The Securities and Exchange Commission (SEC) has a long history of using disgorgement as a remedy in seeking redress against alleged wrongdoers. Disgorgement, which is the return of illicit profits to prevent unjust enrichment from misconduct, is one of the SEC's primary enforcement weapons. In a much awaited opinion issued on June 22, 2020, Liu et al. v. Securities and Exchange Commission, the Supreme Court upheld the SEC's authority to obtain disgorgement as equitable relief under 15 U.S.C. § 78u(d)(5), but with some notable limitations.
In short, the Court found in Liu that disgorgement constitutes proper equitable relief rather than an improper penalty, provided that the amount disgorged does not exceed the wrongdoer's net profits and the disgorged proceeds are awarded to investors as "equitable relief." The Court's decision is significant because it resolved the "antecedent question" reserved in Kokesh v. SEC, 581 U.S. ___ (2017), about whether the SEC has authority "in the first instance" to obtain disgorgement. Op. at 1. While the opinion places certain limitations on disgorgement, the Court could have ruled that the SEC lacked authority to obtain any disgorgement at all. Instead, the Court reaffirmed the equitable nature of the remedy and the agency's longstanding policy of denying wrongdoers "the fruits of their ill-gotten gains." Id. at 15. Below, we briefly discuss the ruling and its practical implications.
The SEC had brought a civil action against Charles Liu and Xin Wang, a married couple, charging that they had misappropriated funds solicited from foreign nationals in connection with an EB-5 Visa program. Despite representing in a private offering memorandum that the bulk of the investments would be spent on the construction of a cancer-treatment center, Liu spent nearly $20 million of investor money on marketing expenses and salaries, diverted a sizable portion of the funds to personal accounts and to a company under Wang's control, and spent only a fraction of the funds on legitimate expenditures. The district court found for the SEC and, among other things, ordered disgorgement equal to the full amount Liu and Wang had raised from investors, less $234,899 that remained in their corporate accounts. Liu and Wang appealed, arguing that the disgorgement award failed to account for their legitimate business expenses. The Ninth Circuit disagreed and affirmed the disgorgement figure.
Following a grant of certiorari on Liu and Wang's petition, the Supreme Court, by an 8 to 1 vote, vacated the judgment and remanded the case to the Ninth Circuit for further proceedings. Writing for the majority, Justice Sotomayor held that the SEC has the power to seek disgorgement pursuant to its authority under the securities statutes to obtain equitable relief. The Court noted, however, that the SEC's power to obtain disgorgement is limited in several specific ways. As part of its analysis, the Court identified two primary principles derived from equitable jurisprudence that should be applied to any disgorgement sought pursuant to 15 U.S.C. § 78u(d)(5): "First, equity practice long authorized courts to strip wrongdoers of their ill-gotten gains, with scholars and courts using various labels for the remedy. Second, to avoid transforming an equitable remedy into a punitive sanction, courts restricted the remedy to an individual wrongdoer's net profits to be awarded for victims." Id. at 6. According to the Court, "[b]y incorporating these longstanding equitable principles into [15 U.S.C. §] 78u(d)(5), Congress prohibited the SEC from seeking an equitable remedy in excess of a defendant's net profits from wrongdoing." Id. at 12.
In applying these principles, the Court considered three arguments that Liu and Wang advanced—but without fully briefing—in support of their position that the district court's disgorgement award was unlawful. First, Liu and Wang argued that the award "fails to return funds to its victims." Id. at 14. Second, they assert that the award "imposes joint and several liability." Id. Third, Liu and Wang contend that the award fails to "deduct business expenses from the award." Id. According to the Court, although the parties did not fully brief these narrower questions in addressing the broader question of the SEC's authority to award disgorgement, "[w]e nevertheless discuss principles that may guide the lower courts' assessment of these arguments on remand." Id. In proceeding this way, the Court left open important questions for future resolution.
