A SCOTUS Win for the SEC on Disgorgement?

In a decision of consequence to securities industry participants, the U.S. Supreme Court just answered a long-unresolved question and ruled, in Liu v. Securities and Exchange Commission, that the U.S. Securities and Exchange Commission could ask courts to order disgorgement of ill-gotten gains. In doing so, the Supreme Court affirmed and at the same time, to some extent, circumscribed the SEC’s federal enforcement powers in civil proceedings.

Background

For decades, the SEC has sought disgorgement as a remedy against defendants. This issue was explored in a prior Kleinberg Kaplan client alert, “Supreme Court Limits SEC’s Recovery on Disgorgement Claims,” when the Supreme Court reviewed in Kokesh v. Securities and Exchange Commission the SEC’s disgorgement remedy that appeared to exceed certain traditional, equitable principles.

But the central issues in the just-decided Liu case were whether disgorgement is available in civil cases and whether this remedy constitutes “equitable relief” for purposes of the SEC’s authorizing statute, 15 U.S.C. § 78u(d)(5). This statute permits the SEC to seek “equitable relief” but says nothing about compensatory damages.

The Liu Facts

The defendants Charles Liu and Xin Wang – who were accused of misappropriating funds from foreign investors in connection with the EB-5 program – challenged a disgorgement order requiring them to pay out most of the funds they had raised from investors. The disgorgement order, affirmed by the Ninth Circuit, did not make any allowance for the defendants’ legitimate business expenses, to the extent there were any. For this reason and related ones, the defendants argued that the disgorgement order impermissibly awarded compensatory relief and fell outside of the SEC’s purview in a civil case to enforce the federal securities laws.

The Decision

On June 22, 2020, the Supreme Court, in an 8-1 decision authored by Justice Sotomayor, disagreed with the defendants’ argument that disgorgement relief is unavailable to the SEC in civil cases.

Although the term “disgorgement,” in this context, is of relatively recent origin, the Court looked to its substance to determine the analytical category in which it is properly placed. Reasoning that disgorgement is little different from what “[e]quity courts … routinely [do in] depriv[ing] wrongdoers of their net profits from unlawful activity,” the Court found that the remedy is properly considered a form of equitable relief that falls comfortably within the SEC’s statutory mandate. The Court concluded that “a disgorgement award that does not exceed a wrongdoer’s net profits and is awarded for victims is equitable relief permissible under [federal law].”

The Court, however, did not find the disgorgement award against Liu and Wang entirely unobjectionable. As the Court pointed out, the award deviated from historical equity practice in several respects (“[w]hile equity courts did not limit profits remedies to particular types of cases, they did circumscribe the award in multiple ways to avoid transforming it into a penalty outside their equitable powers”). In particular, it is anomalous for equitable awards not to be returned to the defendant’s victims, for such awards to be levied against “multiple wrongdoers under a joint-and-several liability theory,” and for such awards to exceed a defendant’s net profits.

In order to keep the SEC’s remedies within statutory boundaries, the Court therefore called upon the lower court to consider modifying the disgorgement award against Liu and Wang in accordance with principles it then laid down, as follows:

1. the award be tailored to “benefit [the wronged] investors”;
2. the award reflect the profits each defendant personally accrued; and
3. the court consider whether the defendants incurred legitimate business expenses that should be deducted from the award.

The Court declined to specifically apply these principles to the Liu award, so it will be left to be seen how lower courts interpret the Supreme Court’s – seemingly quite flexible – guidance.

Conclusion

The Liu decision is a partial victory for the SEC since it reaffirms its ability to obtain disgorgement orders in federal court enforcement proceedings. While disgorgement remains in the SEC’s arsenal, it would have been a significant surprise for the Court to take this remedy off the table.

But the decision, in practice, likely represents a modest victory for parties grappling with the SEC, since the decision limits the SEC’s authority to recover more than the amount of net income generated through the defendant’s unlawful conduct. Depending on how the Court’s guidance is interpreted and applied by the lower courts, the scope of disgorgement orders could be curtailed to some extent in future court proceedings, and Liu could have an impact on the SEC’s disgorgement practices going forward.