A near-unanimous majority of the U.S. Supreme Court recently upheld, and simultaneously reigned in, the Securities and Exchange Commission’s (SEC’s) ability to obtain disgorgement under the federal securities laws. In the lead up to Liu v. SEC, many observers believed the Supreme Court would extend its recent decision in Kokesh v. SEC and declare that federal courts were prohibited from ordering securities fraud and insider trading defendants to disgorge their ill-gotten profits. This remedy is not in any statute and was judicially created. While the Court did not go as far as some defendants may have hoped, the majority provided for limitations as to the amount the SEC could obtain in disgorgement, including limiting the amounts to the defendant’s net profits. The Court did not specify what this meant and left it to lower courts to determine what — and the extent to which — costs and expenses incurred by a defendant will offset the total profits of the fraudulent scheme. The Court also limited disgorgement to amounts returned to victims and held it was not available as a joint and several remedy, unless the parties engaged in concerted wrongdoing.

Key takeaways from Liu:

• Defendants cannot be ordered to disgorge more than the net profits gained from their violation of the securities laws.

• District courts “must deduct legitimate expenses” when calculating net profits. But the Supreme Court left it to lower courts to determine what, exactly, counts as a “legitimate expense.”

• Courts may not impose joint-and-several disgorgement liability absent “concerted wrongdoing” by multiple individuals.

• Absent a showing of countervailing authority, the SEC must return disgorged net profits to the victims of fraud and may no longer deposit funds with the U.S. Treasury Department.

Each of these restrictions will be subject to future litigation to determine the parameters.

The SEC has long obtained disgorgement of profits in federal court, though the securities laws do not explicitly permit that remedy.

Congress provided the SEC with two avenues to pursue alleged violations of the securities laws: administrative enforcement or a civil action in federal district court. The SEC’s forum choice affords different remedial possibilities. For example, if the SEC chooses administrative proceedings, the agency can issue orders “requiring a person to cease and desist from committing or causing a violation” of the securities laws or mandating an individual take “steps to effect compliance” with the law. An administrative law judge may also “impose a civil penalty” consistent with three “tiers” corresponding to the defendant’s conduct. Alternatively, in administrative proceedings, “the Commission [also] may enter an order requiring accounting and disgorgement, including reasonable interest.”

A similar remedial menu exists in federal court. Instead of a cease-and-desist order, the SEC can seek “a permanent or temporary injunction” against future violations of law. District courts can authorize penalties, again divided into tiers, based on “the gross amount of pecuniary gain to [the] defendant as a result of the violation.” In addition, the SEC may pursue “any equitable relief that may be appropriate or necessary for the benefit of investors.” Disgorgement is not mentioned among these options.

Despite that, the SEC has long sought — and district courts have granted — orders for disgorgement to address securities law violations. Though disgorgement is not explicitly mentioned in the statute, courts have considered the remedy within their equitable “discretion to prevent unjust enrichment.” And the Supreme Court has explained disgorgement is “traditionally considered an equitable remedy.”

Though traditional equitable remedies are tempered by the principle that no award should result in a windfall to the harmed, district courts have increasingly fashioned disgorgement orders for amounts that exceed the net profit of the wrongful conduct. Indeed, some courts only deduct monies returned to victims from the total disgorgement award, causing defendants to pay back otherwise legitimate expenses and costs incurred in making a profit. Other courts calculate disgorgement on a joint-and-several basis and order individual defendants to disgorge profits that may have accrued to their affiliates but not them personally. A remedy meant to reallocate profits has, at least in the SEC disgorgement context, begun to resemble a penalty.

Disgorgement has proven to be a lucrative tool for the SEC. In fiscal year 2019, parties were ordered to pay $3.248 billion in disgorgement. Deceived investors only received 37 percent of total disgorged funds, and the rest was deposited in Treasury accounts. This amount was inevitably inflated by disgorgement orders in excess of the defendants’ net profit gained from the unlawful conduct.

Kokesh opened the door to a challenge to SEC disgorgement.