Principles for Lower Court Consideration
The Disgorgement Award "Fails to Return Funds to its Victims"
Under 15 U.S.C. § 78u(d)(5), Congress has expressly limited the SEC's ability to seek equitable relief to what "may be appropriate or necessary for the benefit of investors." In practice, however, the SEC does not always return the entirety of recovered funds to investors. In some cases, the amount awarded is not sufficient to justify the costs of a distribution (i.e., the administrative costs of distribution exceed the amount to be distributed) or it is difficult to identify the specific investors injured by the misconduct, such as when insider trading occurs. In those cases, the Commission transmits to the U.S. Treasury funds that it cannot otherwise distribute to injured investors. Id. at 14. Whether this practice is consistent with equitable principles or the terms of the statute is a question left to the Ninth Circuit. Nonetheless, the Court indicated that the SEC's equitable remedies "must do more than simply benefit the public at large by virtue of depriving a wrongdoer of ill-gotten gains." Id. at 16. In doing so, the Court did not address the Government's argument that depositing funds with the Treasury is permissible where the distribution of an award to victims is impracticable or not feasible, going so far as to expressly decline to take a position as to whether feasibility should be a factor here. Id.
The Disgorgement Award "Imposes Joint and Several Liability"
Second, the SEC historically has required disgorgement payments from all defendants who realize ill-gotten gains, including on a joint and several basis. The Court indicated that this practice is "seemingly at odds with the common-law rule requiring individual liability for wrongful profits," but also acknowledged that the common law did permit liability for partners acting in concert. Id. at 17–18. Because there is a "wide spectrum of relationships between participants and beneficiaries of unlawful schemes—from equally culpable codefendants to more remote, unrelated tipper-tippee arrangements"—the Court declined to articulate guidance as to the specific circumstances where a disgorgement remedy would be considered impermissibly punitive as applied to multiple defendants. Accordingly, the Ninth Circuit on remand will need to determine whether Liu and Wang should be subjected to joint liability. The Court did note, however, that (1) the couple is married, (2) Liu formed business entities and solicited investments, which he misappropriated, and (3) Wang held herself out as an executive of the entity to which Liu directed misappropriated funds. Id. at 18.
The Disgorgement Award "Declines to Deduct Business Expenses From the Award"
Finally, with some exceptions in the context of heavily-negotiated, settled cases, the SEC has typically disallowed the deduction of expenses from disgorgement awards under the theory that such expenditures are made in furtherance of the illegal conduct or scheme. Significantly, the Court in Liu now holds that legitimate expenses must be deducted before awarding disgorgement under § 78u(d)(5). Id. at 19. Specifically, courts must determine "whether expenses are legitimate or whether they are merely wrongful gains 'under another name'" to ensure that disgorgement awards "fall within the limits of equity practice." Id. The Court further noted that, while there may be some schemes in which all expenditures might be appropriately characterized as fraudulent, there were expenditures in the instant case that "arguably have value independent of fueling a fraudulent scheme." Id. This, too, will need to be examined on remand. For instance, Liu and Wang made lease payments and payments toward cancer-treatment equipment. Such items might be considered legitimate expenses meriting deduction from the disgorgement figure.
While the Court's ruling in Liu was an overall victory for the SEC, it is a mixed result. The SEC and its Division of Enforcement undoubtedly are relieved that the Court upheld the legal authority to obtain disgorgement in enforcement actions. Had the Court not done so, and instead answered the question left open in Kokesh by concluding that there was no such authority, the ruling would have dealt a material blow to the SEC's enforcement program. Despite this programmatic issue being settled favorably, the SEC will need to grapple with the limitations imposed by Liu, including the requirement that only net profits can be disgorged and legitimate business expenses must be deducted. The SEC's enforcement staff will now be required to look behind the numbers and make assessments relating to such expenses and what constitutes net profits. This inquiry largely will be one of fact, and defense counsel will be able to take legitimate expenses into account when arguing for lower disgorgement dollars. Going forward, we expect that the calculation of net profits likely will be a factor in settlement negotiations as well as contested proceedings. We also expect that the full impact of the multiple limitations set forth in Liu will play out over time in future litigation and depend, in part, on how all three issues discussed above are resolved on remand.
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