On Monday, June 22, 2020, the Supreme Court decided in Liu v. SEC by an 8-1 vote that the Securities and Exchange Commission (SEC) can continue to collect disgorgement awards as equitable relief, but limited the award to the amount of the wrongdoer’s net profits and required that it be distributed to victims.
In 2017, the Supreme Court held in Kokesh v. SEC that SEC disgorgement operates as a penalty under 28 U. S. C. § 2462 and is thus subject to a five-year statute of limitations. That case left open the issue of whether federal courts may order equitable relief in SEC actions pursuant to 15 U.S.C. § 78u(d)(5). That issue was squarely raised in Liu v. SEC, which affirms the SEC’s ability to collect disgorgement awards, but places limits on such awards in order to prevent them from constituting penalties.
The SEC Enforcement Action
Petitioners Charles Liu and Xin Wang solicited nearly $27 million in investments from foreign nationals under the federal EB-5 Immigrant Investor Program (EB-5 Program), which allows noncitizens to apply for permanent residence to the United States by investing in commercial enterprises that are based on proposals for promoting economic growth. Liu sent potential investors a private offering memorandum that specified that only amounts collected from a small administrative fee would fund “legal, accounting and administration expenses” and the bulk of the contributions would go towards the construction costs of a cancer-treatment center. An SEC investigation found, however, that only a fraction of the funds was put towards a lease, property improvements, and machines for cancer treatment. Instead, the majority of the funds was spent on marketing expenses, salaries, and for the defendants’ personal uses.
The SEC brought a civil fraud action against the Petitioners seeking, among other things, disgorgement equal to the full amount that had been raised from investors. The district court found for the SEC and the Ninth Circuit affirmed. In the Supreme Court, Petitioners argued that the disgorgement award is outside the bounds of equitable relief because the disgorgement SEC seeks fails to return funds to victims, imposes joint-and-and several liability, and does not deduct business expenses from the award.
The Supreme Court’s Ruling
The Supreme Court decided that a disgorgement award is permitted as equitable relief under 15 U.S.C. § 78u(d)(5), finding disgorgement to fall within “those categories of relief that were typically available in equity.” Liu v. SEC. The Court noted that equity practice allows courts to strip wrongdoers of their ill-gotten gains – also referred to as “unjust enrichment” – and return those amounts to victims. However, the Court found that over the years courts have occasionally awarded disgorgement in SEC actions that “test the bounds of equity practice” by ordering the proceeds of fraud to be deposited in Treasury funds instead of disbursing them to victims, imposing joint-and-several disgorgement liability – that is, making defendants responsible for other parties’ ill-gotten gains – and declining to deduct even legitimate expenses from the receipts of fraud.
First, the Court agreed that the equitable nature of the disgorgement remedy requires the SEC to return a defendant’s gains to wronged investors. The Court noted that the SEC “must do more than simply benefit the public at large by virtue of depriving a wrongdoer of ill-gotten gains.” However, because the SEC had not been able to return the funds to the investors because the funds had not been recovered, it remains unanswered whether an order directing the proceeds be paid to the Treasury is sufficient return of the funds to the victims. The Court left it to the lower court to determine on remand whether an order for payment to the Treasury in this case would be “for the benefit of investors” as required by Section 78u(d)(5).
Second, the Court held that disgorgement liability could not be imposed on a wrongdoer for benefits that accrue to his affiliates; they must be individually liable, not joint and severally liable. However, in this case, involving a married couple, neither of whom was a passive recipient of profits, the Court directed the lower court to determine whether Petitioners could be found liable for profits as partners in wrongdoing or whether individual liability is required.
Third, and most notably, the Court ruled that disgorgement awards cannot exceed the net profits of the scheme after taking into account both receipts and payments. Thus, courts must deduct legitimate expenses before ordering disgorgement. The Court did not give detailed guidance on what expenses are legitimate, but noted that the expenses must have value independent of “fueling a fraudulent scheme.” This leaves it to the Ninth Circuit to decide whether expenses such as lease payments and cancer-treatment equipment have independent value separate and apart from the fraudulent scheme sufficient to justify their exclusion from an equitable disgorgement order.
Justice Thomas dissented, arguing that disgorgement can never be awarded under 15 U.S.C. § 78u(d)(5) because it is not a traditional equitable remedy. However, prior Supreme Court opinions speak contrary to this, and the general takeaway of the opinion makes clear that the other factors are of greater importance.
Implications / Takeaways
The Supreme Court’s decision in Liu v. SEC affirms the SEC’s ability to seek equitable relief in civil proceedings under 15 U.S.C. § 78u(d)(5). However, the disgorgement award cannot go beyond the defendant’s net profits from wrongdoing, discounting legitimate business expenses, and the disgorgement award must be for the benefit of investors. These are important limitations on disgorgement available to the SEC and creates opportunities for defendants to argue against a disgorgement award. The decisions leaves open several questions:
- Did the fraudulent conduct cause losses to any definable group of victims to whom disgorgement could be distributed? For example, in the Liu case, such a group could consist of those subscribing to the private placement offering made by Liu and his wife. However, if the SEC is unable to identify harmed investors, then under Liu disgorgement should not be awarded. This issue will be particularly complicated in insider trading actions, where the SEC might be required to identify the precise sellers on the other side of the wrongful purchases (or vice versa) made while in possession of material nonpublic information. Identifying the actual trading counterparty could be challenging or even impossible where the security at issue is a widely traded stock. Similarly, it could be difficult to identify victims that suffered harm stemming from FCPA violations and/or what the amount of harm was to each victim. These issues suggest that the Court’s holding may limit disgorgement to garden variety fraud cases where the victim’s losses result directly from the actions of the defendant.
- If the Court is no longer permitting recovery of disgorgement from a defendant for benefits that accrued to someone who was jointly and severally liable, does that rule out the traditional theory in insider trading cases that the tipper must disgorge the benefit that was “gifted” to a tippee? And, moreover, will a first-level tipper be responsible for profits made by a remote tippee with whom she had no interaction?
- Lower courts will have to navigate the bar on penalties handed down in Kokesh. Consequently, this will require them to determine how to award disgorgement in an SEC enforcement or civil action without it being a penalty. The difficulties inherent in walking such a fine line creates the potential for a divergence in rulings that could again bring this issue to the Supreme Court.
- The ruling in Liu creates the possibility that aggrieved investors will fare better relying on private civil litigation and the remedies afforded under Section 20A of the Securities Exchange Act of 1934 to recover from directors and officers benefitting from securities fraud than they would by seeking recovery from fair fund proceeds obtained and distributed by the SEC.