Three years ago, in a footnote to its unanimous opinion in Kokesh v. S.E.C., the Supreme Court left open two questions: “whether courts possess authority to order disgorgement in SEC enforcement proceedings” and “whether courts have properly applied disgorgement principles in this context.” On June 22, the Court in Liu v. S.E.C. answered the first question with a simple “yes,” but, as to the second, significantly limited the authority of a court to grant the remedy.
In extended commentary, the Supreme Court stated that courts generally may not grant disgorgement:
(1) when the proceeds are not remitted to investors, though it left open for the future any possible exception when it would not be feasible to identify the investors who had been harmed;
(2) when one defendant is made to disgorge profits that were received by someone else, with possible exceptions for certain relationships such as business partners or married couples; or
(3) when the amount of disgorgement fails to deduct legitimate business expenses, except where the business as a whole constitutes a fraudulent scheme.
There is no provision in the federal securities laws explicitly authorizing courts to order “disgorgement” in SEC enforcement proceedings. Initially, the securities laws did not contain provisions for any kind of monetary remedies; the only statutory remedies available to the SEC were injunctions barring future violations. In the 1960s and ’70s, however, the SEC’s Enforcement Division began to argue that courts could order defendants to give back their illicit profits under their inherent equitable powers. This theory was accepted for the first time in SEC v. Texas Gulf Sulphur Co. (a case well known for recognizing that insider trading constitutes a violation of the federal securities laws). After Texas Gulf, courts widely embraced disgorgement as a remedy.
As one former assistant director of the Enforcement Division has written, “the temptation for the SEC to request and the courts to grant disgorgement” during this period of time “was understandable, lest securities law violators appear to avoid punishment by suffering a mere injunction against future wrongdoing without any accompanying monetary sanctions.” However, Congress later amended the securities laws to explicitly permit civil penalties for insider trading in 1984 and for other securities violations in 1990. Congress also explicitly authorized the SEC to seek “disgorgement” in administrative and cease-and-desist proceedings.
More recently, as part of the Sarbanes-Oxley Act, Congress authorized courts in 11 U.S.C. § 78u(d)(5) to award “equitable relief” in civil enforcement actions, but Congress did not clarify whether disgorgement, as sought by the SEC, was a form of “equitable relief.” This question has arguably been complicated by the lack of a clear historical practice of describing any form of equitable relief as “disgorgement.” The term was not widely used prior to its application in the SEC enforcement context. As one court noted in 1974, “The word ‘disgorgement’ appears to be a term of modern vintage utilized in connection with [SEC] suits seeking to deprive the defendants of the gains from their wrongful conduct . . . .”
The Facts in Liu
Petitioner Charles C. Liu operated a regional center under the EB-5 Immigrant Investor Program, the stated purpose of which was to develop and operate a cancer treatment center. The project raised $27 million from at least 50 investors, consisting of $24.7 million in capital contributions and $2.3 million in administrative fees. The project’s offering documents stated that all capital contributions would be used to develop the cancer treatment center, while marketing expenses would be drawn solely from administrative fees. However, according to the SEC, Liu paid nearly $13 million to overseas marketers, exceeding the total amount of administrative fees paid by investors. In addition, the SEC alleged that Liu paid himself approximately $6.7 million, purportedly as “salary,” and his wife, petitioner Xin Wang a/k/a Lisa Wang, $1.4 million. At the end of the day, no significant construction on the cancer treatment center took place and petitioners “burned” through nearly the entire investment.
On the SEC’s motion for summary judgment, the district court held Liu and Wang liable under Section 17(a)(2) of the Securities Act of 1933. Among other remedies, the court ordered Liu and Wang, jointly and severally, to disgorge an amount equivalent to nearly the entire $27 million raised from investors. Petitioners argued that the court should disgorge only net profits and was therefore required to deduct nearly $16 million in “legitimate business expenses.” The court, however, declined to afford petitioners any deductions, reasoning that “‘[i]t would be unjust to permit the defendants to offset against the investor dollars they received the expenses of running the very business they created to defraud those investors . . . .’”
After the district court’s decision in Liu, the Supreme Court decided Kokesh, in which it held that SEC disgorgement was a “penalty” within the meaning of 28 U.S.C. § 2462, the federal statute of limitations. Thereafter, on appeal to the Ninth Circuit in Liu, petitioners argued that Kokesh undermined the SEC’s authority to seek disgorgement, on the theory that a penalty cannot be equitable. The Court of Appeals rejected this argument and affirmed the disgorgement order.
The Supreme Court’s Decision
On Nov. 1, 2019, the Supreme Court granted certiorari on the following question: “Whether the Securities and Exchange Commission may seek and obtain disgorgement from a court as ‘equitable relief’ for a securities law violation even though this Court has determined that such disgorgement is a penalty.”
