- The U.S. Supreme Court heard arguments on March 3, 2020, in Liu v. SEC, a case in which the petitioner challenged the U.S. Securities and Exchange Commission's (SEC) statutory authority to pursue the remedy of disgorgement in judicial proceedings.
- If the Supreme Court ultimately decides to restrict, but still allow the SEC to seek disgorgement in judicial proceedings (which seems likely), just how broadly the Court defines the legitimate expenses that may be deducted in order to determine the amount of the net profits of the fraud (which must be disgorged) will likely determine the implications of the Court's decision.
- Because the SEC may be reluctant to pursue disgorgement in administrative proceedings in the face of the recent challenges to the very legitimacy of its administrative adjudicatory process, if the Supreme Court limits the SEC's ability to seek disgorgement in judicial proceedings, it may, for quite some time, and at least until the courts resolve the recent administrative challenges, have a significant impact on the SEC's ability to use one of its most powerful enforcement tools.
The U.S. Supreme Court heard arguments in Liu v. SEC, a case in which the petitioner challenged the U.S. Securities and Exchange Commission's (SEC) statutory authority to pursue the remedy of disgorgement in federal court. Based on the arguments on March 3, 2020, it appears that the Supreme Court is poised to restrict the SEC's ability to seek disgorgement in judicial proceedings.
In Liu v. SEC, Charles Liu and Xin Wang — business partners who operated an investment fund that solicited investments from foreign nationals by falsely promising investors that the $27 million raised through the fund would be used to develop a cancer research center in California — challenged one of the three forms of relief that the SEC sought and obtained in a judicial proceeding against them. The trial court 1) barred Liu and Wang from participating in the immigrant-investor program through which they solicited the $27 million, 2) imposed penalties equal to the amount of the $8 million personal gain that Liu and Wang received as a result of the fraud, and 3) ordered Liu and Wang to "disgorge" the remaining $19 million that they received from investors but did not personally pocket.
Liu and Wang challenged only the SEC's authority to seek, in a judicial proceeding, the third remedy, "disgorgement." Liu and Wang argued that because 1) the SEC is not explicitly authorized to seek disgorgement in a judicial proceeding and 2) the SEC's authority to seek disgorgement as an "equitable" remedy was significantly undermined by the Supreme Court's 2017 decision in Kokesh v. SEC, which held that disgorgement was a penalty rather than an equitable remedy, the $19 million disgorgement order must be overturned. Relying heavily on Kokesh, Liu and Wang contended that, without explicit statutory authorization to seek disgorgement in judicial proceedings, the SEC must rely on its authority to seek "equitable" remedies. And, according to Liu and Wang, the reasoning of Kokesh — wherein the Supreme Court recognized that the SEC has no obligation to return disgorged funds to investors and regularly retains the funds for itself — requires that the Court view the disgorgement award against Liu and Wang as punitive, rather than compensatory. As such, Liu and Wang argued, the SEC lacks authority to seek disgorgement in any judicial proceeding.
From the outset of the oral argument, justices from across the ideological spectrum spoke openly about the possibility of rejecting Liu's argument that the SEC should never be permitted to seek disgorgement as a remedy in federal court.1 Oral Argument Transcript 22:19-20 ("Justice [Elena] Kagan: Well, suppose we were to reject your broad argument . . . ."); id. at 26:5-6 ("Justice [Neil] Gorsuch . . . [W]hy can't we police it, assuming we reject your primary argument?"). The questions from the justices strongly suggest that, going forward, the Court is interested in allowing the SEC to obtain disgorgement in federal court, but only where 1) disgorgement does not exceed the "net profits" of the fraud and 2) the SEC makes all reasonable efforts to return the disgorged amounts to investors.
The justices seemed certain that, if the SEC seeks disgorgement as an equitable remedy, the disgorged amounts should be returned to investors where feasible, id. at 36:9-11 ("Justice Gorsuch: Would the government have any difficulty with a rule that the money should be returned to investors where feasible?"), but less sure about exactly what deductions should be taken into account when arriving at net profits, id. at 28:9-11 ("Justice [Stephen] Breyer: If the leases in the machinery was just a printout, only used for more fraudulent stuff, would you deduct it then?"); id. at 49:12-15 ("Justice [Ruth Bader] Ginsburg: What do you do with the Ninth Circuit saying that there were no legitimate expenses to . . . deduct, to arrive at net profit?"). Indeed, the justices wrestled with precisely where to draw the line when it comes to legitimate expenses that need not be disgorged.
