Disgorgement And Intervening Causes In an SEC Enforcement Action

by Dorsey & Whitney LLP

In SEC v. Teo, Case No. 12, 1168 (3rd Cir. Decided Feb. 10, 2014) the Court, in a two to one decision, considered a question regarding the calculation of disgorgement and the impact of an intervening cause in an SEC enforcement action. In reaching its conclusion each judge agreed that the question of disgorgement in an SEC enforcement action and a private damage case differs. The judges disagreed, however, on how an intervening cause might impact the overall calculation.

Appellant Alfred Teo is an investor. In 1992 he established the MAAA Trust for which he is the beneficial owner. In February 1997 28 brokerage accounts controlled by Mr. Teo, including those in the name of the Trust, held about 5.25% of the outstanding shares of Musicland, a retailer of music, video, books and computer software.

Musicland had a “poison pill” that would be triggered when an individual or group acquired 17.5% of the firm’s shares. On July 30, 1998 Mr. Teo filed Amendment 7 to his Schedule 13D disclosures. It stated that Mr. Teo no longer had investment power with respect to the trust. A later filed schedule represented that Mr. Teo’s sister had investment authority for the trust.

Subsequently, Mr. Teo consistently reported that his ownership percentage in Musicland remained below the 17.5% threshold, although he continued to acquire shares. By August 2, 1998, together with the trust, Mr. Teo controlled 17.79% of the shares while by early December 2000 that percentage had increased to 35.97%, according to the findings of the District Court. Throughout the period Mr. Teo sought to join the Musicland board and take the company private. Mr. Teo did not file Schedule 13D disclosures on any of these activities.

In December 2000 Best Buy Co. announced an all cash tender offer for all of the shares of Musicland. The stock price rose following the announcement. The firm acquired the Musicland shares in January 2001.

In April 2004 the SEC filed an enforcement action against Mr. Teo alleging violations of Exchange Act Sections 13(d) and 10(b). A jury found after trial that Mr. Teo violated both Sections while the trust had contravened Section 13(d). In calculating the remedies the Court concluded that Mr. Teo’s original cost of acquiring the Musicland shares was $89,453,549 and that his gross proceeds from the sale of the shares was $154,932,011. Accordingly, his profits from the sale of the shares, from the date of the first violation, were $21,087,345, including the shares held by the trust. Following certain adjustments the Court directed the payment of $17,422,054.13 in disgorgement along with prejudgment interest.

The Circuit Court affirmed the determination of the District Court as to the amount of the disgorgement. The Court rejected Appellants’ claim that it was error to order as disgorgement the profits that resulted from the Best Buy tender offer which had nothing to do with their violations. In this regard Appellants argued that the amount subject to disgorgement was the profit that came directly and proximately from the specific violation, not any sum flowing from the intervening cause, citing Wellman v. Dickinson, 682 F. 2d (2nd Cir 2982). Wellman, however, does not apply here the Court concluded. That decision is a private damage action based on an implied right of action. Such a claim is based on common law tort theories.

In contrast to actions such as Wellman, SEC enforcement actions are intended to promote economic and social policies. Those actions are not designed to redress claims of particular shareholders. Therefore the Commission need not prove reliance or demonstrate that any investor lost money as a result of the violation. Viewed in this context the SEC’s use of disgorgement as a remedy is intended to deprive the wrongdoer of his unjust profits and deter other violations. Thus the Commission need only establish a reasonable approximation of the illegal profits that flow on a but for basis from the violations. Any question about an intervening cause must be raised by the defendant the Circuit Court concluded.

Here the SEC documented the purchases, the percentage of ownership, the false reporting and the profits that flowed from the violations. This established the presumptive profits. Appellants did virtually nothing to rebut the presumption established by the agency. While it “might have been possible for Appellants to demonstrate that intervening causes made the profits in question greatly attenuated from the violations at issue . . . they failed to do so. Merely positing the Best Buy tender offer as an intervening cause and pointing to evidence that Appellants did not bring it about was insufficient to overcome the presumption established by the SEC that its approximation of illegal profits was reasonable.”

Finally, the Court rejected the contention that the Best Buy tender offer was to far removed in time from the violations. Rather, it concluded that the violations of law here were significant and that the “fraudulent acts enabled Appellants to surreptitiously acquire and hold a large volume of stock that, in turn, netted huge profits when sold to Best Buy. It is precisely this type of shadowy dealing that the Securities Exchange Act – and specifically Section 13(d) and Section 10(b) – was designed to combat in order to uphold the integrity of the stock market.”

Circuit Judge Jordan dissented in part. Judge Jordan agreed that Wellman does not apply and that the but for test is appropriate in an SEC enforcement action. He also agreed that the burden shifting approach as to intermediate causes is reasonable.

The SEC met its initial burden in this case. The Appellants, however, pointed to the Best Buy tender offer as an independent cause. “Neither the District Court nor the Majority appropriately accounts for the Best Buy tender offer . . . [rather ] the majority pays lip service to the limiting principle that, to avoid being a punitive measure, a disgorgement order must be limited to ill-gotten gains . . . “

In this case “[t]he Best Buy tender offer is clearly an independent and intervening event. It bears no relationship to the Appellants’ securities violations.” Once the Appellants presented but for evidence of an intervening cause, it was the burden of the SEC to establish its claim. That was not done here.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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