctive remedies and exclusion of other equitable remedies, disgorgement, or penalties, and in an act of judicial legislation disguised as statutory interpretation—an ipse dixit—reasoned that because courts had previously granted the remedy of receivership to the SEC, also not mentioned in Section 21, it could find and add another unspecified remedy to the statutory section. In effect, the court completely ignored the statutory language.

Judicial disregard of the specific statutory language in 1970 was not the only problem. A second problem concerns the SEC’s standing: How could the SEC stand in the shoes of the injured investors, collect the unjust gains, and dispense with the proceeds at it deemed fit? The SEC was not an investor. By separating disgorgement from restitution, transforming it into a penalty, and justifying its role, after 1990, as a second “civil” penalty for general deterrence, the SEC avoided the problem of standing.

When the judiciary granted the SEC the power to extract money from insider traders, it was a type of restitution or unjust enrichment that, in the interest of justice and good faith, would require a wrongdoer to return to a wronged party the wrongdoer’s unjust gain.17  It was not a penalty for wrongdoing insofar as it was a government-imposed pecuniary punishment.

The Second Circuit’s holdings regarding the availability of disgorgement in SEC enforcement cases spread as other federal circuits quickly adopted the new theory of securities fraud and its remedy, gradually expanding the disgorgement remedy beyond insider trading cases to other types of securities fraud.18  Until Kokesh and Liu, the SEC had few consistent conditions on imposing and calculating the disgorgement recovery, including its practice of collecting disgorged funds for the benefit of the U.S. Treasury rather than to compensate injured investors. Although SEC disgorgement has now celebrated its fiftieth birthday, over this time span the remedy had lost its theoretical justification and became a de facto judicial penalty—an equitable penalty.19

Kokesh and Liu Begin to Place Some Limits on the SEC’s Rampant Disgorgement Practices

In Kokesh, the Supreme Court acknowledged that the SEC disgorgement remedy was a penalty, noting that penalties are imposed for offenses against the state and are intended to deter future violations “as opposed to compensating a victim for his loss.”20  The Kokesh Court did not accept the SEC’s argument, made to avoid application of a five-year statute of limitations on its use of disgorgement, that SEC disgorgement is not punitive but “remedial” because it “lessens” the consequences of a violation.21  In that regard, the Court observed that, while “[s]ome disgorged funds are paid to victims; other funds are dispersed to the United States Treasury,” and “[e]ven though district courts may distribute the funds to the victims, they have not identified any statutory command that they do so.”22  Accordingly, the Court found that disgorgement was a penalty subject to the five-year statute of limitations, set out in 28 U.S.C. § 2462, and that the statute of limitations starts to run upon completion of the violation.

In Liu, the Supreme Court resolved the Kokesh issue, namely that disgorgement is available as equitable relief as long as the award does not exceed net profits and is refunded to the victims.23  The Liu decision, among other things, provided a formula for calculating the disgorgement total and required the SEC to return that total to investors. With minor exceptions, disgorged amounts could no longer go straight to the Treasury. Although Section 308 of Congress’s Sarbanes-Oxley Act24  created the so-called Fair Fund provision, it only gave the SEC the “authority”—and the discretion—to return funds to the investors who were the financial victims of the defendants ordered to disgorge.25  Following Liu, the return of funds to harmed investors is now mandatory.

The NDAA Amendments Codify SEC Disgorgement and Modify the Limitations Period

As noted above, on January 1, 2021, Congress amended certain provisions of Section 21 (“Amendments”).26  These Amendments statutorily crystallized Liu’s holdings about the SEC’s ability to seek and obtain judicial disgorgement, federal courts’ power to grant disgorgement, and extended the five-year statute of limitations on disgorgement to ten years for fraud claims, that is, claims requiring that the SEC show scienter.

In the Amendments, however, Congress is completely silent about the Liu Rules, and this silence creates ambiguity in the state of law: Is the new, statutory disgorgement authority to be used for the benefit of harmed investors, as the judicial Liu Rules contemplate, or can it or will it return to its role as a revenue stream for the Treasury?  By “punting” on this critical question, Congress has left this door open.

Given its history, the SEC will likely soon be asking the judiciary to again stretch the SEC’s authority to obtain disgorgement up to—and perhaps beyond—the limits of the statutory language.

[1] William M. (Mac) Thornberry National Defense Authorization Act for Fiscal Year 2021, Pub. L. No. 116-283 (2021) (“NDAA”).

[2] Jordain Carney, Congress overrides Trump veto for the first time, The Hill (Jan. 1, 2021), https://thehill.com/homenews/senate/532321-congress-overrides-trump-ndaa-veto.

[3] 15 U.S.C. §§ 78a-78qq (2020).

[4] 15 U.S.C. § 78u(d) (2020).

[5] NDAA, supra note 1, § 6501.

[6] Id. § 6501(a)(3).