By an 8-1 majority (with Justice Thomas dissenting), the Court answered this question in the affirmative. Disgorgement was a form of “equitable relief,” the Court held, and therefore could be ordered by a court in SEC enforcement proceedings, because “depriv[ing] wrongdoers of their net profits … has been a mainstay of equity courts” under the rubric of “restitution” or “accounting.” The Court declined to read its earlier Kokesh decision to foreclose disgorgement as equitable relief.
The Court then addressed petitioners’ fallback argument: Even if SEC disgorgement is not per se unlawful, the particular order entered by the district court “crosses the bounds of traditional equity practice in three ways:  It fails to return funds to victims,  it imposes joint-and-several liability, and  it declines to deduct business expenses from the award.” Rather than rule on the merits of these arguments, the Court remanded to the Ninth Circuit to address them in the first instance. At the same time, to “guide the lower courts’ assessment of these arguments on remand,” the Supreme Court discussed general principles that will significantly limit SEC disgorgement moving forward.
1. SEC disgorgement should compensate victims where feasible. SEC disgorgement does not always result in a return of funds to injured investors; the funds may instead be deposited into the Treasury. Under the Dodd-Frank Act, disgorgement proceeds that are not distributed to victims may be used to pay whistleblowers reporting securities fraud or to fund the activities of the inspector general.
The funds that the district court ordered to be disgorged in Liu had not yet been collected, and it was unclear whether they would be deposited into the Treasury or distributed to investors after collection. Thus, the Court did not wade into whether the particular disgorgement order before it improperly failed to compensate victims. Nevertheless, the Court questioned whether it was lawful to deposit disgorged funds into the Treasury, stating that “[t]he equitable nature” of disgorgement “generally requires the SEC to return a defendant’s gains to the wronged investors for their benefit.” This conclusion was based on a combination of statutory and doctrinal arguments. First, the text of 11 U.S.C. § 78u(d)(5) authorizes courts to award equitable relief “appropriate or necessary for the benefit of investors,” which the Court interpreted to require something “more than simply benefit[ting] the public at large by virtue of depriving the wrongdoer of ill-gotten gains.” Second, the Court observed that equity courts traditionally converted wrongdoers into trustees for the benefit of “wronged victims,” and “the Government ha[d] pointed to no analogous common-law remedy permitting a wrongdoer’s profits to be withheld from a victim indefinitely without being disbursed to known victims.”
Importantly, however, the Court held that it was an “open question” whether disgorged funds could be deposited in the Treasury “where it is infeasible” to distribute them to wronged investors.
2. SEC disgorgement generally cannot be joint-and-several. The district court in Liu ordered petitioners to disgorge their profits on a joint-and-several basis. However, the Supreme Court questioned the propriety of this aspect of the disgorgement order. It noted that equity courts traditionally did not order profits-based remedies on a joint-and-several basis, and indicated that requiring one party to disgorge profits realized by another “could transform” disgorgement from an “equitable” remedy into an impermissible “penalty.”
At the same time, the Court held that “[t]he historic profits remedy … allows some flexibility to impose collective liability” in the case of, for example, partners engaged in “concerted wrongdoing.” The Court acknowledged petitioners were married and that the SEC presented evidence that Wang held herself out as being in charge of certain of the business entities associated with Liu’s scheme. “Given the wide spectrum of relationships between participants and beneficiaries of unlawful schemes that are possible—from equally culpable codefendants to more remote, unrelated tipper-tippee arrangements”—the Court declined to “wade into all the circumstances” where disgorgement could be applied to multiple individuals. Thus, the Court left it to the lower court on remand to determine whether joint and several liability in the petitioners’ case was “consistent with equitable principles.”
3. SEC disgorgement must deduct legitimate business expenses. Finally, the Court observed that equity courts traditionally “limited awards to the net profits of wrongdoing, that is, ‘the gain made upon any business or investment, when both the receipts and payments are taken into account.’” Thus, the Court held, SEC disgorgement must generally “deduct legitimate expenses.” By qualifying that such expenses must be “legitimate,” the Court clarified that “inequitable deductions” may be denied where the business as a whole constitutes a wrongful activity.
In Liu, the district court declined to deduct expenses “on the theory that they were incurred for the purposes of furthering an entirely fraudulent scheme.” The Supreme Court expressed some degree of skepticism over this finding—noting, for example, “that some expenses from petitioners’ scheme went toward lease payments and cancer-treatment equipment,” which “arguably have value independent of fueling a fraudulent scheme.” This issue too was left for the lower court to consider on remand.