In 2017, the Supreme Court tossed the availability of disgorgement into dispute. Kokesh required the Court to consider whether disgorgement was a “penalty” for purposes of the federal statute of limitations. The Court held affirmatively, subjecting actions for disgorgement to a five-year statute of limitations. A footnote in the majority opinion explicitly reserved the question of whether, in the first instance, the term “equitable relief” permitted the SEC to obtain disgorgement at all. The language signaled to lawyers that the Court was ready to consider the question.

Liu preserves the SEC’s disgorgement remedy but limits the total award to net profits.

Liu involved a scheme whereby foreign nationals defrauded investors who believed they were contributing to a proton-therapy cancer center. Charles Liu and his wife Xin (Lisa) Wang utilized the EB-5 Immigrant Investor Program, which permits noncitizens to apply for permanent residence in the United States by investing in approved commercial enterprises, to secure $27 million from investors. Though the pair’s offering memorandum stated only a small amount of the capital raised would be used for administrative, legal, and accounting expenses, the SEC alleged Liu spent nearly $20 million on marketing expenses and salaries.

The SEC pursued — and was awarded — disgorgement of the misappropriated funds. A district court ordered the defendants to return the full amount raised from investors, less $234,899 that remained in corporate accounts. On appeal to the Ninth Circuit, the defendants argued that (1) under Kokesh, the district court lacked the authority to order disgorgement and (2) even if it had such authority, the district court should have deducted “legitimate business expenses” in deriving an award. The Ninth Circuit declined to address the first question (noting Kokesh did not clearly conflict with circuit precedent to the contrary) and explained a proper disgorgement award is one for the entire amount raised less that returned to the victims.

In an 8-1 decision, the Supreme Court upheld the availability of the SEC’s disgorgement remedy, while limiting district courts’ discretion to order defendants to return an amount in excess of net profits. The opinion does not define, specifically, what constitutes “net profits” but does direct district courts to deduct “legitimate business expenses” from the total amount gained from the fraudulent scheme. Lower courts are left to determine what items can be deducted from the total profits.

Justice Sotomayor, writing for the majority, explained that by using the term “equitable relief,” Congress authorized district courts to deploy all “traditional” equitable remedies to address securities law violations. Disgorgement — used interchangeably with restitution — has long been available for courts to “strip wrongdoers of their ill-gotten gains.” As long as disgorgement is used to “restore the status quo,” the SEC may continue to seek it.

Although the Court held that disgorgement was a proper equitable result, the Court refined the contours of disgorgement orders in three ways: (1) the district court must permit the deduction of legitimate business expenses; (2) there is to be no joint-and-several disgorgement liability absent concerted conduct between the defendants; and (3) unless the SEC can point to some statutory authority, disgorgement funds must be returned to victims, not the U.S. Treasury’s accounts.

Implications

While the Court put to bed arguments that disgorgement is not allowed at all, in providing the limitations that it did, the Court set up many future legal fights over these limitations. Defendants’ next battle will be determining what constitutes a “legitimate business expense.” Liu gave some guidance to lower courts, citing the general rule “that a defendant is entitled to a deduction for all marginal costs incurred in producing the revenues that are subject to disgorgement.” In a fraud case, this may include items like marketing expenses, rent and other fixed costs. Insider trading presents a more difficult scenario because traders often absorb a large loss in addition to the gain. Traders may be able to argue that their net profit was effectively zero if the sum of their transactions during the relevant time period ended in a loss. Additionally, in insider trading cases, it can be very difficult to identify victims and traditionally most insider trading disgorgement has gone to the U.S. Treasury. That may not work following Liu. The same is true for Foreign Corrupt Practices Act violations.

Another area where disgorgement may no longer be available is for insider trading involving tippers and tippees. The SEC often sought disgorgement from a tipper of a tippee’s profits. Unless they are found to have been acting in concert, disgorgement from the tipper may no longer be permitted. In any event, observers will not have to wait long for guidance because the Liu district court will have an opportunity to fashion a disgorgement order consistent with the Supreme Court’s mandate.

A final note for consideration is that, after Kokesh, it was clear that disgorgement was subject to a five-year statute of limitations as it was deemed to be a penalty. The Liu decision suggests disgorgement that is consistent with the limitations set forth by the Court may be equitable and therefore not subject to any statute of limitations. Expect the SEC to pursue this in future cases.