[7] 137 S. Ct. 1635 (2017). We discussed Kokesh in an article prior to the Supreme Court argument in Liu, and noted that the case had highlighted two gaps in the SEC’s enforcement authority “that a statutory amendment can easily address: (1) the efficacy of the SEC’s disgorgement power outside of the context of an administrative proceeding; and (2) determining the appropriate statute of limitations period.” Cory Kirchert & Adriaen Morse, Liu v. SEC: To Disgorge or Not to Disgorge, Arnall Golden Gregory: Publications (Jan. 29, 2020), https://www.agg.com/news-insights/publications/liu-v-sec-to-disgorge-or-not-to-disgorge/.

[8] 140 S. Ct. 1936 (2020). In discussing the Supreme Court’s opinion in Liu, we noted that, although the Court had confirmed the availability of the judge-made disgorgement remedy for the SEC, the opinion imposed new limits on the SEC’s recovery to the net profits of the unlawful activity and a requirement that recovered proceeds be returned to investors whose money is disgorged. Adriaen Morse, Cory Kirchert & Georgina Shepard, The SEC Loses an Arrow from Its Quiver in Liu v. SEC, Arnall Golden Gregory: Publications (June 24, 2020), https://www.agg.com/news-insights/publications/the-sec-loses-an-arrow-from-its-quiver-in-liu-v-sec/.

[9] Fiscal capacity is a government’s ability to generate revenue. Its effective use of coercion through, among other things, the threat of fines and penalties, plays a role in collecting revenue deemed collectible by the state. See, e.g., Eva Hofmann et al., Enhancing Tax Compliance through Coercive and Legitimate Power of Tax Authorities by Concurrently Diminishing or Facilitating Trust in Tax Authorities, Wiley Law and Policy (Apr. 29, 2014), https://www.ncbi.nlm.nih.gov/pmc/articles/PMC4459214/. The German sociologist Max Weber defined the state as a “human community that (successfully) claims the monopoly of the legitimate use of violence within a given territory.” André Munro, State Monopoly on Violence, Encyclopedia Britannica (Mar. 6, 2013), https://www.britannica.com/topic/state-monopoly-on-violence.

[10] 15 U.S.C. § 78u; Exchange Act § 21 (“Section 21”).

[11] Exchange Act Section 21(d)(1).

[12] SEC v. Texas Gulf Sulphur Co., 446 F.2d 1301, 1307 (2d. Cir. 1970) (“TSG II-CA”) (this was the factual liability and remedy phase of the case in which insider trading was deemed to violate fraud provisions of the Exchange Act).

[13] SEC v. Texas Gulf Sulphur Co., 401 F.2d 833 (2d Cir. 1968) (en banc), cert. denied, Coates v. SEC, 394 U.S. 976 (1969) (“TSG I-CA”).

[14] SEC v. Texas Gulf Sulphur Co., 258 F. Supp. 262 (S.D.N.Y. 1966) (“TSG I-DC”).

[15]  Later, the Liu Court stated, “Congress passed the Securities Act of 1933, 48 Stat. 74, as amended, 15 U.S.C. § 77a et seq., and the Securities and Exchange Act of 1934, 48 Stat. 881, as amended, 15 U.S.C. § 78a et seq., and to punish securities fraud through administrative and civil proceedings.” Liu, supra note 8, at 1940 (emphasis added). We suggest that this statement, which cites to the original statutes, is false because Congress originally limited SEC remedies to the equitable and non-punitive relief of injunction—temporary, preliminary, or permanent.

[16] Id. at 1940 n.1.

[17] See, In re McCormick & Co., Inc., 422 F. Supp. 2d 194 (D.D.C. 2019) (Court references private claims for unjust enrichment in various states).

[18] See e.g., John D. Ellsworth, Disgorgement in Securities Fraud Actions Brought by the SEC, 3 Duke L. J. 641 (1977), https://scholarship.law.duke.edu/cgi/viewcontent.cgi?article=2628&context=dlj.

[19] Our discussion does not include the statutory disgorgement remedy for short-swing profits for violations of 15 U.S.C. § 78p(b), also known as Section 16(b) of the Securities Exchange Act of 1934, which is a prophylactic insider-trading rule.  This statutory-based disgorgement is a true equitable remedy, which a third-party, the SEC, enforces for the benefit of the harmed party—the corporation. It is not an equitable penalty paid to the government.

[20]  Kokesh, supra note 7, at 1642.

[21]  Id. at 1644.

[22]  Id.

[23] Liu, supra note 8, at 1949-50.

[24] Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, 116 Stat. 745 (July 30, 2002); see, SEC, Press Release, Statement of the Securities and Exchange Commission Concerning Financial Penalties (Jan. 4, 2006), https://www.sec.gov/news/press/2006-4.htm.

[25] SEC, Information for Harmed Investors, https://www.sec.gov/divisions/enforce/claims.htm (stating, in part, that the SEC “in its discretion, may seek to distribute these [disgorged] funds for the benefit of harmed investors. Some of the distributions in these cases are administered by SEC staff, and in other cases, a third-party Fund Administrator/Distribution Agent has been appointed by the Commission or court to administer the distribution.”).

[26] NDAA, supra note 1, § 6501.

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