Open Questions for Insider Trading and Other Securities Cases
Liu leaves open the possibility that disgorgement will not be available if it fails to compensate victims, even when those victims are impossible to identify in the first place. Liu therefore calls into question whether disgorgement may be ordered in most civil enforcement proceedings against insider traders, given the difficulty in such cases of identifying specific investors who have been harmed by a defendant’s purchases or sales. At the same time, Liu commented that, “[t]o the extent that feasibility is relevant at all, … lower courts are well equipped to evaluate the feasibility of returning funds to victims of fraud.” In support of this point, the Court cited S.E.C. v. Lund, in which the district court appointed a magistrate to determine whether it would be feasible to locate investors injured by the defendant’s insider trading, and ordered any undisbursed funds to be paid into the Treasury. It remains to be seen whether courts will continue to employ this method post-Liu.
Another unresolved issue is whether courts may continue to order insider traders to disgorge profits earned by others on account of their violations, such as tippers disgorging the profits of their tippees or portfolio managers disgorging the gains realized by their clients. In indicating that disgorgement may generally not be imposed on a joint-and-several basis, the Court referenced (among other cases) S.E.C. v. Contorinis, in which the Second Circuit held that “an insider trader who trades on behalf of another person or entity using funds he does not own, and thus produces illegal profits that he does not personally realize, can nevertheless be required to disgorge the full amount of the illicit profit he generates from his illegal and fraudulent action.” Liu cast substantial doubt on this holding, noting that Contorinis and similar cases were “seemingly at odds with the common-law rule requiring individual liability for wrongful profits.”
Finally, by calling Contorinis and similar precedents into doubt, Liu has possible ramifications beyond the disgorgement context. Under Section 21A of the Securities Exchange Act of 1934, courts are authorized to award civil penalties against insider traders in an amount up to “three times the profit gained or loss avoided as a result” of the violation. Last year, in S.E.C. v. Rajaratnam, the Second Circuit affirmed an order requiring the managing general partner and portfolio manager at a registered investment adviser to pay civil penalties under Section 21A of the Exchange Act based on the total profits realized by the fund’s accounts, even though the defendant did not personally realize any gains from the trades beyond his share of management fees and his own personal investments in the fund. Although the Second Circuit’s holding in Rajaratnam was partially based on the text of Section 21A, it also cited Contorinis, noting that disgorgement and civil penalties serve similar deterrence purposes. Quoting Contorinis, the Rajaratnam court broadly reasoned that insider traders should be accountable for the profits realized by clients and/or tippees because, “whether the defendant’s motive is direct economic profit, self-aggrandizement, psychic satisfaction from benefitting a loved one, or future profits by enhancing one’s reputation as a successful fund manager, the insider trader who trades for another’s account has engaged in a fraud, secured a benefit thereby, and directed the profits of the fraud where he has chosen to go.” Liu arguably undercuts much of this reasoning.
 137 S. Ct. 1635, 1642 n.3 (2017).
 --- S. Ct. ---, No. 18-1501, 2020 WL 3405845 (June 22, 2020). Kramer Levin attorneys Michael J. Dell and Chase Henry Mechanick submitted an amicus curiae brief on behalf of the Securities Industry and Financial Markets Association (SIFMA) in support of the petitioners in Liu.
 312 F. Supp. 77 (S.D.N.Y. 1970), aff’d, 446 F.2d 1301 (2d Cir. 1971).
 Russell G. Ryan, The Equity Façade of SEC Disgorgement, 4 Harv. Bus. L. Rev. Online 3 (2013).
 S.E.C. v. R. J. Allen & Assocs., Inc., 386 F. Supp. 866, 880 (S.D. Fla. 1974).
 Liu, 2020 WL 3405845, at *5-*6.
 Id. at *9.
 Id. at *9-*10 (emphasis added).
 Id. at *7, *9.
 Id. at *10.
 Id. at *7, *11.
 Id. at *11.
 Id. at *7 (emphasis added) (quoting Rubber Co. v. Goodyear, 9 Wall. 788, 804 (1870)).
 Id. at *11.
 Id. (quoting Root v. Lake Shore & M.S. Ry. Co., 105 U.S. 189, 203 (1881)).
 Id. at *12.
 Id. at *10 n.5.
 570 F. Supp. 1397 (C.D. Cal. 1983).
 743 F.3d 296, 299 (2d Cir. 2014), cert. denied, 136 S. Ct. 531 (2015).
 Liu, 2020 WL 3405845, at *10.
 15 U.S.C. § 78u-1(a)(2).
 918 F.3d 36 (2d Cir. 2019).
 Id. at 44 (quoting Contorinis, 743 F.3d at 303).