If the Supreme Court ultimately decides to restrict, but still allow the SEC to seek disgorgement in judicial proceedings (which seems likely), just how broadly the Court defines the legitimate expenses that may be deducted in order to determine the amount of the net profits of the fraud (which must be disgorged) will likely determine the implications of the Court's decision. Based on the oral argument in Liu v. SEC, the range of outcomes in this and future disgorgement cases is still quite broad. For example, if the Court were to adopt Liu's theory that net profits should be limited to those that the individual defendants themselves accrued, the net profits in Liu v. SEC would be approximately $8 million (the $6.5 million paid to Liu and the $1.5 million paid to Wang). If, however, the Court were to adopt the SEC's theory that net profits should be calculated by starting with investor losses and then deducting only a few legitimate expenses incurred during the course of the fraud, the net profits in Liu v. SEC would be approximately $27 million.
Why Limiting Disgorgement in Judicial Proceedings Matters
Because the SEC has explicit statutory authority to seek disgorgement in administrative proceedings, many observers have wondered whether a decision restricting the SEC's ability to seek disgorgement in judicial proceedings will have a significant impact on SEC enforcement efforts. Such a decision likely would have a considerable effect on SEC enforcement actions because of the uncertainty currently surrounding the SEC's administrative process. The Supreme Court's 2018 decision in Lucia v. SEC, raised concerns, some of which still exist, about the legitimacy of decisions issued by the SEC's administrative law judges. In Lucia, the Supreme Court held that the SEC's administrative law judges, as "officers of the United States," must be appointed by "the President," "courts of law" or "heads of departments." Because other SEC staff, rather than the Commission itself, selected the SEC's administrative law judges, the Supreme Court held that any adjudication by those judges was invalid and that litigants subjected to the tainted proceedings were entitled to a new hearing before a properly appointed administrative law judge.
The SEC has now properly appointed its administrative law judges. However, as noted by Justice Breyer in his dissenting opinion in Lucia, the question remains as to whether the Supreme Court's decision in Lucia, classifying SEC administrative law judges as "officers of the United States," will require the Supreme Court to again invalidate all adjudications by the SEC's properly appointed administrative law judges because the SEC's removal protections for its administrative law judges violate the U.S. Constitution's separation of powers. The SEC, whose administrative law judges can only be removed for cause by members of the U.S. Merit Systems Protection Board, who themselves may only be removed for cause by the president, may have fixed its appointment problem, but may still face a removal problem under Article II of the Constitution. Indeed, the Court may ultimately hold that, although now properly appointed, given the restrictions on the president's ability to remove SEC administrative law judges, the judges are still unconstitutionally insulated from presidential control.
Challenges to the legitimacy of SEC administrative proceedings before SEC administrative law judges who are, under Lucia, "officers of the United States," but are protected from removal by two layers of protection, have already started to emerge. For example, in Cochran v. SEC, the U.S. Court of Appeals for the Fifth Circuit issued a stay of an SEC administrative proceeding pending appeal where the petitioner challenged the legality of the proceeding before an administrative law judge who was shielded from removal by multiple layers of protection.2 The Fifth Circuit has yet to issue a final decision on the merits.3 A similar challenge was made by Raymond Lucia after his case was remanded for a new administrative proceeding, this time with a properly appointed administrative law judge.4 The issue of whether the exercise of executive power by an administrative law judge who was properly appointed, but is still sheltered from removal by two layers of protection is currently pending in the U.S. Court of Appeals for the Ninth Circuit.
Because the SEC may be reluctant to pursue administrative proceedings in the face of the recent challenges to the very legitimacy of its administrative adjudicatory process, if the Supreme Court limits the SEC's ability to seek disgorgement in judicial proceedings, it may, for quite some time, and at least until the courts decide the removal issue, have a significant impact on the SEC's ability to use one of its most powerful enforcement tools.
1. The transcript of the U.S. Supreme Court oral argument
2. The U.S. District Court for the Northern District of Texas' decision rejecting Cochran's challenge to the validity of any adjudication by an SEC administrative law judge insulated from removal by multiple layers of protection can be found at 2019 WL 1359252.
3. A recording of the oral argument before the U.S. Court of Appeals for the Fifth Circuit in Cochran v. SEC
4. The U.S. District Court for the Southern District of California's decision rejecting Lucia's challenge to the validity of any adjudication by an SEC administrative law judge insulated from removal by multiple layers of protection can be found at 2019 WL 3997332.
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